How the Misappropriation Theory Affects the Amount of Insider Trading

Few types of behavior attract as much attention in corporate and securities law as insider trading – that is, securities transactions based on material non-public information (MNPI).[1]  Yet there is very limited empirical evidence on whether the law effectively deters insider trading, and particularly whether the adoption of the main doctrine behind its prohibition – the “misappropriation theory” – has any deterrent effect. In a new paper, I examine this question by studying the impact of the Supreme Court’s decision in O’Hagan, which adopted the misappropriation theory and, in doing so, significantly expanded the scope of the insider trading prohibition.

Since the 1980s, the “classical theory” was the primary doctrine that courts employed to prevent insider trading. Under this doctrine, people are liable for unlawful insider trading if they trade in the shares of a company using MNPI obtained from the company, and they owe fiduciary duties to the company’s shareholders.[2] This prohibition covers not only situations in which corporate insiders trade on MNPI obtained from the issuer, but also situations in which insiders pass MNPI to a third party for a personal benefit, and the third party in turn trades on the information.[3] But precisely because the classical theory requires that the person who traded on (or tipped) MNPI owes fiduciary duties to the shareholders of the issuer, the doctrine had the important limitation of capturing a very limited set of individuals: corporate officers and directors of the company, outsiders with a confidential contractual relationship with the firm, employees of the issuer other than directors and officers, and tippees of the previous individuals.[4]

The scope of the insider trading prohibition, however, radically changed in 1997, when the Supreme Court adopted the misappropriation theory in its O’Hagan decision.[5] Under this doctrine, people violate the insider trading prohibition if two basic conditions are met: they trade on (or tip) MNPI obtained from a source with whom they have a confidential relationship (whoever that source is), and the transaction (or the tipping of MNPI) is not disclosed to the source. The misappropriation theory therefore eliminated the requirement that people using confidential information for personal benefit owe fiduciary duties to the shareholders of the issuer, which implies a significant expansion of the range of individuals captured by the law. As a result, it seems reasonable to expect that the incidence of insider trading declined after the adoption of the theory.

My paper tests this hypothesis by examining the impact of O’Hagan on a common proxy for insider trading: target run-ups in mergers and acquisitions (“M&A”) – that is, the cumulative abnormal returns for the shares of the target company before the transaction is publicly announced. The intuition behind this proxy is that individuals who hold non-public information about mergers and acquisitions can make significant profits if they buy shares in the target company before the transaction is announced (since mergers typically involve the payment of a large premium over market prices); as a result, a significant increase in the target’s pre-merger price is likely indicative of a high incidence of trading on confidential information about the transaction (see, e.g., Keown and Pinkerton, 1981; Meubroek, 1992; Sanders and Zdanowicz, 1992; Meubroek, 1992).

The results show that the run-ups in fact decreased significantly in relation to the announcement returns after O’Hagan. Before O’Hagan, the average relative run-up was 7 percentage points lower than the announcement returns; after the decision, the difference became 9 percentage points. In this sense, after O’Hagan, there was less anticipatory trading explaining the overall valuation effect of M&A bids, which is consistent with the notion of less insider trading.

The data presented in this paper have several implications. The insider trading prohibition is in large part motivated by the idea that investors will be discouraged from collecting information about firms and even investing in the securities market if they anticipate that they will be trading with parties who obtained an informational advantage by misappropriating confidential information (Manove, 1989; Ausubel, 1990; Fishman and Hagerty 1992; Khanna, Slezak, and Bradley 1994). If this idea is correct, therefore, the results presented in my paper suggest that the misappropriation theory may contribute to a stronger information environment, a lower cost of capital, and a more liquid securities market through its deterrent effect on insider trading.

In addition, some commentators have advocated expanding the scope of the insider trading doctrine beyond the contours delineated by O’Hagan (and, in fact, some courts and Congress have taken some steps in this direction[6]). The fact that my paper shows that the misappropriation theory appears to deter insider trading suggests that those reforms also may have a deterrent effect – and may therefore be desirable.

ENDNOTES

[1] This is a common definition of insider trading, which I follow for ease of reference. However, as explained below, this definition is imprecise because under the doctrine that governs insider trading today, the term covers not only insiders but also outsiders that trade on MNPI. In addition, not all forms of trading on MNPI are illegal.

[2] Chiarella v. United States, 445 U.S. 222 (1980).

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

[4] Dirks v. SEC, 463 U.S. 646 (1983) (stating that individuals with a confidential contractual relationship with the firm are subject to the insider trading prohibition, and setting the doctrine for tipper/tippee situations); U.S. v. Whitman, 904 F. Supp. 2d 363, 370 (S.D.N.Y. 2012), as corrected(Nov. 19, 2012), aff’d, 555 Fed. Appx. 98 (2d Cir. 2014) (unpublished) (discussing that circuit courts have held that lower-level employees are subject to the insider trading prohibition).

[5] U.S. v. O’Hagan, 521 U.S. 642 (1997).

[6] See, e.g., Sarbanes-Oxley Act § 807; S.E.C. v. Dorozhko, 574 F.3d 42 (2d Cir. 2009); SEC v. Rocklage, 470 F.3d 1 (1st Cir. 2006). See also Nagy (2009) and Bainbridge (2012) for a discussion.

This post comes to us from Professor Fernan Restrepo at UCLA Law School. It is based on his recent article, “The impact of insider trading doctrine on the incidence of insider trading: An analysis of the effect of the misappropriation theory,” available here.

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