Should Insider Trading be Legal?: A Look at the Question after Salman v. United States

Tuesday, October 17th, 2017 at 8:23 pm, by Caelainn Carney

Though insider trading has been illegal for decades now and has been firmly placed on the wrong side of the law, there has been a healthy academic debate about whether the practice should be legalized.  Scholars debate how insider trading affects market efficiency and if has any ill-effects in the long run.  Despite many arguments against insider trading being penalized, the Supreme Court in Salman v. U.S. took a more expansive view of what counted as insider trading and thus kept actions in that arena as illegal.

Statutory Definition of Insider Trading

Under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, promulgated by the SEC, insider trading is prohibited.  Section 10(b) is the anti-fraud provision of the 34 Act pursuant to which the SEC has rulemaking authority. Section 10(b) proscribes the use of a “manipulative or deceptive device” in buying or selling a security.  10(b) also grants the SEC rulemaking authority to protect “the public interest in protection of investors” in connection with the proscribed acts. 10b-5 is the rule that the SEC created pursuant to that authority.  In connection with insider trading, 10b-5 makes it unlawful “to employ any device, scheme, or artifice to defraud…in connection of the purchase or sale of any security”.

There are two theories of insider trading: the classical theory and the misappropriation theory.  In the classical form, a corporate insider trades in the securities of that corporation, hurting the trust of shareholders.  In the misappropriation form, an outsider misappropriates corporate nonpublic information in a breach of trust to the source of the information. The recognition of the misappropriation theory by the Supreme Court in 1997 broadened the scope of liability under section 10(b).

Arguments For and Against Insider Trading Liability

One main argument in favor of legalizing insider trading is that it promotes market efficiency.  The idea is that it levels the playing field for investors by getting information to the market faster.  “As long as market professionals track insider buying and selling, and respond immediately, stock prices will respond immediately.” In addition, the allowance of insider trading will attract talented management to work for corporations; the ability to trade on nonpublic information will be another form of compensation for them.  Some in favor of insider trading argue that in the long run, there will always be winners and losers in the market place when new developments take place.  All that legalizing insider trading would do would be to speed up that process. It is key to note, though, that for these arguments to be valid, it is necessary to assume that markets are able to assimilate the inside information into price quickly.

There are also arguments that insider trading should remain illegal.  Chief among the concerns about insider trading is that it destroys investor confidence in the marketplace.  Investors may feel alienated and may even go so far as to refuse to invest in the market, which on a large scale could be disastrous for the  .  There are also concerns that corporate insiders or outsiders in a position of trust could exploit material nonpublic information for their trading advantage.  It also stands to reason that if markets are not efficient and cannot quickly incorporate inside information into price, insider traders would have a sustained advantage in the marketplace.

Salman v. U.S.

In December 2016 the Supreme Court issued a decision in Salman v. U.S. that found that a tipper’s receipt of a personal benefit in exchange for furnishing insider information to a tippee would be recognized when the tipper gave the information as a gift to a trading relative. In Salman, a corporate insider gave material nonpublic information to his brother.  The brother then shared that information with a friend of his who was also the insider’s brother-in-law. To come to their decision, the Supreme Court decided to follow the Ninth Circuit’s rationale rather than the Second Circuit’s.  In United States v. Newman, the Second Circuit said that a personal benefit to the tipper must be of a “pecuniary or similarly valuable nature.”  The Supreme Court’s decision in Salman broadened the basis for liability for insider trading.

Conclusion

What is particularly notable is that the Circuit Split between the Ninth and the Second Circuits presented the Supreme Court with two concrete avenues for how to treat insider trading.  Though neither avenue pushed toward totally legalizing insider trading, one avenue definitely cabined liability while the other broadened it.  The arguments that allowing insider trading would get information to the market more quickly and improve market efficiency seemingly have not gotten traction beyond theoretical pieces.  Whether or not there is truth to the arguments behind legalizing insider trading, legalizing the practice would now require the courts to starkly reverse course to make that a reality.

The Supreme Court’s explanation of the personal benefit rule and the law surrounding it makes a compelling case for keeping insider trading illegal.  The decision in Salman recognizes that for insider trading to occur, someone must divulge information when they are under a duty of “trust and confidence.” It naturally follows that in order to make sharing that information worthwhile there must be an advantage to trading on information the rest of the public does not have.  The mere fact that insiders are under such a duty weighs toward keeping insider trading illegal: it makes the whole transaction less than proper.  Further, even in an efficient market where the inside information would integrate into the price of the security very quickly, it is logical to assume insiders still would get to make the first trade, giving them an advantage.  Salman’s broad conception of what counts as a benefit suggests a distaste for using inside information when in a position of trust.  If for no other reason than wanting to give incentives to insiders to act in a trustworthy manner, insider trading should remain illegal.