Equity Funding was one of the great corporate frauds of the 1970s. The US company grew rapidly by issuing 60,000 phoney insurance policies. Stanley Goldblum, the chief executive, 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, Ronald Secrist. He told his story to the New York insurance commissioner and to a tenacious Wall Street securities analyst, Ray Dirks. Both began investigations.
Perhaps as a result of Mr Dirks’ inquiries, 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.
Mr Dirks had played a crucial role in exposing the fraud but the Securities and Exchange Commission 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 Mr Secrist nor Mr Dirks was 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 US. In adopting an insider trading directive in 1989, the EU explicitly adopted the doctrine 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 Mr 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 in most other European countries prosecutions for insider trading are as rare as pumpkin pies.
So there are two views of the nature of the offence of insider trading. 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 honesty, while the commission was concerned to promote the “level playing field” theory of efficient markets.
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 inside information. 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 it fractionally earlier is of no public value at all. Stimulating trade seems more important than establishing truth.
“It is commonplace”, said 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 … It is the nature of this type of information … that [it] 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 Powell’s robust common sense.