Professor Bainbridge...on law, politics, religion, culture & food

Ribstein on Pete Rose and Insider Trading

My friend UIUC law prof Larry Ribstein (best known to the blogosphere as propreitor of the Busfilm blog) sent along the following:

Some random thoughts your readers may have some thoughts on: Pete Rose is back in the news, as he has admitted gambling. He says he didn't bet against the Reds, and didn't bet on inside information about injuries, etc. This makes me reflect on insider trading law. Rose's gambling was regarded as deeply bad - resulting in a lifetime ban. Was it worse than corporate managers betting on or against their own companies or competitors? [Ed.: By inside trading in stock of their company or of competitors.] Think about whether a team owner would ever allow a manager to bet. We would expect not, because team managers have a much better opportunity to affect results with individual decisions than managers of big corporations. But there are similarities between the two cases. Insider trading can counteract managerial risk aversion in both situations. In both cases, while owners will be around for other plays and have other investments, and so may want managers to take chances, managers have only the one job and may lose it as a result of a risky decision. Are better incentive/compensation devices available in sports teams? Note that sports managers truly do serve at will. Maybe their marginal contribution is more easily measured (see Michael Lewis, Moneyball). Of course betting doesn't contribute to the efficient market pricing of sports teams the way insider trading does for corporations. It does contribute information to the betting market, but this doesn't have the same kind of resource allocation consequences as securities markets. In both situations, managers ought to be able to bet (trade) if owners allow it. In sports we may have to define owners to include fans, who should at least get disclosure.

For my take on the economics of insider trading, download this article. In that article, I take issue with two of the arguments to which Larry refers; namely, that insider trading is a useful incentive scheme and that it contributes to capital market efficiency.

Ernie on Law Clerks

Ernie The Attorney thinks law clerks have too much power:

What the hell did I know right out of law school? I knew how to look up the law and I knew a lot about federal procedure, and that was on a good day. But somehow a lot of lawyers seemed to want to believe that I was the secret Oracle. In fact, I remember often in conferences attorneys would address portions of their arguments to me, as though they needed to 'win me over.' Invariably, when I would see an attorney start to do this I would look down and avoid eye contact so as to spare them from a swift rebuke. Most couldn't help themselves and so they persisted even as I looked down. When that happened the judge would issue a sharp warning: "excuse me, what are talking to him for? He's not deciding this case; I am."

I worked for exactly the same kind of judge. He sharply limited his law clerk's role. We were not to talk to lawyers about anything, no matter how trivial. At thew time, I chafed a bit, but like Ernie I am now glad the judge had that rule. It removed the source of temptation to say anything substantive that might come back to haunt the judge. In the unlikely event I ever became a federal judge, I'd have the same rule.

ProfessorBainbridge.com cited in the Yale Law Journal

My humble blog has been cited in the Yale Law Journal by Harvard law prof Guhan Subramanian:

See Stephen Bainbridge, ProfessorBainbridge.com: Delaware's Predictability Redux (Oct. 20, 2003), at http:// www.professorbainbridge.com/2003/10/delawares_predi.html ("I've researched [the California pill question] at some length and have been unable to find any significant guidance in either the case law or secondary literature. As far as I can tell, there is no definitive answer.... Relative to California law, Delaware's substantial body of precedent provides a high degree of certainty.").

113 Yale L.J. 621, 629 n.43 (2003). Now the Dean will have to give me credit for the time I spend blogging. Hah!

Update: Some people are taking this entirely too seriously!

Update 2: On the other hand, I suspect Professor Reynolds likes the idea of getting credit for blogging. [FYI: At most law schools, promotion and salary are based on your performance in three areas: scholarship, public service, and teaching. Blogging could count in all three, but most prominently as scholarship.]

Latest Hollinger News: Shareholder Lawsuit

One is not surprised to learn that a shareholder lawsuit has been filed in Delaware Chancery Court against the directors of Holinger International:

Cardinal Value Equity Partners ... claims the board "comfortably settled into its role as rubber stamping the self-dealing transactions conceived by Black ... to the point where they did not mind being relegated to providing their approval after the fact".

The claim focuses on numerous deals struck by and within Lord Black's labyrinthine empire - among them the sale of some assets to Canadian media group CanWest for $1.8bn in 2000. According to minutes of a board meeting four months earlier, directors were told Lord Black and others would receive a total of $53m in non-compete fees and that further payments would go to Ravelston, his private company. Cardinal claims there was never any independent analysis of the size or need for these payments. The claim .... alleges that investors lost out through "misappropriation of corporate assets as well as self dealing - arrangements, for example, where company executives sold company assets to other companies where they had an interest".

