Insider Trading as Private Corruption

Fighting insider trading is clearly at the top of law enforcement’s agenda. In May 2011, Raj Rajaratnam, the former head of the Galleon Group hedge fund, received an eleven-year prison sentence for insider trading, the longest ever imposed. More recently, in July 2013, SAC Capital Advisors, a $15 billion hedge fund, was slapped with a criminal complaint that threatens the fund’s existence, even after having agreed to pay a $616 million civil penalty, the largest-ever settlement of an insider trading action. Yet, despite the high enforcement priority and the high stakes involved, a satisfying theory of insider trading law has yet to emerge. And this is not for want of trying. As Larry Mitchell remarked as early as 1988, “Many forests have been destroyed in the quest to understand and explain the law of insider trading.”

In my forthcoming article, Insider Trading as Private Corruption, to be published next year in the UCLA Law Review, I make the case that insider trading is best understood as a form of private corruption. I begin by arguing that we need a theory of insider trading law that not only makes sense of the law that has developed but also guides the law forward. In my view, such a theory must do two things.

First, it should respect at least the core features of the received doctrine—in particular, the broad outlines of what qualifies as an insider trading violation as set out by key Supreme Court cases, including the controversial element of the “breach of fiduciary duty.” This requirement of decent doctrinal “fit” is grounded in the view that only such a theory can have any chance at real-world relevance for judges who are constrained by precedent and institutional role. A good theory should be able to rationalize what courts have been implicitly groping towards and bring coherence to what might otherwise appear to be increasingly disordered opinions.

Second, the theory must also be normatively plausible, i.e., it must help make the normative case of why insider trading should be banned in the first place. Since Henry Manne first launched his influential criticism of the insider trading prohibition in 1966, there has been a steady stream of like-minded critics of the ban. They have decried the ban as “puerile” and have argued that insider trading is not harmful—indeed, it may even be beneficial to the securities markets. Hence, a good theory should at least answer those critics with a normatively plausible justification of the insider trading prohibition. Moreover, a theory that is normatively untenable cannot have the persuasive force to carry judicial opinions.

My theory of insider trading as private corruption satisfies both requirements. Acknowledging that corruption is most commonly understood in public sector terms, I begin with the standard definition of public corruption, which is the use of public office for private gain. This definition is then transposed into the private context by making two key substitutions. First, “public office” is replaced with “entrusted position,” a term that encompasses private sector roles in which the individual is expected to act loyally in the context of trust. Second, “private gain” is replaced with “self-regarding gain,” defined as “supererogatory gain to the individual or her relatives, friends, or acquaintances.” By making these substitutions, the admittedly vague notion of private corruption is operationalized into a more specific, analytic definition—the use of an entrusted position for self-regarding gain. To complete the basic analysis, I show that a paradigmatic case of insider trading—SEC v. Texas Gulf Sulphur­—falls under the definition of private corruption.

But what about normative plausibility? Does understanding insider trading as a form of private corruption help justify the insider trading ban in the first place? I argue that the corruption theory does so by helping us appreciate that insider trading inflicts the same types of costs seen in the public corruption context—which I call “temptation,” “distraction,” and “legitimacy” costs. By taking stock of these three types of costs, we can better respond to those who quarrel with the very idea of banning insider trading.

To be sure, the corruption theory is not the first theory proposed to explain insider trading law. Almost three decades ago, courts and commentators began analyzing insider trading through the constructs of “property” and “unjust enrichment.” “Property theory” conceptualizes inside information as corporate property. Trading on inside information is thus like pilfering property belonging to the firm. Although this framing is comprehensible, internally coherent, and connects to a rich literature on information as property, it has an obvious deficiency. Even if attractive in the abstract, it has insufficient descriptive power. To highlight one example, a central feature of property is alienability. Yet, under settled insider trading doctrine, a corporation cannot authorize its employees to trade and profit on material, nonpublic information about itself. In sum, I conclude that the property theory diverges too much from the relevant Supreme Court jurisprudence to say that it describes the law of insider trading that we have.

The other serious contender is the “unjust enrichment theory,” which suggests that insider trading amounts to an unjust enrichment of the defendant whose profits should be disgorged. By shifting focus from the alleged victim’s loss to the wrongdoer’s ill-gotten gain, unjust enrichment theory ably responds to commentators who see insider trading as causing no harm. But upon close appraisal, this theory not only begs the fundamental question of what counts as “unjust” but also departs materially from the received doctrine. I conclude that neither of the two contender theories adequately describes and explains federal insider trading law.

By contrast, the corruption theory does a better job of fitting and explaining the core features of the received doctrine. Importantly, it provides a satisfying account of why decades ago the Supreme Court originally mandated the breach of fiduciary duty for an insider trading violation and has since maintained that requirement. The doctrinal fit of the corruption theory is not perfect, however. But, as explained in the article, the sites where the corruption theory diverges from the received doctrine constitute areas ripe for doctrinal reform. As the analysis shows, viewing insider trading as private corruption reconnects the doctrinal dots in a novel and intuitive way and reveals an implicit order that was previously submerged. Finally, the corruption theory provides relatively concrete guidance in hard cases going forward—such as SEC v. Cuban, which is currently being tried in a federal district court in Texas. The guidance afforded by the corruption theory is precisely what the courts and the SEC need.

The full article is available for download here.