The Regulation of Outsider Trading in the EU and US

In a recent paper, I compare the legal treatment of outsider trading under US and EU law. Outsider trading can be defined as the sale or purchase of listed securities on the basis of material nonpublic information by individuals who do not qualify as insiders. There is substantial (and so far largely unnoticed) divergence between EU and the US in this area of securities regulation.

In both systems outsider trading, like more ordinary insider trading, is subject to severe restrictions. In the US, however, the trading prohibition has a limited scope. It applies selectively, only if certain conditions are met: in order to be sanctioned, the outsider must have misappropriated the information from its legitimate owner, or received it as a tip from a corporate insider, who in turn must have received a personal benefit in tipping the information. Out of such cases, outsider trading is generally permitted.

In the EU, a much broader prohibition applies. Any outsider in possession of “inside information” (material nonpublic information, in EU legal jargon) must abstain from trading, if he knows or should have known that the information he possesses is inside information.[1] Differently from US law, the means and circumstances of information acquisition play no role in determining whether the trading prohibition applies. Simple possession of a piece of material nonpublic information, no matter how obtained, gives rise to a duty to abstain from trading.

Constraining outsider trading has a sound efficiency-based justification, as it curbs investors’ overinvestment in information search. Absent any trading limitation, outside investors would engage in a continuing race to be first in the acquisition of material information. From a societal standpoint, a race of this sort is mostly wasteful: individual search efforts are largely duplicative, and the information at which they are targeted is more often than not bound to be produced irrespective of those efforts, by way of its public disclosure on the part of the information’s source (typically, the listed firm whose securities are affected by the information).[2]

Overinvestment associated with race-to-be-first dynamics provides a rationale for a selective limitation of outsider trading. It does not provide a justification for establishing an unconditional prohibition against exploitation of informational advantages in securities markets. Investors still play a valuable role in the production of information useful for assessing the value of securities. They perform a useful gap-filling function when information, for one reason or another, cannot be expected to be produced and disseminated through top-down mechanisms, via public disclosure on the part of the information’s source. An unconditional prohibition against outsider trading would inhibit such valuable gap-filling, with negative consequences for both the efficiency of securities markets and the governance of listed firms.

Market efficiency would suffer because a prohibition of this sort would likely hinder the activity of securities research and analysis (SR&A) carried out by analysts and market professionals.[3] SR&A is a powerful source of value-relevant information in modern securities markets, and therefore a major contributor to their efficiency. The prohibition, by preventing market professionals and analysts from exploiting any significant informational advantage they may have gained through SR&A, could chill such valuable activity of information production.

An unconditional ban on informed trading by outsiders would also have a negative impact on corporate governance. The prohibition would prevent investors from exploiting the value of information relating to undisclosed corporate misconduct. The impossibility to profit via trading from the information, in turn, would reduce external monitoring over corporate agents, and agency costs of public firms would correspondingly increase.[4]

US law has been judicially crafted so as to minimize the risk of such unintended consequences. The misappropriation and tipping conditions attaching to the outsider trading prohibition effectively prevent the ban from extending to SR&A-based informational advantages (at least so long as these advantages are achieved “independently” and “lawfully”, ie out of insiders’ tips and acts of information misappropriation). By the same token, the US Supreme Court has established that outsiders’ use of fraud-relating information passed on by a corporate insider does not constitute a violation of the securities laws if the insider-tipper received no personal benefit in tipping the information.[5]

EU law, with its blanket prohibition against outsider trading, appears overall less tolerant toward such forms of informed trading by outsiders. Exploitation of SR&A-based informational advantages does not automatically fall within the scope of the prohibition, but it appears exposed to higher legal uncertainty, relative to the US. Whether or not the trading prohibition applies to such cases depends on whether the information uncovered through SR&A is to be considered “nonpublic”. An issue that is subtle in nature, and for which no univocal answer exists under current EU law. Private exploitation of material information relating to undisclosed corporate misconduct, that the trader received from a corporate insider, is instead invariably prohibited.

The US more nuanced and selective approach in addressing informed trading by outsiders is effective in avoiding unintended adverse effects on markets and firms’ governance, but it comes at the price of high doctrinal complexity and, in some cases, inconsistency. On the whole, EU law appears more straightforward and perhaps doctrinally more coherent. Further, there are specific advantages in the broad EU outsider trading prohibition: prosecutors’ evidential burden is substantially lightened, making it easier for them to pursue tippees and secondary insiders more generally. These benefits, however, may not be worth the costs associated with the excessive breadth of the prohibition.

ENDNOTES

[1] See European Parliament and Council (EU) Regulation 596/2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC [2014] OJ L173/1, Art. 8(4) last sentence.

[2] See Hirshleifer, J, The Private and Social Value of Information and the Reward to Inventive Activity, 61 Am. Econ. Rev. 561 (1970) (for an early theorization).

[3] See most recently Coffee, JC, Jr, Mapping the Future of Insider Trading Law: Of Boundaries, Gaps, and Strategies, 2013 Colum. Bus. L. Rev. 281, 312-3; Greene, E, Schmid, O, Duty-Free Insider Trading?, 2013 Colum. Bus. L. Rev. 369 (2013), 411.

[4] See generally Macey, J, Getting The Word Out About Fraud: A Theoretical Analysis Of Whistleblowing And Insider Trading, 105 Mich. L. Rev. 1899 (2007); Grechenig, KR, The Marginal Incentive of Insider Trading: An Economic Reinterpretation of the Case Law, 37 U. Memphis L. Rev. 1 (2006).

[5] See Dirks v. SEC, 463 U.S. 646 (1983).

This post comes to us from Sergio Gilotta, Assistant Professor of Business Law at the University of Bologna. The post is based on his recent paper, which is entitled “The Regulation of Outsider Trading in EU and the US”. The paper is available to download here.