Mr. Foley, a partner in Schwabe, Williamson, and Wyatt. practices law in Portland, Oregon.
Sabena Dowd, an engineer for Super Software, overhears a conversation during a morning elevator ride to her office on the 38th floor of the New Market Building. She observes the two passengers leave the elevator on the 27th floor. She knows—as does anyone who can and will read the building directory—that the 27th floor is the exclusive domain of Reuben & Rotten, investment bankers reputed to specialize in acquisitions, mergers, lever-aged buy-outs, and other common financial market activities. Sabena also recognizes one of her departing fellow passengers as Richard Rotten, a partner whose visage has appeared on several recent occasions in both the social and the financial pages of local publications. Neither Mr. Rotten nor his companion make any attempt to hide or disguise their discussion from others in the car; indeed, they take no notice of anyone else.
The gist of the conversation leads Sabena Dowd to conclude that International Thun-dermug Corporation (ITC) may represent an excellent investment opportunity. She confirms her conclusion by a venture to the public library that noon hour, during which time she reviews not only the latest annual and quarterly reports of ITC, but also the analyses of several financial writers; this quick study suggests that ITC has scant debt, solid cash assets, strong market share, and experienced management. Sabena calls a national brokerage house where her account executive assures her that, in his mind, ITC is an “excellent stock.” She buys 1,000 shares of ITC at $25.00 a share, the midpoint of the selling range for the last twelve months. Within a week, Barron’s and The Wall Street Journal report that International Thundermug, counseled by Reuben & Rotten, has agreed in principle to acquisition by Old Arrogant Foundry (OAF), a nationally known conglomerate famed in the news as a “raider.” Both ITC and OAF are listed on the New York Stock Exchange. ITC stock opens the next day at $57.00 a share. Sabena calls her friendly neighborhood discount broker and sells out her position, pocketing a neat short-term $32,000 profit. Has she engaged in that currently odious and heinous offense of “insider trading”?
Shocking as it may seem to those of us steeped in traditional ethics, the answer is not clear-cut. In fact, situations such as these perplex many honest and well-intentioned individuals daily, stifling their productive endeavors and creating a fear of criminality in the decent and the ethical. No one disputes the necessity for rules preventing fraudulent conduct and overt misrepresentation; unfortunately, the “insider trading” arena extends far beyond ordinary boundaries of proscribed activity and accepted ethical definition.
This paper will not discuss the “extension of knowledge” or entrepreneurial analyses of normative rules regarding security transactions. More qualified scholars have homed in on the value of open information markets in the absence of activity which is coercive or deceitful in the customary sense. Instead, this essay seeks to consider, in cursory fashion, the essential ethical or moral standards which are assumed, seldom enunciated, and virtually never understood under the “insider trading” rubric. The hypothetical situation proposed in the opening paragraph—sounding all too much like a law school examination question—with some modifications, illustrates some of the issues which settle like a plague upon our marketplace.
Is Sabena Dowd an “Insider”?
Is Sabena Dowd an “insider”? Not in any ordinary sense. She merely overhears an open conversation; she occupies space where she has every right to be; she has not eavesdropped, as by tapping a telephone or employing a spike mike; she does not represent any party to the transaction, nor is her employment in any manner connected to the acquisition, save in the fortuitous sense of use of a common elevator to unrelated offices. Under these circumstances, one would suppose that Sabena Dowd would be free to act on this information; after all, she does run a real risk of loss, as anyone who has acted on “tips” gleaned from the beauty shop, the shoeshine stand, or the singles’ bar can testify with sorrow.
Nonetheless, the current frenzy instilled by the envious busybodies of the day forecasts a trend which would or could indict Sabena Dowd.
One could modify the hypothetical to justify conviction. Suppose Sabena Dowd to be a lawyer retained to represent ITC or OAF. Most codes of professional responsibility prohibit attorney conduct violative of the retainer, at least in the absence of full disclosure and knowing consent by the affected clients. These rules form express or implied contractual promises; the breach of these promises provides justification for a civil action by any victimized party. Note well, however, that under traditional legal analysis, the only “victim” would be Sabena’s client, and proof of any harm (assuming a freely traded security) is difficult to fathom. While the common law recognized a few “third party beneficiaries” entitled to sue for a broken contract to which they were not parties, such occasions represent the extraordinary rather than the commonplace. Again, it is difficult to conjure up a readily recognized third party beneficiary in the example.
