When is it wrong to trade stocks on the basis of non-public information? Public views of the morality of insider trading.

• Author: Green, Stuart P.

Introduction I. General Background on Insider Trading II. Why Citizens' Intuitions About Moral Blameworthiness Matter III. Previous Studies of Community Attitudes Regarding Insider Trading IV. Possible Psychological Roots of Opposition to Insider Trading V. Empirical Studies of Public Views of Insider Trading A. Study 1--Initial Look at Insider Trading 1. Study 1 Method 2. Study 1 Results Table 1--Ratings of Study 1 Scenarios in Terms of Blameworthiness, Deserved Punishment, and Percentage of the Sample Criminalizing the Activity B. Study 2--Criminal vs. Civil Liability, Tipper vs. Tippee Liability, and Other Doctrinal Puzzles in Insider Trading Law 1. New Distinctions Investigated in Study 2 a. "Possessing" vs. "Using" Information b. Amount of Insider Trader's Profits and Professional Status of Trader c. Tipper vs. Tippee Liability d. Existence of Confidential Relationship 2. Study 2 Method 3. Study 2 Results a. Liability for Direct Buyers b. Tipper/Tippee Liability C. Study 3--Subjects' Underlying Reasoning 1. Study 3 Method 2. Study 3 Results Conclusion INTRODUCTION

For most people, the prototypical criminal offense involves an action that is clearly and unambiguously morally blameworthy, such as an unjustified act of violence or taking of property. Yet many crimes, especially so-called white collar crimes, exist in a realm of substantially greater ambiguity. In a previous article, we examined lay intuitions toward a series of white collar offenses--fraud, perjury and false statements, and bribery and gratuities--in an effort to determine how lay people distinguish between criminal fraud and "sharp dealing," bribery and "horse trading," perjury and "wiliness on the witness stand," and the like. (1) In this study, we examine lay views of insider trading.

Our system of securities law prohibits investors from buying or selling stock on the basis of "non-public" information unless such information is first disclosed. Those who engage in insider trading can be prosecuted criminally or subjected to substantial civil sanctions. (2) Yet, as in the case of the other white collar offenses we have studied, the line between illegal insider trading and mere "savvy investing" can seem elusive. Some even argue that insider trading should not be prohibited at all. (3) Even among those who agree that certain "core" cases of insider trading should be illegal, there is likely to be confusion about exactly how to deal with outlying cases and about what factors should distinguish violations that are criminal from those that are civil.

We wanted to know what the general public thinks about various acts of insider trading and related activity. If ordinary people agree with those who advocate for the abolition of insider trading laws, then those who attempt to enforce such laws will operate at a considerable disadvantage. Offenders will generally not be tarred with moral approbation and potential jurors will wonder whether the pursuit of these actors is worth public resources. If, as we believe is more likely, people do tend to support a prohibition on at least some forms of insider trading, then the limits and priorities they endorse should be of interest to policymakers. As we will explain in Part II, there is reason to believe that it is important for the criminal law to maintain a connection to the moral intuitions of the lay public and, when the law must differ from that intuition, for it to do so deliberately and coherently.

We begin by outlining in broad terms the scope of insider trading law. We then explain why it is important to consider how the views of the lay public contrast with legal practice. We present a brief discussion of the psychological literature on procedural fairness, which is relevant to understanding lay views on insider trading. Finally, we describe three linked empirical studies that examine lay views of insider trading from several different perspectives.

1. GENERAL BACKGROUND ON INSIDER TRADING

   Our system of securities law forbids investors from buying or selling stock on the basis of "non-public" information, at least in certain circumstances. (4) Yet the most successful and celebrated investors are precisely those who have the best access to (and the best ability to interpret) information that is generally unavailable to the casual investor, even if it is not, strictly speaking, "non-public. This dichotomy presents something of a puzzle: where does one draw the line between illegal insider trading and mere savvy investing?

