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Wanted for Outsider Trading

August 23, 2002

Those who lost their laptops buying overpriced stocks are looking for scapegoats. The self-made delusionaires are hunting for self-made millionaires. They are no better at picking the villains of the stock market bubble burst than they were at picking stocks.

Accordingly, one of our most productive citizens is being targeted for destruction by our most unproductive entity, the federal government, whose principals are always whoring after the votes of the depraved. So I decided to find out what Martha Stewart's legal exposure was.

Or so I thought. After all, I am a lawyer and litigator who studied securities law in school, and I am pretty good at computer research. Nevertheless, it took me many hours to reach a conclusion, only to find that I had been overruled by the Supreme Court. The nerve. To understand the law of insider trading, you have to be a real insider. Yet, ignorance of the law is no excuse (unless you are a judge).

Stewart allegedly sold about 4,000 shares of ImClone stock based on insider information from Chairman Samuel Waksal that the FDA was about to reject its application to market a new anti-carcinogen drug Erbitux. Stewart entirely denies the charges and states that the shares were sold pursuant to pre-existing instructions. Waksal has since been indicted for insider trading for tipping off family members, but not Stewart, about the imminent FDA action.

The United States Code legalizes naturally criminal behavior by the state and its agents while criminalizing naturally lawful behavior by citizens. Nevertheless, the federales' army can take Stewart’s bodyguards, so I repaired to the United States Code, that inscrutable and unscrupulous repository of numerous victimless (nonexistent) crime laws.

Using secondary sources, I quickly found the relevant statute, though it might take a non-lawyer hours to do the same. The law, 15 U. S. C. Section 78j, is entitled "Manipulative and deceptive devices" and is part of a chapter entitled "Securities Exchanges."  It states:

"It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange – . . . (b) To use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors."

That's it. That’s your insider trading statute. That's why they're hunting Martha, Inc. When I read that statute, I knew it was going to be a long night. As Justice Clarence Thomas asked, "that's rather unusual, for a criminal statute to be that open-ended, isn’t it?" As Thomas implied, I saw that Congress had improperly delegated its constitutionally based lawmaking powers to another agency, the Securities and Exchange Commission (SEC). Is the SEC part of the executive, legislative, or judicial branch of government? Let's let it speak for itself. The SEC describes its functions as follows (my comments are in parentheses):

  • interpret federal securities laws (judicial)          
  • amend existing rules (legislative)          
  • propose new rules to address changing market conditions (legislative);          
  • enforce rules and laws (executive). 
  • Thus, the SEC combines legislative, executive, and judicial power, precisely the result the framers of the Constitution sought to avoid because of a minor problem called tyranny. FDR was not about to let the Constitution get in the way of a progressive state that would micromanage the affairs of the pathetically stupid people (stupid enough to vote for FDR four times). The SEC would be run by five commissioners, who would be appointed by the president, who was elected by the same stupid people the SEC is to protect from bamboozlers.  

    The Supreme Court has refused to destroy the SEC and other bureaucracies on the grounds of improper delegation of powers, oblivious to whether the Constitution is destroyed in the process. See, e.g., American Light & Power Co. v. SEC329 U.S. 90 (1946). As my wily law Professor Henry Mark Holzer told his administrative law classes: "Agencies do agency business." I wish I could remember who defined a federal judge as "a lawyer whose best friend was a senator."

    Off I go to the SEC website to read its interpretation of the statute that could land Martha in jail. Sorry, no regs there. No matter. I find them elsewhere on the Web. Rule 10b-5 states:

    "It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security."

    Rule 10b5-1, enacted in 2000 and entitled "Trading on the Basis of' Material Nonpublic Information in Insider Trading Cases," purports to define insider trading. It uses 751 words to do so. The basic definition is buying or selling securities "on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information." The regulation defines "on the basis of" as including all instances in which "the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale."

    One wonders why the drafters didn’t simply use "awareness" rather than "on the basis of" as part of the original definition. This is one of many wonders in the wonderful world of insider trading law. This stipulation certainly makes the law much harsher and leads immediately to absurd consequences. For example, if a corporate executive buys his own stock in the face of nonpublic bad news about his company, he is guilty of insider trading.  

    Likewise, if one who sells in the face of nonpublic good news that will likely increase the price later, he is guilty as charged. A law that punishes the exact opposite of the behavior it is designed to deter is a stupid law. Or perhaps it is a smart law that gives the federal government tremendous power over a competing class: business executives. No wonder these guys are generally gutless supporters of the statist quo. They are terrified because they know that, given the bewildering complexity of federal laws affecting business, a federal raid on their offices, even if its initial impetus turns out to be bogus, is likely to eventually turn up evidence of some crime they never heard of and wouldn’t understand if they had.

    But wait; there is hope. The regulations provide various affirmative defenses. An affirmative defense is a means for getting off the hook if one can prove the elements of the defense. This shifts the burden of proof to the accused, however--a rather important factor in a criminal case. The regulations provide for an affirmative defense that the sale was pursuant to a contract, instruction, or plan to sell made prior to becoming aware of the information. You have to prove that this was done in good faith and not to evade insider trading restrictions.  

