Promoting public confidence in securities markets is a policy goal that is frequently cited by commentators, Congress, the courts, regulators, and prosecutors for the adoption and vigorous enforcement of insider trading laws.

For example, in the seminal insider trading case United States v. O’Hagan, the U.S. Supreme Court explained that “investors likely would hesitate to venture their capital in a market where [insider trading] is unchecked by law.”[1] More recently, Preet Bharara, who earned the title of “Wall Street Sheriff” by successfully prosecuting scores of insider trading cases in the wake of the 2008 financial crisis, emphasized that part of his job as the U.S. Attorney for the Southern District of New York was to aggressively prosecute insider trading cases “to bring people back to a level of confidence in the market.”[2] Such expressions of the link between insider trading and market confidence, however, assume far more than they explain.

At least three claims seem implicit in the market-confidence argument. First, that a large portion of the general public shares the perception that insider trading is economically harmful and morally wrong. Second, that this perception will lead potential market participants to stand on the sidelines of any market in which insiders are free to trade on their material nonpublic information. Third, that this chilling effect upon market participation will be significant enough to result in an appreciable decrease in market liquidity and therefore an increase in the cost of capital for those who would put it to socially beneficial uses.

There are, however, at least two reasons for questioning the validity of the link between market-confidence and the regulation of insider trading. First, insofar as it relies on a socio-psychological claim—that most investors believe insider trading is economically harmful or morally wrong—it is subject to the problem of false consciousness (i.e., the psychological claim could be true though the shared belief is demonstrably false).

Second, even if the problem of false consciousness is set aside, the market-confidence argument’s empirical claim (that a shared public perception that insider trading is prevalent will send most market participants to the sidelines) must be proven; it cannot be simply assumed. Empirical evidence for the market-confidence claim is, however, notoriously weak. And still more concerning, it is difficult to imagine what strong empirical evidence for the claim would even look like.

The Problem of False Consciousness

The market-confidence argument for regulating insider trading rests on the assumption that the trading public perceives insider trading to be inefficient or morally wrong. But what if this attitude exists despite the fact that, in reality, insider trading is neither inefficient nor morally wrong? In other words, what if the prevailing ethical attitudes regarding insider trading are just incorrect?

If such false consciousness does take hold, the mere perception of moral risk (though false) would, under the market-confidence argument, still affect liquidity, cost of capital, and market value in precisely the same way as if it were true. As a result, conduct that is not itself wrong or harmful to investors would end up having harmful consequences simply because others falsely perceive it to be wrongful. The question then becomes, how should those who recognized public attitudes are false react?

One response may be to continue to regulate insider trading solely to prevent the pervasive false consciousness from reducing market participation. This response would, however, be unwise because it confronts a false consciousness that negatively affects market performance by reinforcing and perpetuating it. Further, it results in wrongful punishment by targeting individuals for conduct that is neither economically harmful nor morally wrong.

An alternative response is to educate the public to correct the false consciousness. This takes the far wiser tack of addressing the inefficient and harmful attitude by correcting it. With this in mind, it should be understood that the market-confidence argument offers a sound justification for regulating insider trading if and only if insider trading is proven to be economically harmful and morally wrong on grounds quite independent of the public’s attitudes toward it. This moral claim must be proven, not assumed, by proponents of the market-confidence argument.[3]

Assume arguendo, however, that the moral claim is proven and the problem of false consciousness is overcome. The next step in the market-confidence argument is its empirical claim: that belief in the harmful effects of insider trading is indeed prevalent, and that this pervasive attitude has a negative effect on markets that do not vigorously enforce insider trading regulations. Like the moral claim, this empirical claim also must be proven.

The Empirical Claim

As things stand, the existing empirical evidence for and against the market-confidence argument is meager, and there are some significant challenges and counter-examples that any future empirical study looking to prove or disprove the market-confidence thesis will have to overcome.

To begin, the few completed studies testing public attitudes reflect more ambivalence than indignation or anxiety concerning the prevalence of insider trading in securities markets, and they do not specifically address the question of how (if at all) investor attitudes concerning insider trading affect their willingness to participate in securities markets.

For example, a fairly recent study by professors Stuart Green and Mathew Kugler suggests “that professionals and the lay public are united in their confusion over the rationale for prohibiting insider trading.”[4] Such public ambivalence concerning what (if any) harm results from insider trading suggests a problem for the market-confidence thesis.

Another approach to testing the market-confidence thesis might be to track the market’s reaction to headline-catching insider trading releases, enforcement actions, or changes in the law. But, to be convincing, any such study testing the correlation between an insider trading event and broad market reaction must account for the problem of alternative explanations. This will be challenging, if not entirely impracticable.

The problem is that proponents of the market-confidence theory can always dismiss conflicting data as driven by alternate causes: Improved market performance after a major insider trading prosecution is announced may reflect new confidence that future traders will be deterred, but poor performance after a major arrest may be interpreted as reflecting fear that insider trading is more pervasive than once thought. A market upswing following a major court decision that limits the government’s power to enforce insider trading laws (or a market decline after the implementation of new insider trading regulations designed to boost enforcement) may be dismissed as driven by other catalysts.

One begins to see how easy it would be to discount counter-example after counter-example by shifting explanations for the data—and this raises the concern that the empirical claim underlying the market-confidence theory may be unfalsifiable.[5]

Unfalsifiable theories cannot  be proven true or false by objective criteria. Espousing such theories signals a departure from rational discourse and entry into the realm of myth, faith, and dogma. These and other considerations have driven many scholars to conclude that the assumption that insider trading undermines market confidence may be unfounded.

