Right now, the United States is in the middle of a major definitional fight over what constitutes insider trading.Brian Jackson
Here's a fun story about what is – or isn't – insider trading. Back in 2002, York University finance professor Moshe Milevsky entered The Globe and Mail's annual stock-picking contest. Thinking that the exercise would be more fun if he had a bit of skin in the game, Prof. Milevsky made a modest investment in a stock. Low and behold, he won the contest and made himself a bit of scratch on the side.
The following year, he entered the contest again. Beforehand, he told his colleague Tom Salisbury, also a professor at York University, of his choice stock. This time, however, neither Prof. Milevsky nor his colleague invested any money in the stock. Partly, this choice was because they were worried about the legalities of such an investment.
In 2002, Prof. Milevsky was just another contest participant; in 2003, he was the defending champion. Once his pick became known, the price of that stock was bound to significantly increase (and it did) and that meant that Prof. Milevsky's stock pick was probably material, non-public information about the stock. So, if Prof. Milevsky or his colleague bought the stock before the announcement, they would have been trading on an undisclosed material fact. Being finance professors and not lawyers, they were concerned not just that such a purchase would be unfair, but that it would be illegal insider trading.
As luck would have it, Prof. Milevsky would win again that year. Far from being a stock-picking genius, however, Prof. Milevsky was more of a mathematical prankster – he picked stocks with a very high variance that tended to move the opposite way the market did. His choice would either win big or crash hard. The market, however, thought the finance professor knew something special about the stocks he picked. So much for the efficient capital markets hypothesis.
That said – and please don't take this as legal advice – Prof. Milevsky probably should have thrown a bit of cash into the second round. As I've said in my previous columns, illegal insider trading requires not just that you trade on material undisclosed information, but that you do so in violation of a special relationship to the company you're trading on. Slice it however you want, it's pretty tough to say that Prof. Milevsky was in a special relationship with his annual high-variance, low-beta stock pick.
The story of our two York professors illustrates something about insider trading – it's actually kind of tricky to define. At its core, insider trading is a kind of theft. The offence is taking information that you don't have a right to take and using it to turn a profit. Pinning down that improper taking of information is tough. Define it too broadly, and you'll capture behaviour that we generally want to encourage – the smart hedge fund analyst who is cannily able to read between the lines during a one-on-one meeting with a CEO. Define it too narrowly, and you'll miss behaviour that we generally want to prohibit – the proverbial hot tip from a company insider to a close friend at a stock brokerage.
Right now, the United States is in the middle of a major definitional fight over what constitutes insider trading. Just last week, the U.S. Department of Justice petitioned the Supreme Court to review the decision of the Second Circuit in its insider trading case United States of America v. Todd Newman and Anthony Chasson.
The case involved an analyst at a hedge fund receiving information about Dell's quarterly earnings from Dell investor relations employee Rob Ray and passing that information up to Mr. Newman, who traded on the information. In Canada, these facts look offside our insider trading laws – the person who gave Mr. Newman's analyst the material non-public information was pretty clearly in a special relationship with Dell at the time the information was transmitted. In the United States, the call was much closer – U.S. insider trading law requires that the tipper receive some personal benefit for disclosing the information or be in a close personal relationship with the tippee in order for an insider trading offence to occur. Traditionally, almost anything could count as a personal benefit. The Second Circuit, however, decided that the personal benefit requirement had to be taken seriously.
While Mr. Ray may have breached other rules – in particular, rules about fair disclosure – Mr. Newman's trade was onside if Mr. Ray gave him the information as a Dell employee. Had Mr. Ray disclosed the information for a personal benefit (or a familial benefit, per the recent decision of the Ninth Circuit in Salman), the trade would have been offside. Although Mr. Ray passed along the information during off-the-job hours, he didn't receive a personal benefit and, therefore, Mr. Newman didn't insider trade. This is a pretty fuzzy standard and, as you can imagine, the DoJ wants to go back to the pre-Newman days where the benefit bar was low.
While the DoJ doesn't like Newman, hedge fund analysts should. It's now much safer to get information from company employees who disclose information during the course of their duty to the company, even if that information is disclosed on the 16th green (Matt Levine does a great job unpacking this here). Contrasted with Canada, where personal benefit is irrelevant, the U.S. now has a much more permissive standard for insider trading.
Now, we shouldn't get too smug about our definition of insider trading. As I've discussed before, our regulators and courts have had a devil of a time with parsing the materiality requirement in our insider trading law. For example, the OSC has found that information that materially affects stock price is sometimes immaterial. While Canada's rule nominally catches more activity under the insider trading rubric, we still can't figure out exactly what activity is being captured.
Insider trading rules are about finding the optimal balance between prohibiting conduct that is both unfair and will chase investors out of capital markets, and encouraging information to flow efficiently between market participants. Creating a rule that expresses that balance – without prohibiting conduct we don't want to prohibit or allowing trades we think should be banned – is very hard work.
And this brings us back to our two professors. In hindsight, they may wish they put a stack of Robert Bordens on the pick. But I don't blame them for their reticence. Winning The Globe's stock picking contest is easy compared with defining insider trading. It's 15 years later and courts and regulators in two of the most sophisticated securities markets in the world still can't figure out what illegal insider trading is. What hope, really, did a couple of professors have?
Adrian Myers is a lawyer at Torkin Manes LLP.
Adrian Myers