    Good luck. Corporations can escape liability for insider trading if they prove that the trader did not know the inside information, even if others at the corporation did, and that the corporation

    "had implemented reasonable policies and procedures, taking into consideration the nature of the person's business, to ensure that individuals making investment decisions would not violate the laws prohibiting trading on the basis of material nonpublic information. These policies and procedures may include those that restrict any purchase, sale, and causing any purchase or sale of any security as to which the person has material nonpublic information, or those that prevent such individuals from becoming aware of such information."

    Is all that clear? It isn’t to me. The whole definition begs the question. Insider trading is trading with nonpublic information "in breach of a duty of trust or confidence that is owed . . . to the issuer of that security or the shareholders. . . " Since all language in a statute is presumed to mean something, it is apparent that not all trading with nonpublic information is banned, only that which breaches a duty of trust or confidence. Sadly, that critical element is not defined.  

    The good news for Martha, however, is that by no stretch of the imagination does she, an outsider, owe a duty of trust or confidence to the corporation or its shareholders. She is not an officer or director or employee of the corporation. Martha, you’re off the hook. No charge; it's on me.

    Not so fast, though. Congress created a blank slate of securities law to be filled in by the SEC; in turn, the courts have rescued the SEC's opaque definition with their own flights of fancy. The courts invented the so-called "misappropriation theory" of insider trading.  

    In 1983, the Supreme Court, in a case involving a tip from a corporate insider to an outsider, while reversing sanctions against a broker, stated that:

    "[A] tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information . . . when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach." Dirks v. SEC, 463 U.S. 646 (1983).

    The misappropriation theory was formally adopted by the Supreme Court in United States v. O’Hagan , 117 S. Ct. 2199 (1997). This is an interesting line of reasoning and one which a legislature might well ponder while considering legislation. However, it has no basis in the statute or the regulation interpreting that statute (10b-5). It is not an interpretation of anything. It is a statement of a new, judicially created crime of outsider trading that has ruined lives and will do so again soon.  

    In addition to being without any statutory basis, the judicially created crime of outsider trading has numerous problems. Under the theory, it is improper for outsiders to use the information to buy or sell stocks, but it is not improper to release the information to the entire world--even though, in the case of bad news, the latter option (legal) will damage the existing shareholders more than the former (illegal).  

    Also, how did anyone know in advance of the court decisions which created the rule that receiving a tip was illegal? How does anyone know in advance how the newer Rule 10b5-1 will be reconciled with the older Dix and O’Hagan cases? You may sit in jail for years, just as others have, while the lawyers and judges fight over definitions. How does the prosecutor prove that the tippee knew the tipper had breached a fiduciary duty? Even lawyers who don’t deal with trusts and estates may err on this point. How is a layman to know? Yet, he had better know or he may be prosecuted.   There is solace, however. While you are rotting in your jail cell, at least you will have the satisfaction of knowing you have committed no crime.

    If there is any need for the law to concern itself with the issue of insider trading, that concern would be best expressed in the form of a common-law civil suit for breach of a fiduciary obligation brought by a shareholder against a corporate insider. The advantage of this route would be that the plaintiff would have to prove actual damages.  

    Such is not the case in today’s statutory regime, where only certain actual damages are incurred by the targets of the law. For example, in the case of ImClone, a shareholder of ImClone would have to prove not only that Waksal breached a fiduciary duty by not disclosing his alleged advance knowledge of the FDA decision, but that the shareholders were harmed by his failure to disclose. Query: if Waksal had announced this information publicly, who would have been willing to buy the stock of these shareholders? How would they have been better off?

    Better yet, why not rely on private regulation and competition to resolve the “problem” of insider trading? We are told that investors do not want to invest in corporations that engage in insider trading. Fine. Corporations that wish to maintain a healthy stock price and raise capital will announce and enforce strict policies against insider trading. Such companies will tend to raise more capital than companies that tolerate the practice. If insider trading truly has a harmful impact on companies and their stock prices, the companies that ban it will tend to drive the companies that do not ban it, out of business.  

    Actually, this private regulatory approach can work hand-in-hand with the common-law suit proposal. Companies that ban insider trading as a matter of policy will stipulate that stockholders may sue corporate officials who violate this policy. Investors will tend to invest in those companies that offer this legal protection. Private arbitration, cheaper and faster than the courts, is also a viable option.

    Martha Stewart would be unlikely to face common-law liability, since she had no fiduciary duty to anyone at ImClone, to any ImClone stockholder, or to anyone who bought ImClone stock prior to the public announcement of the FDA decision. Nor, apparently, did she cause any harm to any ImClone stockholder. (The same cannot be said for the FDA.  See, James Ostrowski, "The Most Lethal Agency,'' Free Market, 12/91.)     

    On the other hand, if a complete ban on insider trading is not the panacea we are led to believe it is, then companies with a more relaxed attitude about it might well be more successful and attract more capital and make more money for their shareholders.  In the political market, a judge is often a lawyer whose best friend is a senator. In the free market, you can be the judge.


    James Ostrowski practices law in Buffalo, N.Y. See his Mises.org Articles Archive and send him MAIL.


    Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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