Corporate Governance

Blaming Regulation FD for Insider Trading

By J Robert Brown Jr.

There is, apparently, a massive insider trading investigation underway by the SEC and the US Attorneys Officve that is looking into the distribution of material non-public information by "expert-networks".  The Journal reported on some criminal indictments that have just emerged in that investigation.  There is nothing wrong with sharing information through a network to hedge funds and other investors. 

What cannot occur is the transmission of material non-public information by corporate officials who are doing so in violation of a duty to their employer (or to the shareholders of their employer).  In most cases, this means they cannot give out material non-public information in return for payment.

The Journal also, however, included a second piece that effectively sought to blame Regulation FD for the situation. 

Regulation FD requires companies that reveal material non-public information to certain persons (shareholders, analysts, brokers, for example) to disclose the same information to the public.  If the disclosure is deliberate, market disclosure must be simultaneous.  If it is accidental or inadvertent, market disclosure must be within 24 hours.  Regulation FD was designed to overturn one of the worst consequences of the Supreme Court's jurisprudential approach to insider trading, specifically the holding in Dirks that deliberate, selective disclosure of material non-public information by a corporate official did not violate Rule 10b-5. 

Regulation FD was harshly criticized when it was adopted.  Analysts did not like the limitations.  Corporate officials understood both that they could not selectively disclose material information to analysts, apparently a common enough practice, or that accidental disclosures would now have to be revealed to the entire market.  Nonetheless, the Regulation has been in place for a decade and most have gotten used to it, with the criticism dying down.

According to the WSJ, however, Regulation FD resulted in the spread of expert-network firms as a "back door."  See WSJ ("But a back-door method was discovered to help big investors find an edge: companies offering to match 'experts,' such as midlevel executives at various companies, with investors."). 

The assertion is little more than a misplaced criticism of Regulation FD.  The flaws in the analysis are numerous.  First, it assumes that expert network firms only arose because of Regulation FD, as if investors, but for Regulation FD, would have little interest in acquiring information that provides trading advantages. 

Second, the networks apparently benefited, among others, "major hedge funds", a category of investors unlikely, even in the pre-Regulation FD era, to have access to material nonpublic information from corporate executives.  Moreover, even if some had access, the other hedge funds would still seek alternative avenues for information.  Thus, with or without Regulation FD, hedge funds would have an incentive to acquire informational advantages in the market.   

Third, whatever they are called, these networks, apparently, involve the disclosure of material non-public information by corporate officials in return for payments.  This was going on before Regulation FD and will go on afterwards.  It was illegal before Regulation FD and is still illegal. 

Market participants always seek informational advantages.  Expert networks are one more way of trying to gain such an advantage.  They likely coincided not with Regulation FD but with the growth in hedge funds, aggressive, often short term, investors that thrived on short term gains that arose from modest or temporary informational advantages.  In other words, blaming Regulation FD for creating the dynamics that led to the current insider trading investigation is probably wrong but in any event quite incomplete.  

Full post as published by The Race to the Bottom on December 21, 2010 (boomark / email).