St. Martha

Why Martha Stewart should go to heaven and the SEC should go to hell.

Michael McMenamin from the October 2003 issue

(Page 2 of 4)

It has been, in many respects, a successful campaign. In a June survey by the Sienna Research Institute, 60 percent of those polled thought Martha Stewart was guilty of insider trading, and 51 percent thought she was guilty of obstruction of justice. Many people think Stewart "should have known better" because she used to be a stockbroker. But when it comes to insider trading, the SEC and the Justice Department don't want anyone to know better. If they did, they would have long since asked Congress to clearly define the offense. Instead, as Barron's Editor Thomas G. Donlan wrote in June, "The government prefers to define [insider trading] case by case. 'He did what? Oh, that should be illegal.' So it is."

Insider trading was not a crime until passage of the Securities and Exchange Act of 1934, Section 10(b), which prohibits "fraud" in the sale of securities. This offense was intended by Congress to cover stock trades by a corporate officer, director, or major shareholder -- someone with a fiduciary responsibility to a company's stockholders -- based on nonpublic, material, "inside" information. In 1961 the SEC for the first time claimed that Section 10(b) and its SEC-promulgated companion, Rule 10(b)(5), extended beyond people traditionally considered to be corporate insiders. The case involved a Cady, Roberts & Co. broker who learned from a director of Curtis-Wright Corp. that the company was going to reduce its dividend. Before the reduction became public knowledge, the broker sold Curtis-Wright shares owned by his wife and clients.

Although the broker was not a traditional insider and did not have a fiduciary duty to Curtis-Wright or its stockholders, the SEC charged Cady, Roberts with insider trading. It argued that Section 10(b) was "designed to encompass the infinite variety of devices by which undue advantage may be taken of investors and others." The SEC thought it was inherently "unfair" for the broker to sell shares when he knew that the people buying them did not have the same information he had. The SEC ignored the fact that all trades on impersonal stock exchanges involve the potential for asymmetric information; one party frequently will know something the other does not. That is how markets work. It's why two people can simultaneously think XYZ stock is a buy and a sell at $2.

Yet the SEC is still using the same "fairness" rationale today. Commenting on the insider trading case against Martha Stewart, SEC enforcement director Stephen M. Cutler told The Washington Post, "It is fundamentally unfair for someone to have an edge on the market just because she has a stockbroker who is willing to break the rules."

Bad Economics

That position makes no economic sense. In his classic 1966 book Insider Trading and the Stock Market, Henry Manne of George Mason University Law School demonstrated that inside information makes stock markets more efficient. Stock market efficiency depends on the speed and the accuracy with which new information is assessed by the market and reflected in share prices. When insiders trade on their knowledge, that information is immediately reflected in stock prices, thereby conveying this "inside" information to the market. The more information available, the more accurate the stock prices and the more efficient the allocation of capital.

What's more, there is no evidence that insider trading harms the market. The SEC says insider trading has to be prevented because it would cause the public to lose confidence in the market and abandon it. Yet such flight does not seem to have occurred in the years before 1934, when insider trading was still legal, and scholars such as Manne point out that the 1929 stock market crash was not caused by insider trading.

A 1987 study by the SEC's own economists casts further doubt on the commission's view of insider trading. The study, which looked at the effect of corporate takeovers on stock prices during the 1980s, determined that, on average, nearly 40 percent of the increase in a target company's stock price occurred before the takeover announcement. Yet the economists found that insider trading did not cause the pre-bid rise, which was entirely the result of speculation in the media, how much stock the acquirer bought before announcing the takeover bid, and whether the bid was hostile or friendly.

A footnote to the report questioned the assumption that inside traders profit at the expense of less-informed investors. "Those selling into the market when the better informed are buying probably would not have sold had they possessed the same valuable information," the economists noted. "However, they still would have sold if the information specialist had refrained from buying, especially if the trading of the specialist did not affect significantly the stock price. This holds true whether the trading is based on insider information or on careful analysis and successful anticipation of the event."

An insider, by definition, has better information than an outsider. So does a market professional. Market professionals sometimes track insiders' buying and selling of their company's positions, which are available through public filings. Whether the trader with better information acquired it from an inside tip or simply through diligence and hard work, the SEC economists reasoned, does not change the effect on either the market or the other party to the trade.

Bad Law

Not only is the SEC's "level playing field" theory bad economics, the U.S. Supreme Court has held that it is bad law. The Court first rejected the theory in a 1980 case involving Vincent Chiarella, who worked in the composing room of a financial printing company, Pandrick Press. Chiarella handled the announcements of five corporate takeover offers. Despite Pandrick's use of code names for the companies, Chiarella was able to deduce their identities. Armed with this knowledge, he bought modest amounts of the target companies' stock before the takeover announcements and sold it immediately afterward. The SEC investigated, confronted Chiarella, and not only made him give up his profits (about $30,000) but referred the case to the U.S. attorney for criminal prosecution. Based on the SEC's level playing field theory, Chiarella was indicted for securities fraud, brought to trial before a jury, and convicted. The always SEC-friendly U.S. Court of Appeals for the 2nd Circuit rubber-stamped the verdict.

On appeal, however, the Supreme Court ruled that Chiarella could not have been guilty of securities fraud. His employer worked for the corporate raider, not the target. Chiarella therefore had no duty to shareholders of the target corporation. "Section 10(b) is aptly described as a catchall provision," Justice Lewis Powell wrote for the majority, "but what it catches must be fraud. When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak." Chiarella had no such duty, unless the law required all market participants to disclose what they know or to refrain from trading on such information. As Powell noted, "Neither the Congress nor the Commission ever has adopted a parity-of-information rule."

The second defeat for the SEC's level playing field theory involved an investment analyst, Ray Dirks, who specialized in the insurance industry. Two employees of Equity Funding Corp. of America gave Dirks information that enabled him to uncover a shocking and pervasive insurance scandal. Dirks learned that Equity Funding had invented records of policies that never existed to bolster sales figures, intimidated employees who threatened to expose the fraud, and falsified other corporate records to paint a picture of fiscal health. The corporation's executives knew all this was taking place.

Upon learning the extent of the scandal, Dirks told his clients, who promptly sold their Equity Funding stock. Then he told the SEC and The Wall Street Journal. Instead of praising Dirks for uncovering the scandal, the SEC hauled him into court. As punishment for giving his clients the "inside information" on Equity Funding, Dirks was prohibited for six months from trading or associating with a registered broker/dealer.