The Impact of Insider Trading on the Market Price of Securities: Some Evidence from Recent Cases of Unlawful Trading.

• Author: Rosenfeld, David

I. Introduction II. The Government Crackdown on Insider Trading A. Insider Trading at SAC Capital 1. Wyeth 2. Elan B. Insider Trading at Level Global and Diamondback 1. Dell's First Quarter 2008 Earnings Announcement 2. Dell's Second Quarter 2008 Earnings Announcement 3. NVIDIA 's First Quarter 2009 Earnings Announcement C. Insider Trading at Galleon 1. Trading in the Securities of Akamai 2. Trading in the Securities of ATI Technologies 3. Trading in the Securities of Google D. The Octopussy 1. Trading in the Securities of 3Com 2. Trading in the Securities of Axcan E. The Expert Network Case 1. Trading in the Shares of Omnivision 2. Trading in the Shares of Marvell III. Other Recent Examples of Unlawful Insider Trading A. Trading in the Shares of Informatica B. Trading in the Shares of Acme Packet C. Trading in the Shares of Nexen D. Trading by an Investment Banker in Advance of Various Deals 1. Trading in the Shares of Westway I 2. Trading in the Shares of Westway II 3. Trading in the Shares of Titanium 4. Trading in the Shares of Evercore E. Trading in Advance of Various Takeover Announcements 1. Trading in the Shares of Brink's Home Security 2. Trading in the Shares of Graham Packaging Company 3. Trading in the Shares of PharMerica IV. Why the Market May Not Always Detect Informed Trading I. INTRODUCTION

The government's recent crackdown on insider trading has revived an old debate about the wisdom of insider trading prohibitions. Opponents of insider trading laws like to point out that insider trading is at most a victimless crime because, in an impersonal market, counterparties to the insider trader are neither induced to trade nor deceived in any way by the insider, and may not suffer any concrete harm. (1) But some opponents of insider trading laws, starting with Henry Manne in the 1960s, go a step further and argue that insider trading actually has beneficial consequences, most notably that insider trading brings information to the market which gets incorporated in the price of the security, resulting in more accurate pricing on a more timely basis. (2) opponents of insider trading prohibitions argue, in other words, that insider trading promotes market efficiency. (3)

The market efficiency argument has gained considerable acceptance, even by many who are otherwise opposed to insider trading. Rather than disputing the efficiency argument, proponents of insider trading prohibitions tend instead to rely on a fairness argument--that it seems unfair to allow some parties to take advantage of information that is not equally available to other market participants (4)--which gets translated into a rough policy prescription: people will not participate in the market if they feel that some players have an unfair edge, that the playing field is not level, and that if they withdraw, liquidity will dry up and capital formation will be impeded. (5) Proponents of insider trading prohibitions argue, in other words, that long term market integrity is more important than any possible short-term market efficiency. (6)

The idea that insider trading may be market efficient because it leads to more accurate pricing of securities certainly has intuitive appeal: most people recognize that trading sends signals to the market, and that buying or selling pressure will lead to a rise or fall in the price of the security. Trading by those in possession of material non-public information is therefore likely to push the stock price in the direction of the trading, particularly if the trading is voluminous, which should bring the price of the security closer to the price at which it will trade when the information becomes public. This is particularly true if the market is somehow able to "decode" the identity of the trader, or even just infer that the trading must be informed.

There are several empirical studies supporting this simple intuitive insight. For example, Lisa Meulbroek conducted an empirical analysis of SEC insider trading cases over a 10-year period to gauge the impact of illegal insider trading on the market price of the securities in question. (7) The study showed that "insider trading is associated with immediate price movements and quick price discovery" and that the "extent to which insider trading aids in price discovery" could be "substantial." (8) Specifically, Meulbroek found that the "cumulative abnormal return on insider trading days is half as large as the price reaction to the public revelation of the information on which the insider trades." (9) Meulbroek concluded from this that "the stock market detects informed trading and impounds a large proportion of the information into the stock price before it becomes public." (10) Meulbroek's study suggested that trading volume and "other" trade-specific characteristics such as trade size, direction, and frequency, signal the presence of an informed trader to the market." (11) This and other empirical studies led Manne himself to conclude that "there is almost no disagreement that insider trading does always push the price of a stock in the correct direction." (12)

