Insider Trading and the Integrity of Mandatory Disclosure

James J. Park is Professor of Law at UCLA School of Law. This post is based on his recent article, forthcoming in the Wisconsin Law Review. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation by Jesse Fried (discussed on the Forum here).

For decades, two theories have shaped insider trading regulation. The first argues that insider trading should be prohibited because unequal access to information corrupts the integrity of markets. The second views trading on inside information as misappropriating property belonging to the corporation. Neither approach is entirely satisfying. The market integrity theory does not address the reality that there will always be significant disparities in the ability and willingness of investors to access and analyze information. The property rights theory downplays the harm of insider trading by arguing that the corporation is the main victim of the offense. Despite their limitations, the Supreme Court cited both theories in one of its last major insider trading decisions, United States v. O’Hagan.

The dominance of the market integrity and property rights theories obscures an important reason to regulate insider trading—it can undermine the integrity of the disclosure mandated of public companies by the securities laws. Federal insider trading regulation is on its firmest footing when it addresses insider trading on mandatory disclosure information. As federal regulation of mandatory disclosure has increased, the case for preventing insider trading on such disclosure has grown stronger.

This Article examines the argument that insider trading is inconsistent with a system of mandatory disclosure. It shows that even when mandatory disclosure is not continuous, there is a strong case for regulating trading on information that public corporations must compile to comply with disclosure mandates. Permitting such trading would undermine the integrity of the mandatory disclosure system by giving favored investors advance access to information that is meant to benefit all investors. Unlike prior efforts, this Article acknowledges that some selective disclosure is necessary for companies to communicate effectively with investors.

The formative debates about insider trading regulation happened at a time when public companies had fewer mandatory disclosure obligations than they do today. In 1968, the SEC only required public companies to file an extensive disclosure once a year. The New York Stock Exchange mandated quarterly disclosure but the quality of the disclosure was not uniform. Professor Henry Manne thus argued that insider trading was necessary to convey information to the market because of the ineffectiveness of SEC disclosure. The SEC and courts based their initial regulation of insider trading through SEC Rule 10b-5 (Rule 10b-5) on the ambitious principle that investors must have equal access to information in order for markets to have integrity.

While the Supreme Court eventually limited Rule 10b-5 insider trading liability to individuals with duties to keep information confidential, Congress and the SEC have steadily increased the disclosure obligations of public companies. The primary purpose of such mandatory disclosure is to provide equal access to the company’s most important information. Companies not only must file quarterly reports, markets focus intently on whether a company’s results meet projections of its performance. Two statutes passed after public company scandals, the Foreign Corrupt Practices Act (FCPA) and the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley), require public corporations to invest substantial resources in verifying the accuracy of their disclosures.

Insider trading on the information contained in mandatory reports is fundamentally inconsistent with the purpose of mandatory disclosure. Permitting advance knowledge and trading on a company’s quarterly earnings reports would mean that insiders could personally profit from information that is produced for the benefit of all investors. Moreover, insider trading is particularly problematic in a system of periodic disclosure. The delay inherent in a periodic disclosure system creates opportunities for insider trading because the most valuable information is compiled and released at once. Insiders should not be able to exploit delay that is meant to allow verification of company information for their own personal profit.

Because U.S. securities law has chosen a policy of mandatory periodic disclosure, there is a need to incentivize public companies to disclose additional information to investors. In addition to needing updates between quarterly reports, it is helpful for markets to receive information through formats other than written disclosures or press releases. Companies have thus long voluntarily disclosed information selectively in conversations with investors and research analysts. The SEC has been suspicious of selective disclosure and attempted to regulate it with limited success through Regulation FD. On the other hand, a panel of the Second Circuit, in U.S. v. Newman, expressed concern that an insider trading prohibition that reached too broadly would undermine the way in which corporate information is disseminated to the market.

In contrast to mandatory disclosure information, where there should be equal access, there is a case that information that is not subject to disclosure mandates should be governed by a property rights regime that allows for selective dissemination. The difficult question is whether there is a principled way to distinguish between information that must be disclosed to all investors and information that can be disclosed to a few. While it is clear that simply handing over a copy of a company’s quarterly earnings would undermine the integrity of mandatory disclosure, selective disclosure is usually subtler. Rather than divulging the precise contents of an earnings filing, the tipper will more often give hints that allow a savvy trader to predict its contents. Even without divulging quarterly results, such trading is inconsistent with the policy of equal access to SEC disclosure.

Selective disclosure is less problematic when it conveys information relating to the company’s long-term strategy and prospects that is not effectively described by mandatory disclosure. The nuances of a company’s strategy and character of the management that will lead the company are difficult to meaningfully describe within the limited confines of a dry disclosure document. Conversations with management about the business, tours of a new factory, a demonstration of a new product, are examples of disclosure that are better released selectively to those investors willing to make an investment of time to learn about a company. When selective disclosure supplements rather than duplicates mandatory disclosure, it is less likely to conflict with the goals of mandatory disclosure.

The need to maintain the integrity of mandatory disclosure provides a better foundation for the prohibition of insider trading than either the market integrity or property rights approaches. Rather than attempt to achieve an unrealistic parity between investors, a disclosure theory would focus insider trading regulation on information that must be disclosed pursuant to the securities laws. The property rights approach has some appeal with respect to certain types of voluntary disclosure, but it is not a good fit for disclosure that must be compiled, verified, and produced pursuant to a government mandate. Moreover, the disclosure theory provides answers to a number of puzzles such as why insider trading is prohibited in securities markets but not commodities markets.

The complete article is available here.

Both comments and trackbacks are currently closed.