Insider trading deterrence versus managerial incentives: a unified theory of section 16(b).

• Author: Fox, Merritt B.
• Position: Section 16(b

TABLE OF CONTENTS

INTRODUCTION 2089 I. IDENTIFYING THE COSTS OF A ROUGH RULE OF THUMB: THE IMPACT OF SECTION 16(B) ON MANAGERIAL INCENTIVES 2096 A. The Importance of the Managerial Incentive Structure 2096 B. The Impact of Section 16(b) on Managerial Incentives 2106 II. A GENERAL THEORY 2107 A. A World With Only Positive Inside Information 2108 1. Purchase and Sale Behavior in the Absence of Section 16(b) 2109 2. The Six-Month Rule of Inference 2117 3. Purchase and Sale Behavior If Section 16(b) Is Applied 2121 4. Conclusion 2124 B. A World With Only Negative Inside Information 2125 1. Purchase and Sale Behavior If Section 16(b) Is Not Applied 2125 2. The Six-Month Rule of Inference 2126 3. Purchase and Sale Behavior If Section 16(b) Is Applied 2132 C. A World With Both Positive and Negative Inside Information 2135 1. Direct Applicability of the Preceding Models 2135 2. Combining the Models 2136 III. DETERMINING THE REACH OF THE STATUTE 2138 A. An Overall Principle of Decision 2139 B. Must the Term in Office Include the Time of Purchase or Sale? 2141 1. The Time of Purchase 2141 2. The Time of Sale 2151 C. Market-Acquired Options 2153 1. The Purchase and Sale of Calls 2153 2. The Purchase of a Call Followed by Its Exercise and the Sale of the Share 2160 3. The Purchase of a Share Followed by the Purchase of a Put 2175 D. Stock-Price-Based Officer and Director Compensation Plans -- Employee Stock Options and Stock Appreciation Rights 2181 1. Application of the Rule of Decision 2182 2. Court Decisions and Pre-1991 SEC Rulemaking 2183 3. The 1991 Rule Revisions 2190 CONCLUSION 2201 INTRODUCTION

Officers and directors have special access to information that they can use to profit in the purchase and sale of their company's securities. Section 16(b) of the Securities Exchange Act of 1934 (Exchange Act)(1) is the only provision of the federal securities laws explicitly designed to deter such transactions.(2) To accomplish its purpose, section 16(b) requires insiders to disgorge to the company any profit they realize from "any purchase and sale, or any sale and purchase, of any equity security" of the company within a six-month period.(3)

Does section 16(b) in fact deter officers and directors from trading on the basis of nonpublic information?(4) If so, to which pairs of transactions should section 16(b) be applied among all that the statute's language can be stretched to cover? Proper answers to these fundamental questions require a coherent theory of section 16(b)'s application. This theory should determine whether and how a penalty on short-swing transactions deters insider trading, and it should account for the costs of imposing this penalty. Despite section 16(b)'s sixty years of existence, the courts and legal scholars have yet to develop such a theory.(5) This article intends to fill this void, using the techniques of modern financial economics, the theory of the firm, and analogies to basic concepts of statistical inference. The theory developed here shows that a penalty on short-swing trading deters insider trading and suggests a simple framework for deciding on which pairs of transactions to impose the penalty.(6)

Section 16(b) is one of the most important provisions of the federal securities laws. Section 16 has been the subject of more interpretations by the

staff of the Securities and Exchange Commission (SEC) than any other provision.(7) If the talk of inside corporate counsels is to be believed, section 16(b) gives rise to a substantial portion of the securities work of their offices as well. It was the basis of a claimed cause of action in twenty-four reported cases between 1987 and 1992, ranking it eighth among all provisions of the federal securities law,(8) and it has spawned a small industry of plaintiffs' lawyers.(9) It probably plays a larger day-to-day role in constraining the behavior of America's corporate executives than rule 10b-5's headline-grabbing, judge-made strictures against insider trading.(10)

Section 16(b) is unusual in that it seeks to accomplish its stated purpose by indirect means rather than by direct prohibition.(11) The statute's operation does not depend on whether there is any direct evidence of the use of inside information. Instead, it identifies certain pairs of transactions in terms of their nature and timing and in effect conclusively presumes that inside information was in some way used in connection with one or both of the transactions in the pair. Section 16(b), therefore, is the paradigm of a crude legal rule of thumb. Because it applies automatically and without respect to the actual use of inside information, section 16(b) imposes sanctions in some circumstances on insiders who have not relied on inside information in deciding whether to trade. The sanctions imposed on persons who have not used inside information are justified because they facilitate the imposition of sanctions on persons who have traded on the basis of inside information.