A similar modification could result in a similar analysis if Sabena were employed by Reuben & Rotten, and if her employment agreement expressly forbade participation or investment in transactions in which the employer acted as counsel. Accountants and auditors, for example, often insert such covenants in their employment agreements if the governing professional body does not expressly prohibit professional-client transactions.
In similar fashion, if Sabena had broken into the offices of ITC, OAF, or Reuben & Rotten, and secured private information by stealth or force of arms, few would find her innocent of all wrongdoing, although “insider trading” would prove to be a particularly inept description of her crime.
Thus, Sabena Dowd in the opening example does not come within any of the suspect catego ries which might justify penal sanction. She violated no implied or express covenant in a rec ognized professional code. She breached no term of an employment contract. She engaged in no deceit, no theft, no robbery. She merely received information (which proved to be accurate and valuable) not available to the general public, acted upon it, and profited. Under what justificatory talisman could the law find her guilty of a criminal act or a civil wrong in the category of “insider trading”?
The most likely fundamental response is a resort to a redistributionist theory of envy: a perceived “public,” represented by government minions, mistakes or labels Sabena’s actions as blameworthy merely because she pro-fired and someone else did not; therefore, under standard redistributionist theory, the law ought to take away her “ill-gotten gains” and figuratively spank her as well!
It would pay conceptual dividends to consider the theoretical support for rules and regulations prohibiting security transactions in cases where no force, fraud, or breach of contract takes place. Suppose Sabena Dowd served as an officer and director of ITC and that her employment agreement was silent as to investment in her company. Suppose further that she sat in the very inner councils of her company and participated actively in the ITC/OAF acquisition. Suppose that, by virtue of her position and participation, Sabena heightened her attitude concerning ITC as a profitable investment. What moral wrong does she commit by investing in, or trading, ITC stock on the open market? I suggest that Sabena Dowd, under such circumstances, has done no wrong and that the crime of “insider trading” (beyond the basic force-fraud-contract analysis) is mala prohibita, not malum in se.
The Sources of Knowledge
One might urge that Sabena Dowd has engaged in misconduct by profiting from select or special knowledge. Two answers appertain. First, as the introductory hypothetical example illustrates, “knowledge” may be derived from several sources; also, “knowledge” may be quite wrong, as the redoubtable attorney, Charles Mackay, chronicled in 1841. In the opening example, note that while Sabena overheard an “inside” conversation, she supplemented that information before making her decision by using sources available to anyone willing to dig: published company reports, written commentaries, and broker recommendations. In addition, she employed her background observations and deductive reasoning in recognizing Mr. Rotten from the daily press, and in deducing the measure of a good company (strong and vital balance sheet, market share, management). Each of these sources—and more—would be available to Sabena Dowd in the altered hypothetical case where she serves as an officer and director.
Second, and more importantly, no recognized and acceptable principle of ethics bars an entrepreneur, observer, or anyone else from taking action and making decisions based upon any and all information secured by means un-constrained by laws against fraud, breach of contract, and use of force. Consider the fundamental tenets of personal behavior which are of such a nature as to deserve to be encrusted into law. One ought not cheat another or coerce him or steal from him; Sabena Dowd, in our “of-ricer/director/insider” example does none of those things. Hence, one can argue cogently against the imposition of any civil or criminal barriers or penalties.
Can we torture some extended definition of deceit or misrepresentation which would bar Sabena’s use of “inside knowledge” so posited? I think not. The common law elements of the civil wrong of “fraud and deceit,” having survived the test of at least five or six centuries, still stand us in good stead. Fraud requires proof that A made a (1) knowing or intentional (2) false (3) representation (4) of fact (5) to B (6) intending that B rely upon the representation, and that (7) B did reasonably (8) rely upon the false statement (9) to his loss, detriment, or damage. Modern tort law has extended liability in some jurisdictions to encompass negligent or inadvertent misrepresentation, thereby modifying the first and sixth elements. Sabena has not violated either the strict or the attenuated version: In the “officer/director/insider” example, none of the elements can be shown!
