Equity Funding was one of the great corporate frauds of the 1970s.  The company grew rapidly by issuing 60,000 phony insurance policies.  The chief executive, Stanley Goldblum, and five of his colleagues  went to prison.

Astonishingly, many people in Equity Funding knew about the fraud, and the company made the mistake of firing one of them, Ron Secrist.  Secrist told his story to the New York insurance commissioner and to a tenacious securities analyst, Ray Dirks.  Both began investigations.

Perhaps as a result of Dirks’ activities, the price of Equity Funding stock began to slide.  As panic spread, the New York Stock Exchange suspended trading.  A week later, the company filed for bankruptcy.

Dirks had played a key role in exposing the fraud, but the SEC charged him with insider trading.  Convicted, he appealed.  In 1982 the Supreme Court finally affirmed the obvious conclusion that the public interest in the revelation that Equity Funding was corrupt was  considerably stronger than the public interest in maintaining an orderly market in its worthless shares.

Delivering the Court’s judgment, Justice Lewis Powell declared that fraud was the essence of insider trading:  the offence required a breach of fiduciary duty, and an intention (not necessarily on the part of the insider) to benefit from that breach. But there is no fiduciary duty to maintain the confidentiality of  the unlawful acts of one’s employer.  Neither Secrist nor Dirks were concerned to make personal financial gain from exposing the crimes at Equity Funding. 

       There could therefore be no sound basis for the conviction.  ‘Only some persons, under some circumstances, will be barred from trading while in possession of material non public information’, said Powell.  He rejected what he described as the SEC’s theory ‘that the anti-fraud provisions require equal information among all traders’.

The SEC has never much liked that ruling – and has sought to chip away at it – but it remains the law of the United States.  In adopting an insider trading directive in 1989, the European Union explicitly adopted the doctrine which Justice Powell had equally explicitly denied.  European laws prohibit an insider – someone in possession of information not known to the public but relevant to the market price of a security – from dealing in these securities or encouraging others to deal in them.   If Dirks had been in Europe, he should have been convicted – although it is hard to imagine a British jury actually returning a guilty verdict, and prosecutions for insider trading are as rare as pumpkin pies in most other European countries.

So there are two views of the nature of the offence of insider trading.  Justice Powell’s view – the fraud theory – is the basis of American law. The “level playing field” theory is the preferred stance of the SEC and the basis of European law.  Both the Supreme Court and the European Commission agree that a director who leaves a Board meeting to call a hedge fund manager with the latest news – as Rajat Gupta allegedly did –  should be in jail.  But the Court thought the issue was one of duty and dishonesty, while the Commission was concerned to promote the “level playing field” theory of efficient markets. 

        But there is something odd about the concept of the level playing field. Exchanges tell you that a trader risks jail if he roots out and uses information others do not know. But these same exchanges will sell you co-location -the opportunity to trade on information that everyone will soon know, a few milliseconds before it reaches them.    Yet obtaining better information about companies is essential to the efficiency of markets and society:  obtaining such information fractionally earlier  is of no public value at all. Stimulating trade seems more important than establishing truth.

‘It is commonplace’, said Justice Powell, ‘for analysts to ferret out and analyse information, and this often is done by meeting with and questioning corporate officers and others who are insiders.  And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation’s securities.  It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation’s stockholders or the public generally’.  Much intellectual effort has been devoted, without success, to evading the implications of Justice Powell’s robust common sense.