The Yale Law Journal has posted Richard Epstein's characteristically thoughtful article on insider trading law after the Second Circuit's United States v. Newman decision. Professor Epstein argues that, as the abstract of the article puts it, "in some instances the law does not reach far enough, while in other instances the law reaches too far." Crucially, "contractual solutions work better than regulatory solutions to constrain various forms of misrepresentation, concealment, and nondisclosure that arise in connection with insider trading." (A principle that applies to a lot more things than just insider trading, but that's for another day.)
Professor Epstein agrees with the outcome in Newman but not the reasoning.
The article includes a discussion of the SEC's Regulation FD, or "fair disclosure," which Professor Epstein recommends scrapping.
To be sure, there are powerful instincts today on behalf of protecting the small investor who chooses to trade on his own account. The efficiency losses of that protectionist strategy seem clear, so it is fair to ask exactly from where the benefits come. In this sense, there is no instinct to protect poor or ignorant people, because few individuals of either type are active as individual players in the securities market. Rather, the more modest objective is for the SEC to protect that small sliver of individuals who wish to manage their own portfolios with complex trading strategies that often do not work well at all. But the SEC is the wrong institution to attack this problem, for financial education on such matters as index funds and portfolio diversification is better provided for by private firms operating independent of the SEC.
Whatever the sentiment for this view, this rationale should be resisted for the same reason that we should resist imitating the worst features of the Robinson-Patman Act, whose major mission was to protect small businesses that were losing market share to the more efficient chain stores. These distributional objectives are murky at best. In general, open entry can preserve competitive pricing. Accordingly, it is a mistake to try to redesign the Indianapolis speedway to accommodate go-karts, which is what the parity principle tries to do. The better strategy is to let the go-karts be hopelessly outclassed, after which the savvy small investor places his money in a real racecar. Unwisely, the SEC took the opposite tack, which was to slow down the entire process by harping on the supposedly favorable distributional consequences that come from sacrificing the efficiency gains obtainable from the freer flow of information.
The article concludes:
the sole violation that matters is the deliberate use or sharing of information contrary to the wish of the firm that has supplied it in the first place. These unauthorized uses should impose liability on the immediate recipient and any person who takes with knowledge of the illegal release. That prohibition should apply under a constructive trust theory, whether or not the recipient is deemed to have in fact some relationship of trust and confidence with the corporation, and it should apply wholly without regard to whether the party who leaked the information received some return benefit, tangible or intangible. Following these simple principles should vastly improve the overall operation of the securities law, which is now in a sad state of intellectual and administrative disarray.