Could or should the law imply a misrepresentation by Sabena’s silent acquisition and use of knowledge? Not reasonably. Not pursuant to any established and logical moral code. As a practical matter, any rule of law compelling “full disclosure of all essential (or material) matters” would open up an unlimited realm of absurdity. For example, what is “essential” or “material”; to whom must disclosure be made and by what means; to what extent must the speaker ascertain that her disclosure is heard and comprehended; is disclosure required solely as to matters of investment or finance; if some disclosure must be made beyond the ordinary investment and financial context, what boundaries exist and whither privacy; if knowledge is acquired inadvertently and purely fortuitously (as in the original hypothetical) must that information be imparted; and myriad other inquiries too numerous to mention. The resulting quagmire of uncertainty leavened with a tattletale mentality could only increase the growing frustration indigenous to government regulation in an age of the busybody.
Ought the law impose a duty upon Sabena to abstain from use of “inside information” acquired without force, fraud, or breach of contract? Again, thoughtful ethical rules invoke a negative answer. No one ought to be compelled to share knowledge; the very essence of the ballyhooed right to privacy lies in a recognized domain from which each individual may exclude all others at will. To compel the distribution of knowledge not only truncates the normal workings of the marketplace but also erodes the essence of the individual by chipping away at his private preserve.
Conversely, no one ought to be constrained from the gainful (if risky) employment of knowledge secured without force, fraud, deceit or in breach of a binding contract. Extension beyond these given rules of constraint would, once again, create a living theater of the absurd. For example, under what circumstances should the noncoercive, nonfraudulent acquisition of knowledge result in prohibition or forfeiture? Indeed, the current murk of Federal and state statutes, regulations, and decisions concerning “insider trading” demonstrates the inadequacy, artificiality, and utter foolishness of regulators run amok.
Apparently, the proponents of “insider trading” legislation rest their case upon some sort of “fundamental fairness” argument. Unfortunately, few lawmakers trouble themselves with essential analysis; they avoid difficult questions and engage in untenable assumptions. Hence, in the context of “insider trading,” those lacking in secondary linguistic sophistication assume, without reflection, that Sabena has not acted “fairly” in our “officer/ director/insider” modification. Yet, the vital inquiry persists: Why this assumption? She has not cheated or robbed anyone. She has not broken any contract. In short, she has not engaged in traditionally dishonest conduct.
“Aha!” cry Sabena’s traducers. She has gained an “unfair advantage” and that, in and of itself, calls her conduct into question. Reflect. Almost everyone enjoys, or could create, an analogical “unfair advantage.” After all, despite the pains and plans of generations of normative witch doctors, each individual remains precisely that, a discrete individual, ever so much distinct from every other living creature before and since. Moreover, an additional complication crops up inasmuch as the inexorable passage of time and events, leavened by the interaction of myriad human beings, constantly creates new and different challenges and circumstances. This ebb and flow of time and persons presents opportunities for the acquisition and employment of knowledge in many arenas of life, one of which concerns the creation, production, and distribution of goods, services, and ideas available to satisfy the subjective desires of fellow sojourners on this planet.
Nor can one argue convincingly that Sabena acquired her “edge” fortuitously, although a random acquisition of values, talents, health, and the like ought not undermine the governing moral postulate. Normally, an “insider” such as Sabena in our “officer/director/insider” modification has achieved her status as a result of the satisfaction of the wants of others in the market, and not by random chance.
In some circumstances, the law provides civil or penal sanctions for conduct which thwarts reasonable expectations of third parties or the public; does Sabena Dowd’s hypothesized activity in the “officer/director/insider” example fall within this emerging jurisprudential concept? Again, I think not. Assuming, for argument’s sake, the efficacy of such a legal doctrine, under any standard the broken expectation must be reasonably held. Since the pertinent issue here concerns the existence or nonexistence of a moral condemnation of “insider trading,” the inquiry must properly reflect this limit. Properly phrased, then, does any individual possess a reasonable expectation that, as a moral principle, the “officer/ director/insider” ought to avoid participation in security transactions where the actor may possess special knowledge?