In self-dealing claims such as this one, the shareholders have a cause of action against the directors or officers who misappropriate corporate assets or pursue conflicted interest transactions. The claim against the non-participating directors is more complex. Most self-dealing transactions do not require director approval as a matter of law, although many corporate conflict of interest policies go beyond what the law requires. Instead, approval by the disinterested directors provides a partial safe harbor if the transaction is challenged by a shareholder (such approval shifts the burden of proof from the director with the conflict of interest to the shareholder). Ordinarily, the failure of the directors to make an informed decision in this regard is invoked merely to vitiate the safe harbor rather as grounds for an independent cause of action against the approving directors. Yet, under Smith v. Van Gorkom, directors' duty of care requires that when they make a decision they do so on an informed basis. Likewise, the Caremark decision plausibly could be interpreted as imposing an affirmative duty on directors to investigate conflict of interest transactions and to ensure that the conflicted directors do not take advantage of the corporation.

The Hollinger lawsuit thus could be distinguished from the recently dismissed case against Martha Stewart (blogged here). In the Stewart case, the shareolders' suit alleged that Martha Stewart Omnimedia's disclosure documents routinely stressed the importance of Martha Stewart to the company's success. After the controversy over Stewart's trading in ImClone stock broke, MSO's stock price dropped precipitously, ultimately bottoming out at a 65% loss. The suit alleged Caremark violations by MSO directors and execs (click here for a discussion of Caremark), who allegedly failed to "ensure that Stewart would not conduct her personal, financial, and legal affairs in a manner that would harm the Company, its intellectual property, or its business." In dismissing, Chancellor Chandler explained that: (1) plaintiff had failed to allege facts that would have put the board on notice of potential wrongdoing; and (2) the Delaware precedents speak to wrongdoing in a corporate capacity, not in an exec's personal life. Based on what we know thus far about the suit against the Hollinger board, it sounds like both of those criteria will be satisfied. Because the alleged misconduct involved self-dealing with corporate assets and because it is alleged the directors were aware - even approved ex post - of some of the transactions, a strong case is already made out that the board had a duty to investigate and make an informed decision as to the proper course of action.

This is not to say that the board necessarily should have invalidated these transactions. Self-dealing transactions are allowed provided they are fair to the corporation (and for very good reasons discussed here). It is only to say that the board was obliged to make an informed decision as to whether to allow the transaction to go forward.

Does Howard Dean have an Insider Trading Problem?

Via Hugh Hewitt, I learned that the NY Post reports:

Howard Dean acknowledged yesterday that he sold $15,000 in stock in five Vermont banks in 1991 after getting "inside information" from a state banking regulator soon after he became Vermont governor. Dean yesterday portrayed the sale as a bid to avoid a conflict of interest - not an attempt to profit from inside information.

Trading by a government official in possession of material nonpublic information potentially is an insider trading violation. To be sure, classic insider trading (the so-called disclose or abstain rule) is irrelevant. Classic insider trading occurs when an insider or other fiduciary trades in the stock of the company to whom he owes fiduciary duties. As governor, Dean owed no duties to the banks in whose stock he traded or the other shareholders thereof. So no liability there.

An alternative theory of insider trading, however, is potentially applicable. Under the so-called misappropriation theory, liability arises where the trader breaches a fiduciary duty owed to the source of the information. Suppose, for example, that Acme Corporation is planning a big contract with Ajax Corporation. When announced, the stock of both companies is expected to rise. I am a lawyer working for Acme. I owe fiduciary duties to Acme. I owe no duties to Ajax. If I trade in Acme stock, that is classic insider trading. If I trade in Ajax stock, that is misappropriation. I used confidential information belonging to Acme to make a personal profit by trading in Ajax stock. In doing so, I breached my fiduciary duties to Acme. (If you're wondering why a securities fraud issue like insider trading is bollixed up with fiduciary duties, you need to read my book.)

So what would have to be shown to say that Dean committed insider trading? Key issues: First, that he had a fiduciary duty to the source of the information - presumably the state of Vermont - not to use information learned in his official capacity for personal gain. There is precedent for imposing such a duty. Second, that he traded while in possession of material nonpublic information. The information evidently was nonpublic, but was it material? Information is material where there is a substantial likelihood that the reasonable investor would consider it important in making decisions. Dean's people claim "the regulator's report was 'innocuous.'" We'll need some enterprising reporter to track down the regulator's report to find out (unless it's buried away in Dean's sealed records). Third, in some circuits it is not enough to trade while in possession of material nonpublic information. Instead, you must trade on the basis of the information - in other words, there must be a causal link between the information and the trade. Dean claims that he sold to avoid a conflict of interest. Possible, maybe even probable. A claim that the sale was made to avoid a conflict of interest rather than on the basis of inside information, however, would be an affirmative defense with the burden of proof on Dean. As the Post points out, moreover, he didn't sell other stocks that also presented at least some potential for similar conflicts of interest. (Update: See also Newsweek's report on Dean's conflicts of interest.) Finally, he must have made a profit or avoided a loss. Did he? According to the Post article, the AP is reporting that the bank stocks were headed down, which suggested he avoided a loss. (Update: AP report here.) Dean's people are claiming that long-term the bank stocks went up, but the long-term is irrelevant for this purpose.

Based on what we know so far, which admittedly isn't much, it looks like a plausible case could be made. The main issue would be the contents of the report. Was the information material? There is no way of knowing without seeing the report. The other key issue would be whether Dean can make out an affirmative defense that he traded to avoid a conflict of interest rather than on the basis of the information in question.

