Insider Trading and the Scienter Requirement

On its face, the connection between insider trading regulation and the state of mind of the trader or tipper seems fairly intuitive. Insider trading is a form of market abuse: taking advantage of a material, non-public secret to which one is not entitled, generally in breach of some kind of fiduciary-like duty. It is an exploitation of status or access, typically coupled with some form of faithlessness. Certainly the extraordinary public attention that insider trading enforcement and prosecutions command reflects the idea that the essence of unlawful insider trading is cheating. These prosecutions are main-stage morality plays, with greed as the story line. The SEC in particular seems to sense that it garners public political support by casting itself in the role of tormentor of the greedy.

If this is right, then what the legal system should be looking to proscribe is deliberate exploitation—trading on the basis of information in order to gain an unfair, unlawful advantage over others in the marketplace. That involves a fairly tight causal connection between knowledge of the information and the decision to buy or sell.

My paper, What Were They Thinking? Insider Trading and the Scienter Requirement, which will appear is a chapter in the forthcoming Research Handbook on Insider Trading (S. Bainbridge, ed., Edward Elgar Pub.), examines both the law and the psychology associated with this pursuit. The U.S. law of insider trading is actually much more conflicted and confusing as to the necessary state of mind for either trading or tipping. Mostly, this is a product of conceptual confusion in how we define unlawful insider trading—the quixotic effort to build a coherent theory of insider trading by reference to the law of fraud, rather than a more expansive market abuse standard. It is familiar enough that the courts (at the SEC’s urging) have taken dominion of the law of insider trading by deeming it a species of fraud. That is intellectually awkward because there is relatively little about unlawful insider trading that can fairly be considered deceptive, yet deception is the essence of fraud. The result is a crazy-quilt of made-up doctrinal innovations to declare abusive trading fraudulent, either vis-à-vis other marketplace traders (the affirmative duty to disclose when there is a pre-existing duty of trust) or the source of the information (misappropriation by feigning loyalty to the entrustor). Another layer of complication ensues when the subject of the prosecution didn’t trade but instead gave the information to someone else, so that we have to ask why this communication occurred. Given this patchwork, it actually becomes very difficult to describe the legally required state of mind for insider trading prosecutions.

But there is also an interesting psychological question. What actually is going through the mind of the alleged trader or tipper? Is it always simple greed? Or can there be an element of unconscious perception—or rationalization—at work. Given the complexity and occasional arbitrariness of the law, what role might this indeterminacy play in trading decisions? My sense is that the motivations and causal explanations for what is charged as insider trading are often quite murky and not easily explained by pure greed. The poster example for the “what were they thinking” question is Martha Stewart, an extraordinarily savvy and successful businesswoman who went to jail for a cover-up after being accused of selling stock to avoid a loss of less than $50,000, a tiny fraction of her net wealth. My chapter tries to connect the law of insider trading to a more sophisticated approach to state of mind, motivation and causation.

The full paper is available here.