Substitutes for insider trading.

• Author: Ayres, Ian
• Position: Legality of trading in stock substitutes

INTRODUCTION

The securities laws clearly prohibit an executive from using nonpublic information about her company to profit from trades in the securities of that company. But suppose the executive uses the same nonpublic information to profit from trading in the stock of another company. Suppose, for example, that an executive of Intel learns that her company will report higher than expected earnings because of higher than expected chip demand. Can she profit from this knowledge by purchasing the stock of other companies that she knows are likely to benefit from the same increased demand? For example, can she purchase the market basket of companies (other than Intel) that compose the Philadelphia Semiconductor Index? The stock of personal computer manufacturers or retailers? The stock of software companies whose products are complementary with personal computer sales? Under the right circumstances, such companies can all be thought of as stock substitutes for Intel. A strategy of trading in stock substitutes with nonpublic knowledge of Intel earnings will produce a supranormal return.

Profits from such trading can be substantial. To cite but one example, Intel on November 10, 1998 did in fact report higher than expected quarterly demand (by 4% or so) for its microprocessor. On the day following the announcement, Intel's stock rose about 5%, for a rise in market value of about $7 billion. Intel's announcement was interpreted in the financial press as indicating strong demand for personal computers generally. The stock of other companies in that industry, and the market baskets of stocks in that industry (such as the Philadelphia Semiconductor Index), rose between 2.5% and 5%. The stock of Intel's downstream customer, Compaq, rose 4%, a dollar rise of over $2 billion in market value. The price of short-term call options in Compaq increased dramatically. (1) Analysis linked the increase in stock value of Compaq and other companies to the increased demand for PCs, as suggested by Intel's strong earnings report. (2)

In this Article, we will focus on circumstances where an informed insider (or a corporation itself) could trade profitably in its own stock but for Securities and Exchange Commission Rule 10b-5's (3) traditional prohibition on insider trading. To avoid a clear-cut Rule 10b-5 violation, the insider might instead want to substitute trade in other stocks whose price will be predictably affected by the same information. (4) Such substitute trading could potentially take a variety of forms. Particular types of information will cause the price of a stock substitute to predictably move in the opposite direction of the price of one's own company. Information that would make an insider want to buy shares of his or her own company will sometimes induce the insider to want to sell another company's shares. For example, if an insider of Genentech realizes that Genentech is likely to win the race in cloning a particularly useful monoclonal antibody, then selling rivals' stock short may be a close substitute for buying Genentech shares long.

The impetus for substitute trading will not be limited to corporations that sell substitute products. Supranormal returns may also be realized in trades on the stock of upstream suppliers and downstream customers. For example, an executive of Ford Motor Company may hear from her engineers nonpublic information about an assembly-line robotic device tested by Ford but manufactured by another company. Or substitute trading in the stock of complementary products may become profitable. A corporation, rather than its employees, may trade in stock substitutes. In the above examples, supranormal profits may be available to Intel, Genentech, and Ford.

Substitute trading, if legal, could threaten to undermine the effectiveness of insider trading prohibitions generally. Yet legal scholarship has not focused squarely on the problem. (5) In Part I of this Article, we examine the economics of trading in stock substitutes. We summarize the literature on stock correlations and review event studies that measure the effect that a public announcement by one company has on other companies in the same industry. We also discuss the "mechanics" of trading in stock substitutes to assess how profitable such trading might be. A representative issue covered is how much stock a trader could buy, as a percentage of daily volume or market capitalization, without so moving price as to offset any informational advantage.

In Part II, we examine the legality of trading in stock substitutes. Section 10(b) of the 1934 Securities Exchange Act (6) has traditionally been interpreted to prohibit an insider from using material nonpublic information to trade in her own company's stock. An insider for this purpose would include the company itself. Under this traditional interpretation, an insider could legally trade in another company's stock. The rationale for this is that the insider is not a fiduciary of the company whose stock she is trading and therefore owes no duty to its shareholders. The reach of Section 10(b) has been extended under the so-called "misappropriation" doctrine. Under this doctrine, a fiduciary who, in violation of the confidence of her principal, uses information gleaned from her role to profit from securities trading has violated Section 10(b). The misappropriation doctrine requires a fiduciary relationship between the trader and the source of the information; it does not require a fiduciary relationship between the trader and the shareholder on the losing end of the trade.

How would the misappropriation doctrine affect trading in stock substitutes? An employee is a fiduciary of her employer. If a company explicitly prohibits its employees from using nonpublic information to trade in another company's stock, an employee who violates that prohibition will violate Section 10(b). If, on the other hand, a company explicitly permits its employees to trade in another company's stock, an employee who trades will not violate the confidence of her employer and will not run afoul of Section 10(b). The application of the doctrine in the (typical) case in which the employment contract is silent as to the permissibility of trading in stock substitutes is somewhat unclear; security lawyers would advise employees in this situation not to trade. Significantly, the misappropriation doctrine will not limit a company's use of its own nonpublic information to trade in another company's stock. Such trading does not violate the confidence of any fiduciary.

Part III discusses what can be gleaned about current corporate practice--both concerning corporate policies regarding substitute trading and the extent to which such informationally-driven trading occurs. Some companies--particularly in the securities industry--expressly prohibit their employees from trading in stock substitutes. We have also uncovered a few examples of companies that in the past have given employees explicit permission to trade in stock substitutes. But most employment contracts are silent as to whether such trading is permitted or prohibited. This finding is roughly consistent with what we would expect. Stock substitute trading offers a form of compensation paid for largely by the shareholders of another company; an employer who attempts to limit this trading by contract would face difficult line-drawing issues and run the risk of imposing criminal penalties on employees who approach those lines. It is difficult to get even good anecdotal data on the degree of trading in stock substitutes. Our best guess is that low-level employee trading is common, but that large-scale corporate trading does not occur.

Part IV examines the desirability of trading in stock substitutes. We focus on efficiency effects and first review the existing debate over insider trading, that is, trading by a company in its own stock or trading by an employee in her company's stock. (To avoid confusion, we will use the term "insider trading" to describe this form of trading, and the term "trading in stock substitutes" to describe a company or executive trading in another company's stock.) Opponents of Section 10(b) liability argue that insider trading profits are best viewed as a potential form of compensation to executives; if insider trading were legalized, shareholder losses on trades with insiders would be offset by shareholder gains from lower explicit pay to insiders. Insider trading would produce a social good: more accurate stock pricing. In any event, since losses from insider trading are internalized to the company and its shareholders, the decision whether to permit such trading ought to be left to the company. Supporters of the present law argue that insider trading distorts employee incentives. We extend the analysis by pointing out another problem with employee insider trading: It inefficiently ties the purchase of executive services to the sale of trading rights. We conclude that employee insider trading is presumptively inefficient. However, insider trading carried out by a corporation, rather than its employees, may well be efficient.

We agree with a primary contention of opponents of the present law: Efficiency gains and losses are internalized to each company, and focusing at least on efficiency-related goals, the present no-trade rule might be made elective, rather than mandatory. However, because a corporation's decision to let its manager trade on material nonpublic fiduciary information is a quintessentially self-interested transaction, the decision should be subjected to the heightened procedural and substantive scrutiny that arises under the duty of loyalty standard.

Trading in stock substitutes raises many of the same costs and benefits issues as direct insider trading. Trading may distort incentives but lead to more accurate stock prices; shareholders gain from lower explicit pay but lose on trades. However, gains and losses in stock...