   For many years, courts and commentators have struggled to define the proper limits of insider trading. (5) Much of the confusion rests on a lack of clarity about exactly what harms, if any, insider trading causes and who, if anyone, it wrongs. Some commentators have gone so far as to argue that insider trading should be no crime at all. (6) Others have sought to limit the scope of its coverage in a variety of ways. One problem is that no statute or rule specifically prohibits insider trading. Rather, the offense has developed mainly through a body of judicial interpretations of the anti-fraud provisions of the Securities Exchange Act Section 10(b) and Securities Exchange Act Rule 10b-5, which bar "manipulative or deceptive devices" in connection with securities transactions. (7)

   There have been several different and sometimes overlapping theories of what conduct should constitute insider trading. In its broadest form, insider trading law was viewed as prohibiting essentially all trading by those who had access to non-publicly available information, regardless of how those individuals obtained that information. The Securities and Exchange Commission (SEC) and several lower courts--in early cases such as Securities & Exchange Commission v. Texas Gulf Sulphur Co. and In re Cady, Roberts & Co.-justified such a rule primarily on the basis of the supposed unfairness of unequal access to such information. (8)

   The scope of insider trading law under modern case law, however, has been more limited. It focuses less on whether the trader had an unfair informational advantage and more on how he came to have such an advantage in the first place. (9) Thus, under the so-called "classical" or "traditional" theory of insider trading, trading on material, non-public information is illegal only if the trader is a corporate insider. A corporate insider may be a permanent insider, such as an officer or director, or a temporary insider, such as a lawyer or consultant. The rationale is that by trading on information unavailable to the public, an insider violates his duty to corporate shareholders. (10) For example, in Chiarella v. United States, the defendant, an employee at a financial printer responsible for printing deal announcements, deduced the identities of takeover targets and, on the basis of that information, purchased shares before the public announcement led to an increase in the shares' value. (11) In overturning the defendant's conviction in the trial court, the Supreme Court rejected the view that merely possessing non-public information made his trading illegal. (12) The Court reasoned that for a trade to constitute insider trading, the trader must owe a fiduciary duty to the company's stockholders or derivatively assume the duty of the person who gave him the inside information (the "tipper"). (13) The mere fact that a trader holds an advantage, and that a trade is in some sense "unfair," does not make it fraudulent under the securities laws. (14)

   Under the complementary "misappropriation theory" of insider trading, a defendant is liable for violating a pre-existing duty to the source of the inside information on which he traded. For example, in United States v. Carpenter, the defendant, R. Foster Winans, a columnist for the Wall Street Journal, was charged with operating a scheme through which he would trade in stocks that were to be the subject of his forthcoming "Heard on the Street" columns. (15) The Second Circuit held that although Winans owed no duty to the shareholders of the companies in whose stock he had traded (and therefore had not committed insider trading under the classical theory), he did owe a duty to the source of the information, his employer, the Journal. (16) Therefore, he had committed insider trading under the misappropriation theory. (17)

   The Supreme Court's decision in United States v. O'Hagan is similar. There, the defendant was charged with trading on the basis of non-public information obtained from his law firm, which represented a client contemplating a tender offer for shares of the Pillsbury Company. (18) Because Pillsbury was not a client of his firm, the defendant was not liable under the classical theory; he had no duty to Pillsbury's shareholders. Instead, the Court held that O'Hagan could be held liable under the misappropriation theory of insider trading for breaching a duty to the source of the information (namely, his firm and its client). (19)

2. WHY CITIZENS' INTUITIONS ABOUT MORAL BLAMEWORTHINESS MATTER

   The law of insider trading, like much white collar criminal law, makes fine distinctions between conduct that appears to be merely "aggressive business behavior" and conduct that is illegal and potentially criminal. (20) We wanted to know whether similar distinctions would appear in lay subjects' judgments about such conduct.

   Citizens' beliefs about the seriousness of various criminal acts matter for a number of reasons. (21) Most scholars agree that society's ability to enforce compliance with the law lies less in the power to impose sanctions than it does in its ability to influence the way people live their daily lives. Generally, people refrain from committing crimes not because they fear sanctions, but because they believe the underlying conduct is morally wrong. (22) Thus, law deters by informing citizens that society has decided a certain act is wrong and by persuading them to adopt that view. If the law does not reflect...