Insider Trading Flaw: Toward a Fraud-on-The-Market Theory and Beyond

Kenneth R. Davis is Professor of Law and Ethics at Fordham University Gabelli School of Business. This post is based on a recent article by Professor Davis. Related research from the Program on Corporate Governance includes Rethinking Basic by Lucian Bebchuk and Allen Ferrell, discussed on the Forum here.

Since its inception, insider trading law has perplexed the legal community. Scholars have criticized the law for its lack of clarity and over-complexity. Such criticisms are understandable. Insider trading law is a dysfunctional hodge-podge of rules that make little intuitive sense. The problem arises in part because no U.S. statute defines insider trading. Nor does any federal statute specifically prohibit it. Rather, the United States Supreme Court, with minimal congressional guidance, has seized on the general antifraud provision in the Securities Exchange Act of 1934 to construct an incoherent legal regime. Section 10(b) of the Exchange Act makes it unlawful to use “any manipulative or deceptive device” “in connection with the purchase or sale of a security.” The Supreme Court has used this injunction as the starting point to fabricate a confusing brand of insider trading law.

The fundamental problem is that the Supreme Court has defined “a manipulative or deceptive device” as a breach of fiduciary duty or confidentiality to the source of the inside information. A breach of such a duty, however, has little, if anything, to do with what one would consider wrongful trading on material, nonpublic information. If, for example, someone overhears Mark Zuckerberg tell a colleague that Facebook will soon announce blowout earnings, the eavesdropper may trade on that nonpublic, material information with impunity. A more egregious case arises when a thief steals corporate inside information and trades on it. Because it is unclear whether the thief, an outsider with no link to the corporation, has breached a fiduciary duty to the corporation or even had such a duty, it is unsettled whether the thief has violated section 10(b). In such cases, the trade is a wrong distinct from the breach of a fiduciary duty or confidentiality to the source. Furthermore, the source of the information sustained no loss from the trade. Nevertheless, insider trading has a victim: the trade causes financial loss to the counterparty. Rather than focusing on a breach of duty to the source of the information, the law should focus on the breach of duty, established in In re Cady, Roberts & Co., to publicly disclose material, nonpublic information. Meeting this duty would make the inside information available to everyone. Breaching this duty would injure the counterparty to the trade.

Another fault of insider trading law is that in a tipper/tippee scenario liability arises only when the original tipper received a benefit from the original tippee. This requirement, which the Supreme Court adopted in Dirks v. SEC, is extraneous to the wrong insider trading law seeks to redress. When a tippee knowingly trades on material, nonpublic information, liability should not depend on whether the tipper received a benefit. If a corporate director intentionally provides inside information to another expecting that person to trade, and if that person does trade on the inside information, liability should not depend on the tipper’s motive or whether the tipper received a payment or a reputational boost.

A promising approach to resolve these contradictions is to apply fraud-on-the market theory to insider trading. The application of this theory would be based on the Cady, Roberts duty to publicly disclose inside information. This theory would hold that someone breaching the Cady, Roberts duty employs a “manipulative or deceptive device” violating section 10(b). By failing to disclose the inside information publicly and thereby breaching the Cady, Roberts duty, the trader commits a fraud on the market. The counterparty to a trade based on inside information is a victim of that fraud because, like all traders of securities, the counterparty relies on the premise that market prices reflect all relevant available information. Benefiting from conceptual clarity, this approach would eliminate the senseless requirements that the Supreme Court has engrafted onto its version of section 10(b) insider trading law.

A fraud-on-the-market approach to insider trading has a limitation. It would apply only to markets such as the New York Stock Exchange or the NASDAQ. Such markets are presumptively efficient at disseminating information. The efficient dissemination of information would affect the market price of the security in question, and the nondisclosure of such information would therefore constitute a fraud on the market. This drawback, however, is minor because most insider trading cases involve trades on efficient markets.

Adopting a fraud-on-the-market approach grounded on the Cady, Roberts duty to disclose would conform insider trading law to a the common sense idea that, excepting the results of bona fide market research, the law should prohibit intentionally trading on material, nonpublic information. Though it might well be preferable for Congress to enact a law specifically prohibiting insider trading, a fraud-on-the-market approach would vastly improve the law within the existing framework of section 10(b).

The full article is available for download here.

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