Internalizing outsider trading.

• Author: Ayres, Ian

TABLE OF CONTENTS I. INTRODUCTION II. AN INTERNALIZATION MODEL OF INFORMATIONAL DISPARITY A. Disaggregating the Internal and External Impacts of an Information Advantage B. Implications for Insider Trading C. Implications for Outsider Trading III. THE PRESENT U.S. REGULATION OF OUTSIDER TRADING A. Misappropriation Theory B. Rule 14e-3 Tender Offer Rule C. Regulation FD IV. INTERNALIZING OUTSIDER TRADING A. The Outsider Trader Dilemma 1. Third Party Externalities 2. Managerial Opportunism B. Internalization Proposal 1. Choosing the Right Default 2. Current Opportunities for Traded Firms to Control Informed Trading 3. Tailoring the Opt Out Menu of Trading Restrictions 4. Summary C. Implementation Problems V. CONCLUSION I. INTRODUCTION

Investing in the United States has become a hobby for many. (1) Individual ownership of equity, moreover, has increased over the past decade due in part to the introduction of internet-based trading. (2) While providing the possibility for greater returns compared with bank savings accounts, among other investment alternatives, the public capital markets also pose greater risks for investors. (3) Many individual investors lack both the resources and the incentive to analyze the value of any particular security in the market. Such investors thus trade at a systematic disadvantage relative to more informed parties. In response, regulators have asserted that certain informational disparities cause uninformed investors to lose confidence in the market, thereby justifying stringent regulation. (4) This Article analyzes the impact of information advantages in the market and proposes a unified approach to regulating such advantages.

Informational disparities in the market arise from a number of different sources. An individual investor may contemplate a trade in a particular publicly traded company. Call the company whose securities are being traded the "traded firm". In a world without regulatory prohibitions, individual investors first face the possibility that the traded firm itself will provide nonpublic material information to only a subset of investors in the market. Insiders at the traded firm, for example, may enjoy preferential access to confidential information about the company's business prospects and expansion plans, among other things. Insiders may then exploit this information to profit from trades in the market at the expense of outside investors. The traded firm may also provide internal information to outside investors selectively; for example, giving nonpublic material information solely to a group of analysts that regularly follow the firm. (5)

Several sources of information advantage may also originate outside the traded firm. Market professionals command far more resources than any one individual investor. (6) Through their resource and expertise advantage, market professionals may determine more accurately whether the market price over or undervalues the traded firm's securities. An analyst, for example, may use its knowledge about the general economy, the industry sector, the movement of oil prices, and the political situation in the company's various worldwide markets, in combination with the securities filings information to estimate the company's overall value. Non-market professionals may also possess an information advantage with respect to the traded firm. Industry regulators about to impose new regulations on a particular company may possess nonpublic information pertaining to the new regulations material to the valuation of the company. (7) Newspaper reporters may possess material, nonpublic information obtained from their employment relevant to the valuation of a particular company. (8) Companies that interact with the traded firm, including suppliers, customers, and competitors, may also possess nonpublic information material to the valuation of the traded firm's securities. (9) For example, a biotech firm which knows it has just patented a particular gene may have a profitable opportunity to trade its rivals' shares short. (10)

In response to the potential harm uninformed investors face from informational disparities in the market, U.S. regulators have focused on the use of information in the public capital markets. The insider trading prohibitions under Rule 10b-5 of the Securities Exchange Act of 1934 ("Exchange Act") generally permit trading on the basis of deliberately acquired information advantages (which other market participants also had the opportunity to acquire). (11) Conversely, the securities laws often--although not uniformly--prohibit individuals from trading on information that is casually acquired through an investor's fiduciary position or privilege and not from a source readily available to all investors. (12) Insiders, for example, are prohibited from engaging in trades based on nonpublic material information casually acquired from the insiders' privileged fiduciary relationship with their own company. (13) Under the misappropriation doctrine, fiduciaries of an outside source cannot flee-ride on the source's effort by trading without the source's consent (or at least knowledge). (14)

Commentators have put forth several theories that justify (at least in part) the present securities law's focus on the source of the information and whether a trader acquires her information through deliberate hard work or casually through a fiduciary duty breach. Under one prominent theory, individuals should not be able to trade on casually acquired, "unerodable" information advantages. (15) Trades based on unerodable information, under this theory, reduce the confidence of uninformed investors and the willingness of such investors to put money into the capital markets. (16) Information obtained by outsider traders is erodable (and therefore tradeable) because any person had the opportunity to invest the effort in uncovering the valuable information. (17) We are all on a level information playing field when it comes to unearthing erodable pieces of information, and market competition will mean that advantages based on such information will quickly erode as the information is incorporated into the stock price. In contrast, in a world where markets are not strong form efficient, (18) outsiders do not have an opportunity to erode the information advantage of insiders with superior information. Explicitly referring to the need to stem "unerodable information advantages," the Securities and Exchange Commission ("SEC") designed Regulation FD to curtail the ability of companies to provide nonpublic material information selectively to favored outside investors and market professionals. (19) Stock analysts can trade on information that they work to obtain, but the rules work to stop analyst trading on the basis of information that is bestowed on them by the firm itself. The recently promulgated SEC rules under Regulation FD also resonate with the Lockean notion of desert under which a person enjoys a natural right to the results of her labor. (20)

This Article comes to bury the concept of unerodable advantage as the basis for regulating informationally driven trades. (21) The distinction between erodable and unerodable advantages is to our minds unworkable in practice, (22) but more importantly, it is not sufficiently connected to either efficiency or equity. Even the use of unerodable information advantages in securities transactions may result in a net social benefit. Managers engaged in insider trading may very well benefit from their unerodable advantage at the expense of uninformed investors. Nevertheless, the use of such insider information may alter the securities market price, resulting in increased price accuracy. (23) Similarly, shareholders may benefit both from the reduced direct compensation necessary to attract the manager as well as from the increased incentives to maximize share value that the manager may experience from the ability to engage in insider trading. (24) Conversely, the use of erodable information advantages in securities transactions may generate a net social loss. Competition between investors to gain a brief information advantage may create duplicative research costs, for instance.

This Article instead proposes a common framework to assess all forms of informational disparities. From a social welfare perspective, informational disparities have similar impacts. On the one hand, informational disparities certainly raise the cost to uninformed traders. To the extent a trader lacks information, the trader will suffer systematically reduced returns compared with more informed investors. Investors seeking an information advantage as well may expend costly resources doing so. On the other hand, the same informational disparities may generate benefits. The trading losses of uninformed investors translate directly into trading profits for the informed traders. Trades based on an information advantage will also result in an increase in overall securities price accuracy regardless of the source of the advantage.

Applying the framework, the Article shows that the informed outsider (25) fails to internalize the social impacts of her trading. She compares her expected profits from informed trading to her expected costs of acquiring the information--and ignores, inter alia, the impact on stock price accuracy or the costs to the other side (consisting of uninformed investors) of the transaction.

Just like a polluter who fails to internalize the social impact of its pollution, the outsider trader is not well placed to decide whether informed trading enhances social welfare. We will argue that outsider trading can produce externalized costs that the outsider ignores in deciding to trade. Informed outsider trading will predictably increase the bid-ask spread that shareholders of a traded firm must bear as a transaction cost of buying and selling their positions. Informed outsider trading can also distort the decisionmaking of the...