No, for several reasons. First, one could not will the rule as a universal, for the identical reasons discussed heretofore regarding the reduction to absurdity of an open limit on the use of knowledge. Second, any expectation would be unreasonable inasmuch as inconsistent and disparate rules of conduct would appertain to analogical situations: Consistency would vanish as the human tendency to create exceptions for self and to require strict compliance for others would prevail. Third, and most saliently, the general moral law which most neatly accords with human action in this ordered universe decries breach of express contractual covenants, theft, and deceit in this regard, but otherwise permits free, self-determined conduct. This historically accepted and proven norm rests upon a recognition that no individual ought to select for another and a rejection of the doctrine of “might makes right.” Since Sabena’s supposed conduct does not involve force, fraud, or breach of contract, no reasonable third person could expect her to renounce or eschew her opportunity or position.
This moral analysis gains currency from an examination of the nature of the use of “inside information.” Two characteristics stand out.
First, “inside information” may be wrong, unprofitable, or both. Few commentators dwell on the point; yet, how many civil or criminal proceedings are prosecuted against users of “inside information” who lose? The information may be faulty; e.g., Sabena Dowd may overhear a conversation concerning an ITC/OAF buyout which is untrue. Or, the information, while accurate, may not produce expected and profitable results; e.g., the ITC/OAF buy-out takes place but the market (the discrete conduct of millions of parties who act upon their subjective value systems) does not believe the combination to be beneficial and the price drops from $25.00 a share to $12.00 a share in a few hours, in either event, Sabena Dowd has lost as a result of her “insider trading”; who will weep for her?
Second, consider the transient nature of much of what the pontificators label “inside information.” In many instances, one can liken any price advance and profit to a tour of Reno blackjack tables or, more fittingly, idle participation in a government-sponsored lotto game. Often, the price fluctuation results not from some disguised use of secret knowledge but, rather, from psychological stampedes akin to those described by Charles Mackay. The careful and successful investor normally considers fundamentals ever so much more important than hunches. Thus, the deductive investigation performed by Sabena Dowd in the opening example—review of reports and published opinions, study of management and markets—assays more likely success than a chance elevator encounter. Viewed in this manner, the assault on the “insiders” amounts to an envious claim upon gambling proceeds in place of a hypocritical but high-toned plea for ethical renewal.
In final analysis, then, the moral case for prohibition of “insider trading” hinges upon facile words lacking analytical depth. As with myriad other fields of concern, the human inability or unwillingness to make fine distinctions imparts a seminal flaw to the required study. Most folks—past and present—agree that the law ought to prohibit and punish assault, aggression, murder, fraud, deceit, cheating, and breach of solemn, voluntary contracts. In similar lingo, most accepted moral codes recognize and propound these normative principles. Thus, if Sabena broke her con tract, or stole her information, or achieved her gain by means of force or fraud, most civilized individuals would consider her conduct reprehensible and a fit subject for punishment. To the extent that “insider trading” constraints deter or penalize such acts, the law coincides with accepted moral principles.
The difficulty appears where some individuals or groups seek to impose different standards upon other parties. Expediency often impels these “law seekers” to equate their new propositions with a supposed rule of ethics; a “moral-ought” argument probably increases the chance of passage of legislation where Congressmen (1) cannot or will not think, and (2) fear voting against (what is perceived as) a moral rule. In these instances, ignorance or venality impede wise action: Normally, the “moral” or “ethical” doctrine proposed is questionable or inimical to a free society. Nonetheless, the proponents confuse those few, standard, accepted, historically tested moral principles with their own evisceral, proposed, self-serving beliefs of right and wrong.
It is one thing to assert that, as an ethical tenet, an executive ought not to own shares or trade in the securities of his employer, and to impose that qualification upon one’s own activity. It is quite another matter to enact that proposition as an immutable normative rule, compelling all others to adhere to the standard. It is not so much the inefficacy of willing the postulate as a universal; instead, it devolves to a recognition of the essence of human nature and the respect for the nonaggressive choice of all individuals.
In a free society, all individuals ought to remain untrammeled in their creative activities; the state should solve insoluble disputes pursuant to common rules of law, and should prevent or punish the aggressive use of force and fraud. The fundamental moral principle underlying the premises of a free society—that each human actor ought to remain at liberty to seek his own creative destiny as he sees fit—cannot exist in harmony with most of the common lore and foolish rules now applied to “insider trading.”
