Insider Trading: From Texas Gulf to Cioffi
By Christopher FailleThere is no very good intellectual case to be made for the present state of the law on “insider trading” in the United States.
I say this because I’ve been attending (too closely) to the predicament of former hedge fund manager Ralph Cioffi. Allow me to summarize that predicament briefly: Working within the Bear Stearns fold, Mr. Cioffi founded two hedge funds with absurdly long names, both of which sought to make money in the structured credit markets. In late March 2007, according to prosecutors, Mr. Cioffi transferred approximately $2 million of the money he had personally invested in one of those funds to another hedge fund. That transfer is the basis of the insider trading charge.
Please ignore the other charges against Mr. Cioffi for the moment and focus on that one. Wouldn’t a rational response to news of that transfer be: So what? After all, the transfer didn’t mean that he no longer had, as they say, skin in the game. He still had $4 million worth of skin in that particular game!
When I talk to people about such issues, one common response is: all market participants know that the prohibition on insider trading is the rule, so they ought to respect the rule. This implies that the reason ‘inside traders’ make such unsympathetic figures isn’t because the prohibition makes any sense, it’s simply because the rule exists.
But so did the old rule against going 55 miles an hour on the highway. It, too, existed. It came about as a knee jerk reaction to the first oil shock in the early 1970s and never made a lot of sense. In time, enough people questioned its wisdom so that, on much of our highway system, the rule has since changed. Drive up to 65 without fear of the patrol car! Surely if we decide that a criminally enforced ban on insider trading (understood as including such acts as Mr. Cioffi’s) doesn’t make a lot of sense either, we can and should change that one, too!
Furthermore, it is very clear when we’re going more than 55 or 65 miles per hour. Either we have a functioning speedometer or it’s easy enough to get one. It isn’t always so clear what constitutes ‘insider trading.’
Some cases of insider trading do, it is true, imply some breach of fiduciary duty. But the law already has a name for the breach of fiduciary duty. It is … “breach of fiduciary duty.” When a particular trade by an insider fits that description; it can be treated under that heading. There is no need for a separate category of thing, an “inside trade,” which only very imperfectly overlaps with that.
The prohibition came out of the collective noggin of the judges of the second circuit in the Texas Gulf case, in 1968, on the basis of nothing better than the vague idea that buyers and sellers should be equally well informed. This is a worthless idea, and although the courts have since retreated from the extreme statements of that unfortunate start to this line of precedent, they haven’t retreated nearly far enough.
A more-or-less incidental passage within Joe Nocera’s recent book, Good Guys & Bad Guys, makes a related point. It’s in a reprinting of a story Mr. Nocera wrote for GQ in December 1992, concerning Drexel Burnham and Michael Milken. [Mr. Milken was still in prison when the column was written].
For the record, Mr. Nocera occupies a ‘moderate’ position on the spectrum of reactions to Mr. Milken: he argues that the infamous financier was guilty of some crimes, but not of the worst of those of which he has been accused, and that his sentence was excessive. But what intrigues me about this article is one incidental comment about an unnamed subordinate of Mr. Milken: “”When a Drexel salesman heard that the corporate-finance department was buying a stock – for what reason he didn’t know – and then advised a client wanting to sell that same stock that he might be better holding on to it, was that an example of insider trading? Or was it something more innocent?”
Good question. Indeed, it’s a better question than Mr. Nocera (who soon drops the query) may understand. Because there is nothing extraordinary about such an instance, and because if there is no good answer to that question, then the courts and prosecutors who punish insider trading are in effect telling traders, brokers, bond salesmen, etc. that they have to drive 55 miles per hour or below – and that they can’t use a speedometer, because none are available.
That’s wrong.
Personally, when I use the phrase “free markets,” I don’t mean the word “free” as an adjective. I mean it as a verb. Let’s free markets.
September 8th, 2008 at 6:16 am
You validate your argument with one dismissive comment, “This is a worthless idea” I am not an academic but markets rely on trust and integrity to function. Markets fuel the economy by facilitating corporate funding. If the market is corrupted by a proportion of the population having knowledge that is not available to the public domain then the market is no longer free in any sense. If I collude with others to talk up a stock by lying about orders and profit forecasts before selling my holdings that is fraud perpetrated by insider trading–two people based in the UK discovered a time lag in a betting operation in China where they could place a bet with full knowledge of the outcome, clever to exploit the technology but still dishonest. Without trust, honesty and integrity, everything fails. We all know what we are doing, if we act differently because we have access to real facts that are not available to others whose actions may be affected by the way we act then in my terms that amounts to insider trading.
December 28th, 2009 at 7:44 am
The author brings up a valid point. In my experience government prosecutors( CID etc) only go after insider traders who are well known so that they can get promoted. The increase in pay lets these gov’t workers bend the insider trading violation too their narrower interpretation such as in the case of Martha Stewart whom even though I don’t know her might not have fully understand the governments interpretation of “INSIDER TRADING’.
December 1st, 2010 at 9:31 am
Yes, I’m slow to reply to both of you gentlemen. Recent headlines have made it sensible to revisit the issue. So here goes.
Mr Matthews, I think the example you cite is inapplicable. You say that if you were to collude with others “to talk up a stock by lying about orders and profit forecasts before selling” your holdings then that would be prohibited as insider trading.
It certainly would be prohibited. And rightly so. But it wouldn’t be insider trading. You don’t have to be an insider to pump-and-dump, just a good liar. Even if you happened to be an insider of the issuer involved in your pump-and-dump scheme, that fact would be irrelevant to the scheme as you’ve described it.
Dr. Bernstein,
I appreciate your observation. Thanks.