Of course, none of the concerns raised above prove there is no correlation between the regulation of insider trading and market confidence. They do, however, suggest that the burden of proof should be shifted to scholars, legislators, judges, regulators, and prosecutors who have assumed such a correlation exists without evidence. If the market-confidence theory is to continue as an express justification for sending people to jail for insider trading, the burden should be on the government to prove the correlation by appeal to a comprehensive empirical study.

Scope and Magnitude

If the market-confidence theory is at best unproven and at worst unprovable, then what consequences should this have for the current state of insider trading law in the United States?

I suggest that the failure of the market-confidence argument (1) gives cause for revisiting the important question of how broad regulators’ and prosecutors’ insider-trading enforcement powers must be, and (2) gives cause for revisiting the magnitude of the sanctions warranted for violations.

The SEC and Congress have historically resisted a statutory definition of insider trading, arguing that any such definition would limit flexibility in enforcement. The claim has been that, since the harm of insider trading is so broad in reach and great in effect, and since market participants are likely to continue to find creative new ways to trade on material nonpublic information in violation of fiduciary duties, the government needs some vagueness in the law to allow it to address new forms of predatory trading as they arise.

If the market-confidence claim is dismissed as myth, however, the need for such flexibility and broad power to enforce is diminished. If the harm of predatory trading is local and is not amplified by the threat to market confidence, then there is significantly less risk in addressing new forms of insider trading by amending or revising statutory language, and there is also less risk to markets in holding the government to strict and meaningful constraints on the common law elements of insider trading.

Anglo-American jurisprudence historically has disfavored common law crimes and vagueness in criminal statutory schemes because they violate the principle of legality—the requirement that a clear rule of law be in place before the government may impose sanctions for illegal conduct.[6] The principle of legality expresses our shared intuition that justice demands that people be given reasonable notice that their conduct may result in civil or criminal sanctions before such sanctions may be imposed.

The government has implicitly suggested that concerns over lack of notice are overridden by the need to address the imminent risk that insider trading poses to market confidence. As noted above, if the market-confidence claim is a myth, however, then the need for such flexibility in enforcement diminishes and presumably would fail to outweigh the presumption against vagueness in the criminal law. Therefore, perhaps Congress should give new consideration to codifying the law of insider trading to satisfy the principle of legality, and perhaps the courts should take weakness in the market-confidence argument into account when determining whether the government needs broader flexibility for insider trading enforcement under the existing common-law regime (e.g., in applying the personal benefit test for tipper-tippee liability).

Finally, the current law imposes stiff civil and criminal penalties for violations of insider trading laws. As one author noted, “[u]nder the federal guidelines, the maximum sentence for insider trading is nineteen to twenty-four years, while a rapist could get fifteen years to life in prison.”[7] The availability of such penalties led Professor James Cox to ask, “where are the bodies, where is the blood?”[8] The civil penalties available for insider trading are also severe.

To the extent that these stiff penalties are driven in part by faith in the market-confidence argument and the consequent need for added deterrence,[9] then, pending new empirical evidence, the conclusions outlined above may warrant reform in the area of civil and criminal sanctions for insider trading as well.

ENDNOTES

[1]  521 U.S. 642, 658 (1997).

[2]  Steve Schaefer, Wall Street Sheriff Preet Bharara Talks Insider Trading, Forbes (Jul. 18, 2012), https://www.forbes.com/sites/steveschaefer/2012/07/18/wall-street-sheriff-preet-bharara-talks-insider-trading/#4d13add86690.

[3]   I have argued elsewhere that two of the three categories of insider trading that are currently proscribed under U.S. law are indeed morally impermissible and economically harmful, but that one form, issuer-licensed insider trading, is neither morally wrong nor harmful. See, e.g., John P. Anderson, Insider Trading: Law, Ethics, and Reform (Cambridge, 2018).

[4]  Stuart P. Green & Mathew B. Kugler, When Is It Wrong to Trade Stocks on the Basis of Non-Public Information? Public Views of the Morality of Insider Trading, 39 Fordham Urb. L.J. 445, 484 (2011).

[5]  Though I express here the worry that the market-confidence theory may be unfalsifiable, I hold out hope that a careful study that addresses the concerns raised here may yet prove enlightening.

[6]  See e.g., Anderson, Insider Trading, 89-91; Miriam H. Baer, Insider Trading’s Legality Problem, 127 Yale L.J. F. 129 (2017).

[7]  Charles Gasparino, Circle of Friends 155 (2013).

[8]  See Jonathan Stempel, Rajaratnam Sentencing May Be a Fight to the Death, Reuters (Aug. 10, 2011, 1:35 PM), http://www.reuters.com/article/2011/08/10us-galleon-rajaratnam-insidertrading-idUSTRE7795MV20110810.

[9]  See e.g,, Brief for the United States of America at 115, United States v. Newman 773 F.3d 438 (2014) (No. 13–1837), 2013 WL 6163307 (arguing that stiff penalties are warranted in part because “insider trading undermines the public’s confidence in the integrity of the financial markets”).

This post comes to us from Professor John P. Anderson at the Mississippi College School of Law. It is based on his recent article, “Insider Trading and the Myth of Market Confidence,” available here.