19 November 2003

As lawyers, we can manage to really get hung up on minutiae. Today, Professor Bainbridge blawgs on whether insider trading rules should be waivable. There are a couple of much simpler reasons than the perfectly valid one that he mentions that they should be mandatory. (Yes, this does have something to do with authors' and other content creators' rights, as perhaps we'll see a few posts down the road.)

  • Although the "fraud on the market" theory is not beloved of corporation law scholars, and most especially not of the securities-defense bar, this is actually a paradigmatic instance of such a fraud. Under the efficient market hypothesis that underlies our securities laws, the markets discount all known information into the price of a security over some relatively short time (it is greater than zero, but presumably smaller than a breadbasket). Allowing trades based on information that the market cannot discount because it is not known to the market inherently means that transactions will occur at other than market prices. Not only is this a subtraction of necessary information from the market, but ironically it adds new distorting information: the insider trades themselves are information that, under the efficient market hypothesis, will influence the price of a security once they become known. And they will become known at some point, absent tax fraud.
  • Professor Bainbridge's scenario asks (and ultimately denies) whether insider trading rules could be waived by both the securities issuer and the prospective insider trader. Of course, this artificially ignores the effects of such a transaction on two other parties. First, there is the market itself, and more particularly the market-maker in the securities. A trade at an unfair value may harm a market-maker's commissions, ability to maintain an orderly market in that security, and ability to balance exposure to various securities. More importantly, however, a "trade" implies that there is somebody else involved. Professor Bainbridge's model posits that the "insider trade" is the sale of a closely held security from the issuer to the insider. Eventually, however, those securities will be sold to a third, non-insider party. If the insider is engaging in arbitrage—buying a $20 stock for $15, on the knowledge that earnings will not meet expectations, then immediately selling the stock or a derivative instrument at the $20 market price, making a quick 33% profit—it's pretty obvious that the "ignorant" party on the other side of the unwinding of the arbitrage has been harmed. Since that harm was without knowledge, it's rather silly to assume that the parties with knowledge can, between themselves, waive that third party's rights.