But does it really? A look at some recent cases of actual, known insider trading suggests that the answer may not be quite so clear cut. There are, to be sure, many instances where the insider trading does correlate with the stock price moving in the "correct" direction--that is in the direction of the price at which the stock will trade when the information becomes public. But there are also many examples where the stock price does not move much at all, even when the insider trading volume is substantial; examples where the price fluctuates in ways that do not appear to correlate with market detection of informed trading; and even examples where the stock price moves in the opposite or "incorrect" direction.

In Parts II and III of this Article, I look at several recent insider trading cases to see whether the trading had any readily discernable impact on the market price of the security. I have not aimed to be comprehensive or to replicate the large-scale data analytics that have informed other studies. Nor have I engaged in a statistical analysis to determine whether, on the whole, there are aberrational patterns associated with insider trading in any particular stock. Rather, I have looked at specific real-world examples to see whether there is any market movement that correlates with the insider trading and that could be attributed to it. My modest conclusion is that insider trading does not "always" move the price of a stock in the correct direction. While there are numerous factors that may affect stock prices, the absence of price movement, or price movement in the opposite than expected direction, is a good indication that the market has failed to detect the presence of informed trading. confounding price movements indicate that insider trading does not always bring information to the market and suggest a possible weakness in the market efficiency theory of insider trading, particularly in its more dogmatic iterations. In Part IV of this Article, I briefly suggest some reasons why the market may not always pick up the presence of an informed trader and draw out the implications for the law and policy of insider trading regulation.

II. THE GOVERNMENT CRACKDOWN ON INSIDER TRADING

Over the past several years, the Securities and Exchange Commission (SEC) and the Department of Justice have engaged in a widespread crackdown against illegal insider trading primarily at hedge funds. (13) Before suffering some setbacks, the US Attorney's Office for the Southern District of New York had obtained at least 85 criminal convictions and guilty pleas, (14) and the SEC obtained civil judgments against the same individuals and several additional entities. In a controversial, and subsequently limited, decision, the Second Circuit overturned two of the convictions, and a few others were set aside as a result of that ruling. (15) Nonetheless, the government's extensive crackdown is noteworthy for a number of reasons. First, it ensnared several large, well-known, and very well capitalized hedge funds, including SAC Capital and Galleon, and numerous prominent market and financial professionals, including Raj Rajaratnam, the billionaire former head of Galleon, and Rajat Gupta, a former Board member of Goldman Sachs and the one-time worldwide head of McKinsey & Company, a global consulting firm. Second, the amount of insider trading at issue was extensive, with very large positions being taken and extraordinary sums being earned as a result. It was, in other words, precisely the kind of high-volume trading, emanating from sources known to be highly sophisticated, that would seem most likely to send signals that would be picked up by other market participants. To the extent that insider trading promotes market efficiency, these cases should be textbook examples. Finally, the lengthy prison sentences that were handed down after convictions-Rajaratnam, for example, received an 11-year prison term--reflect the view, apparently widely held among judges in the Southern District of New York, that insider trading, far from being victimless, is a serious crime with serious consequences. To the extent that insider trading is actually beneficial in some way, these sentences would appear to be truly unfair and draconian. (16) A look of what actually occurred in these cases may help to dispel some of that unease.

1. Insider Trading at SAC Capital

   In February 2014, Mathew Martoma, a portfolio manager at CR Intrinsic, an affiliate of SAC Capital, was found guilty after trial in an insider trading scheme that netted some $276 million in profits and losses avoided. (17) This was "the largest insider trading case ever charged by the SEC," (18) and the US Attorney's Office called it "the most lucrative" insider trading scheme ever. (19) Martoma was sentenced to nine years in prison, a reflection of the extraordinary gains...