Insider Trading: Are Insolvent Firms Different?

Are insolvent firms different from solvent firms with respect to insider trading law and policy? Formally, the law does not change. But economic realities and non-securities law duties do. As a result, the insider trading landscape changes considerably. The law is more permissive in some ways, and more constraining in others, as troubled instruments trade.

One difference is the level of regulation of trading in the residual claims of the firm. In solvent firms, the residual claims are equity securities, and equity securities are subject to the full ambit of trading restrictions.

In insolvent firms, non-equity claims such as trade credit or bank loans typically constitute the residual claims. These non-equity residual claims are subject to less stringent regulation precisely because they are not equity and they may not even be securities. Section 16(b) of the Securities Exchange Act of 1934 (sometimes called the short-swing profits rule) requires disgorgement of insider trading profits in equity securities, but it does not reach debt of any kind. Rule 10b-5, the main weapon of both the government and private plaintiffs against insider trading, and Rule 14e-3, which restricts trading on the eve of a tender offer, both apply only to securities. To the degree that non-securities such as trade credit or bank loans make up the fulcrum class, no federal insider trading laws apply to the most economically significant and informationally-sensitive interests in an insolvent company. Insolvency is therefore deregulatory.

While insolvency deregulates, it also expands the reach of other aspects of federal insider trading law. That is because bankruptcy law creates new roles and new duties. The managers of a company in Chapter 11 pick up new duties to the creditors. Creditors themselves take on new duties by virtue of their involvement in creditors’ committees. Since insider trading law hinges on duties, these new relationships expand the coverage of insider trading restrictions. In particular, a creditor may be accused of wrongfully trading on information acquired in consultation with other creditors and with the bankrupt firm. For example, in the Washington Mutual bankruptcy, Judge Walrath denied confirmation of the bankruptcy plan and raised the specter of more punitive measures, such as equitable disallowance, in light of allegations that members of the creditors’ committee may have traded based on what they learned through their role. Four hedge funds ended up paying $30 million to put these accusations to rest. Outside of the bankruptcy contest, debt traders (particularly those who deal in non-securities) face little risk of insider trading liability – but bankruptcy law changes the equations.

The operation of insider trading law differs materially in and around insolvency.  Is this for good or for ill? Careful consideration of insider trading policy makes clear that these differences have both advantages and disadvantages. However, it is safe to offer two tentative conclusions. First, we should not rush to close the loopholes in insider trading law that open with regard to the residual claims. Deregulating insider trading is a Faustian bargain—greater price accuracy at the risk of lesser liquidity, fairness, and managerial integrity—but we should be more willing to accept the bargain with respect to insolvent firms than solvent ones. This is in part because of the changing relative importance of these priorities. In particular, price accuracy becomes increasingly important in bankruptcy, where the court and parties are struggling to decide the future of real assets. Tiny improvements in the quality or quantity of information may help the parties to select a better plan, directly affecting investment choices in the real economy. Moreover, bankrupt firms are under the scrutiny of a bankruptcy judge; it is somewhat safer to allow experiments in deregulating insider trading law for a particular firm when there is a responsible adult watching.

Second, we should be solicitous of efforts to shield members of creditors’ committees from extensive insider trading regulation, because these creditors occupy a position without analogue in the solvent firm: they both receive and contribute material, nonpublic information. Traditional insider trading law theory may not have the resources to manage a two-way flow of information, requiring new and accommodating thought. If insider trading law penalizes traders who sit on committees, the most informed traders may decline to sit on committees, further starving the parties and the court of vital information (and making it harder to strike a bargain). Right now, parties take numerous steps to protect their dual status as trader and committee member. They establish internal information barriers, send “big boy letters,” and request judicial “comfort orders.” Courts and regulators should support these efforts as important to reconciling bankruptcy policies with insider trading law.

This post comes to us from Professor Andrew Verstein at Wake Forest University School of Law. It is based on his forthcoming article, “Insider Trading: Are Insolvent Firms Different?,” available here.

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