Update: Mark Kleiman thinks I'm impugning Dean unfairly:

Prof. Steve Bainbridge of UCLA says that Dean's explanation that he sold the stock to avoid potential conflicts of interest is "possible, even probable." But Bainbridge then goes on at great length to speculate that (1) IF the information in the report was negative; and (2) IF as a result of that information he sold the stock; and (3) IF by selling the stock Dean avoided a loss; and (4) IF a particular theory of fiduciary responsibility is adopted, THEN Dean might possibly have been guilty of something, UNLESS he could show that he actually sold the stock to avoid a conflict of interest. Of course, all of this is merely theoretical, since any case would have been long since barred by the statute of limitations.

From the SEC's website:

Examples of insider trading cases that have been brought by the SEC are cases against: ... Government employees who learned of such information because of their employment by the government....

Second, while I find Dean's explanation for his sale plausible, if not wholly immune from being questioned, the law of insider trading makes motive irrelevant. If you traded while in possession of material nonpublic information, you are liable. In a few jurisdictions (like the 9th Circuit), you must have traded on the basis of the information. Even there the claim that you traded for some other reason than the material nonpublic information in your possession, however, is an affirmative defense. From the SEC's website:

Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is "aware" of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.

In Dean's case, there was no pre-existing plan (he decided to sell and sold). So he would have trouble making out the affirmative defense. Finally, it is well-established that insider trading liability can be established by circumstantial evidence.

I will concede, however, that all of this arguably says more about the insider trading laws than Howard Dean. The law of insider trading has become a set of hyper-technical rules largely divorced from their legitimate policy function of protecting property rights in information. (See, e.g., Insider Trading Regulation: The Path Dependent Choice between Property Rights and Securities Fraud.) The fact that they can be applied in such a straightforward way in this situation illustrates that point quite forcefully. As for Dean, the question will be whether this is an isolated incident with a plausible explanation.

WSJ on Spitzer

Lead editorial in today's WSJ ($) on Eliot Spitzer:

What's most disturbing is the precedent of an attorney general telling a company what it can charge for its services. Mr. Spitzer has no more business setting mutual fund fees than he has setting the newsstand price of The Wall Street Journal. And there are good reasons why.

The mandate of state attorneys general is to enforce the law, not to serve as a de facto national legislature and regulator. When prosecutors lose sight of this distinction and use their powers behind closed doors to club industry into adopting rules to their liking, they undermine a well-established regulatory framework based on transparency. The open secret that Mr. Spitzer wants to be New York's next governor should raise even more eyebrows.

If the SEC wants to regulate mutual fund fees, for example, it would have to get authority from Congress. And that's just one of several steps that include promulgating a rule and putting it out for public discussion. This important process allows for input from detractors who may feel a rule is misguided or even beyond the regulators' purview. The shareholder access rule recently proposed by the SEC drew thousands of letters from interested parties during the comment period. The Business Roundtable has even threatened to take legal action. Mr. Spitzer, by contrast, operates with virtually unconstrained discretion and none of the institutional checks and balances that apply to federal regulators. Like his past forays into Wall Street's research transgressions, Mr. Spitzer's fee-setting smacks of political grandstanding. The Journal reported last month that his office is steering millions of dollars from the civil settlements in these cases toward "voter constituencies that could be key to Mr. Spitzer's widely expected Democratic run for governor in 2006." This explains a lot.

If you have a WSJ subscription, go read the whole thing. And, for further information, check out my archived blog entries on Spitzer.

A 2004 Prediction: M&A Activity Will be Up

Two trends likely will coalesce in 2004 to generate a substantial amount of corporate mergers and acquisitions activity. First, continued weakness in the dollar will make US assets (such as companies) look cheap to European and Japanese acquirers. Second, continued strength in the stock market will make doing stock-for-stock deals attractive. You'd think that M&A activity would drop when stock prices are high, but in fact M&A activity tends to be positively correlated with boom periods for the stock market. Partly that's due to acquirer confidence (and maybe even irrational exuberance), but it's also because acquirers can offer their own (highly priced) stock as very attractive consideration for a deal.

Parmalat and Sarbanes-Oxley § 307

I've been a pretty consistent critic of SOX and especially § 307's provisions on lawyers' duty to report up the ladder (blog archive here; law review articles here). One of my criticisms has been that all the law does is to create incentives for managers to avoid telling their lawyers anything. The Parmalat scandal confirms it for me. Even though it now appears that the Parmalat bad guys used incredibly simplistic methods of hiding their misconduct, and in many ways were a remarkably bumbling lot, they managed to keep a multi-billion dollar fraud hidden for years largely by using a tiny (5-7) member team. If they can pull that off, it's hard to believe that most managers won't be able to conceal fraud from their lawyers. (And, as Parmalat may end up proving, many managers will be able to co-opt those lawyers who do know.) So SOX § 307 will make life harder for honest folks, while not doing very much at all to deter the bad guys.