1. See, Manne, Henry G., Insider Trading and The Stock Market (The Free Press. New York, 1966); Manne, Henry G., “Insider Trading and The Law Professors,” 23 Vand L Rev. pp. 547-590 (1970). But see, Ferber, David, “The Case Against Insider Trading: A Response to Professor Manne,” 23 Vand L Rev. pp. 621-30 (1970); see also, Manne, Henry G., “Economic Aspects of Required Disclosure Under Federal Securities Laws,” a Charles C. Moskowitz lecture published in Wall Street in Transition: The Emerging System and Its Impact on the Economy (pages 21- 110) (New York University Press, 1974).
2. Professor Manne has argued long and cogently that empirical evidence demonstrates that “insider trading” does not harm long-term investors, and that insider transactions may well perform a very efficient and salient rule in compensating the innovator and the entrepreneur. See, Manne, op. cit. note 1, Insider Trading and the Stock Market. However, the presence or absence of a “victim” does not necessarily determine the moral propriety of human conduct, the touchstone of this paper.
3. This essay assumes, for sake of argument, the propriety of the existence of private codes of conduct, e.g., rules of professional bodies prohibiting representation of multiple interests, Clearly, such an assumption deserves a closer look on some other occasion, for mandated proscriptions tend to violate the fundamental rules of a free society to the extent they exceed the proper governmental function to prevent aggression and deceit and to settle disputes in a forum of common justice.
4. The traditional criminal jurisprudence of the common law employed this differentiation, “Msia prohibita” referred to an act which was unlawful only by virtue of legal proscription; “malam in se” connoted penal laws which punished conduct which was “evil in and of itself,” something all civilized societies would consider wrong, with or without a formal legal sanction,
5. Mackay, Charles, Extraordinary Popular Delusions and the Madness of Crowds (London, Richard Bentley, 1841) recounts myriad examples of common knowledge gone awry. Among the analyses contained in the first 100 pages of this remarkable tome are the investment debacles of “tulipmania” and John Law. Legend records that Bernard Baruch, the wizard of Wall Street, took Mackay’s chronicles to heart in achieving his astonishing financial Success.
6. While it is also true that a market society thrives upon the free flow of information without the artificial barriers noted earlier, I will refrain from addressing that argument here since it is tangential to my main purpose, Professor Manne handles the matter most admirably, See note l, op, cit.
7. See, e.g., Kaufman Inv. Corp, v. Johnson. 623 F2d 598 (9th Cir. 1980), cert den 450 U.S. 914; Mender v, Francis Ford. Inc., 286 Or 451,595 P2d 480 (1979); Metal Tech Corp. v. Metal Tech niques Co., Inc., 74 Or App 297,703 P2d 237 (1985). Confirm 3 Restatement 55, et seq., Torts Second § 525 ff.
9. Another practical impetus resides in the bureaucratic and dictatorial mind. Once regulation passes into law, the enforcement apparatus tends not only to perpetuate its own position but also to expand its territory. In some instances, this occurs out of a misplaced belief in the inerrancy of the administrative mind and vision; in other cases, the administrative agency seeks raw power. Since the primary impetus toward application and enforcement in the present milieu derives from the Securities and Exchange Commission, the reader can draw his own conclusion as to the effective motivation of that agency.
10. I suppose it is equally “unfair” that I was not born with the innate ability to play basketball in the manner of Bill Russell. A disappointed swain in an earlier time might have rued the fact that he was not born handsome or winsome, or that he did not meet his dream girl prior to her betrothal to another. An inventor might despair that he lacked the insight or the intelligence to recognize and apply the properties available to him to solve a problem or to provide a new product. Yet, these equally “unfair” situations cannot and ought not be redressed by law; Job wrestled with seeming unfairness many centuries ago.
11. The satisfaction of market demand may result from the activities of a third party. For example, perhaps Sabena inherited her position in a close corporation from her father or mother, or received it in a marital dissolution settlement. If the acquisition is noncoercive and untainted by fraud, the essential analysis prevails.
12. I will resist any hankering to digress into a discussion of the merits of the concept of “thwarted expectations” as a premise for legal responsibility. Observe, however, that the theory possesses a number of shortcomings, at least in its embryonic form.
14. Both of these events may just as well occur in the “officer/ director/insider” modification of our hypothetical. Executives also wear blinders; indeed, sometimes close vision proves the most myopic.
16. One ought to except the Marxist and Fascist view of things in this regard, since those codes of conduct rest on the “might makes right” premise. Query: How many true adherents—as distinguished from the gulled and the quelled—to those doctrines exist?