The insider trading scandal began with shock and awe. Each week brought a raft of indictments. Well-stationed members of society were exposed as frauds and criminals. With insider trading its most visible focus, the legal violence against the finance industry continues. And like so many TV-addled teenagers, the public may now have lost the ability to respond.
An apathetic public, however, is no a reason to stop. Just because insider trading is no longer shocking doesn’t mean we shouldn’t prosecute it to the full extent of the law. But the failure to shock is also not a reason to search for a response by expanding the definition of insider trading.
Charlie Gasparino, writing with Sital Patel, reports that recent remarks by SEC associate regional director and co-head of enforcement David Rosenfeld advocate expanding the definition of insider trading. Speaking at the February 2nd Directors Roundtable Institute session, Rosenfeld intended to address the spate of insider trading cases, but he revealed alarm at the thought of one on one meetings with management at analyst sessions or company employees participating in expert networks.
Observed one attendee, “Rosenfeld said the government’s view is that no employees should be talking to expert networks even though hedge funds and public firms have been using expert networks legally for years.” Said another, Rosenfeld found “troubling” analyst meetings with corporate officials during “analyst days.” Both of these practices are part of primary research and described by mosaic theory as advocated by the CFA Institute. Did Rosenfeld just put the practice of research itself on notice?
John Coffee, a professor at Columbia law school, suggested the SEC may have reached “an excessive level of suspiciousness.” Professor Coffee pointed out that analysts contact company management not because of nefarious intentions. They contact them, they conduct research because of “the obvious need to get more information and clarification.” Discomfort with this is discomfort with research, and without research, analysts, their customers and their portfolios will have insufficient information to make an investment.
Stephen Bainbridge, a professor at UCLA law school, openly wonders “whether the current crusade is overdoing it and thereby chilling legitimate market analysis.” Citing Dirks v. SEC, he quotes from Supreme Court Justice Lewis Powell’s opinion:
It is commonplace for analysts to “ferret out and analyze information,” 21 S.E.C. Docket at 1406, and this often is done by meeting with and questioning corporate officers and others who are insiders.
Justice Powell’s intention, according to Bainbridge, is to provide research analysts safe harbor in which to conduct their research, so all market participants may benefit from their efforts. Powell’s decision also cites the SEC statements to to support his position.
[t]he value to the entire market of [analysts’] efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by [their] initiatives to ferret out and analyze information, and thus the analyst’s work redounds to the benefit of all investors.
Professor Bainbridge is concerned that comments such as Rosenfeld’s and overly zealous enforcement of insider trading bans can have a highly detrimental effect on market efficiency. Professor Bainbridge is not arguing for insider trading — not at all. Instead, he advocates for analysts to raise the scrutiny on the companies they cover, so it may redound to the benefit of all investors.
If research underpins efficient markets, then it doesn’t end with company news releases and dictums, followed by the faint chorus of sympathetic journalists. It begins with aggressively interrogating anyone who might be able to provide more information and clarification. It includes speaking with management, using expert networks, scrutinizing industry publications. And it ends with rigorously corroborating and testing stories of growth while rooting out fraud and abuse: separating the Apples from Enrons.
Is now the time to expand the definition of insider trading? It’s one thing to observe a public grown are weary of seeing so many indictments on insider trading and none regarding the excesses that led to the collapse, but would the prospect of an expanded definition cripple the research required to maintain the health and scrutiny that has made US equity and credit markets vital?