Section 16(b)'s indirectness makes the questions of efficacy and rational application particularly critical. If the statute is not effective at deterring insider trading, the costs it imposes on persons who are not trading on inside information are unjustifiable. If the statute is effective, the costs imposed on innocent traders need to be considered in constructing a rational approach to its application.

There is an obvious reason to doubt section 16(b)'s efficacy. To avoid the statute's sanctions, all that an insider trader needs to do is to wait six months. This observation causes some prominent commentators to believe that section 16(b) is simply a trap for the unwary that should be repealed.(12) This criticism, however, rests on an assumption that the six-month wait in and of itself does not deter insider trading. The theory developed here shows this assumption to be incorrect.

Rational application of section 16(b) might not seem so difficult at first blush because the statutory language is quite straightforward. A moment's reflection, however, suggests a wide variety of situations beyond the simple cash purchase or sale of a security that would permit an individual to alter her financial position so that her wealth will be either increased if share price subsequently goes up or protected from decrease if share price subsequently goes down. Every such situation presents an insider possessing nonpublic information with an opportunity to benefit in ways the public cannot. Thus, to be consistent with the statute's underlying purpose of preventing unfair use of information, we might want to apply the words purchase and sale to a variety of insider transactions. Such stretching of statutory terms has a long tradition in the securities laws.

It is not obvious, however, which transactions the statute should be stretched to cover. A variety of issues has arisen. For example, for section 16(b) to apply, need the trader be an insider at the time of both the first and the second transactions in the matched pair? Is the acquisition of a call option the "purchase" of an "equity security," and should it make a difference whether the option is acquired in the market or pursuant to a management stock option plan? Should the acquisition of a put option be considered a "sale?" How should the exercise of an option and the subsequent sale of the resulting shares be handled? Should the exercise of stock appreciation rights be treated as involving the simultaneous "purchase" and "sale" of a security even though as a formal matter no securities are involved at all? As this article will show, the record of the SEC and the courts in dealing with these issues has been one of inconsistent treatment of essentially like transactions, frequent conflict among courts and between the courts and the SEC, and numerous reversals of position by both institutions.(13) The courts and the SEC seem lost without the compass of a theory of the costs and deterrent impact of section 16(b)'s short-swing penalty against insider trading.

Part I of this article assesses the social costs of a crude rule of thumb. Because section 16(b) applies to a given class of paired transactions, it deters both transactions based on inside information and transactions not so based. Each time section 16(b) is stretched to include a class of paired transactions, it deters some additional innocent transactions. This side effect will take the form of officers' and directors' purchasing fewer shares in their own companies and refusing to accept as large a portion of their compensation in a form based on share price. There are strong theoretical and empirical reasons to believe that managerial share ownership and share-price-based compensation are important to the proper functioning of our economy because of the significant incentives they provide for aligning the otherwise divergent interests of management and shareholders. The weakening of these incentives is a social cost of including a given class of paired transactions within the reach of section 16(b).

Part II develops a theory of how a penalty on short-swing trades works in the case of transactions clearly covered by the statute -- ordinary cash purchases and sales of securities. It utilizes portfolio theory -- the mainstay of modern financial economics -- to predict the effect of a short-swing penalty on the respective behaviors of insiders who are and who are not trading on inside information. The fact that transactions occur within six months of each other increases the likelihood that one of them is based on inside information -- an increase that is significant over a wide range of plausible values for the relevant parameters. Imposing a penalty on short-swing transactions discourages trades based on inside information by forcing those who would engage in them to remain "dediversified" for six months and hence to be at greater financial risk than they would be without the statute. This theory of section 16(b)'s...