Sharesleuth.com Exposes Achilles' Heel of Insider Trading Laws
The Mark Cuban-backed Sharesleuth.com, discussed in detail here, has found the previously unexploited Achilles' Heel of the insider trading laws and fired an arrow deep into it. The result is that for the first time, a legal form of what most people would consider "insider trading" exists and can be replicated by anyone with (a) the resources to hire a skilled investigative journalist, (b) the ability to generate a readership on the Internet.
To recap, Sharesleuth.com is a new web publication--basically a blog--backed by businessman Mark Cuban. Cuban has hired a business reporter named Chris Carey, formerly of the St. Louis Post-Dispatch, to run the publication and conduct investigations to "identify suspect companies." Once identified, Sharesleuth.com says it will "shine a spotlight on questionable companies," and will "name names and show our evidence, by linking to documents, photographs and other information." What makes Sharesleuth.com unique and controversial, however, is the fact that it discloses right up front that Cuban is going to make personal investments based upon the information discovered, and do so prior to the publication of this information on the website.
In short, the business model for Sharesleuth.com is that Cuban takes short positions in advance of the publication of the stories published on Sharesleuth.com with the hope and expectation that the negative stories will be read by other investors. These investors will then presumably sell the stock, drive down the stock price and enrich Cuban. And repeat.
For those who believe that there is a flat prohibition on insider trading based on material, nonpublic information, the fact that such a business model could be legal may be surprising. As I have written before, however, there is no such prohibition:
The root of the problem with the "insider trading laws" is that there really aren't any. The offense of insider trading stems from Section 10(b) of the Securities Exchange Act of 1934, a vague statute that prohibits the employment of "any manipulative or deceptive device" in connection with the purchase or sale of securities. Although insider trading is sometimes loosely defined as any trading based on "material, nonpublic information," the legal definition flowing from case law is much more complicated and relies heavily on concepts such as fiduciary duty and the "familial duty of trust and confidence."
For instance, in the 1980s, football coach Barry Switzer attracted the attention of the SEC when, after overhearing a corporate executive discuss the imminent "liquidation" of a public company merger, he profitably traded on that information in advance of the liquidation. The SEC brought an enforcement action against Switzer alleging insider trading.
Although Switzer's conduct would seem to meet any commonsense definition of insider trading, he nonetheless defeated the SEC's case against him. The court ruled that the necessary "duty" had not been breached--because the corporate executive was unaware that Switzer had overheard his discussion of the liquidation, the executive had not breached his fiduciary duty to the company. Accordingly, because Switzer's potential liability as a "tippee" under Section 10(b) would have been derivative of his "tipper's" liability, the court's finding that the executive did not breach his fiduciary duty meant that Switzer's trading based on nonpublic information was actually legal.
In numerous ways, Sharesleuth.com's model is identical to the illegal trading scheme carried out by R. Foster Winans, the WSJ reporter who traded in advance of the WSJ's Heard on the Street column and ultimately went to prison over it. The difference is that the WSJ had a confidentiality policy in place protecting its information, and Winans breached his duty to the WSJ by trading on that information. Similarly, as I have written about extensively, many people have been sued by the SEC or face criminal charges for learning/stealing the information to be published in Business Week's Inside Wall Street Column, and trading in advance of its publication. Again, a fundamental part of the cases against them was Business Week's confidentiality policy regarding its data.
Sharesleuth.com has no such policy--to the contrary, it flat-out promises to trade based on its information. As a result, most people who have analyzed the legality of the Sharesleuth.com business model seem to agree that it does not constitute insider trading and is legal. This no doubt includes Sharesleuth.com/Cuban's own lawyers. (The ethics of this plan are another issue altogether and have been the subject of some heated debate).
All of which leads me back to where this post started--the Achilles' Heel of the insider trading laws. That Achilles' Heel, in my opinion, is that the law does not flatly prohibit insider trading based on material, nonpublic information. Rather, as discussed above, it prohibits some such trading, but excuses other trading if there is no legal "duty" under the circumstances not to trade. Such arbitrariness has not been a systemic problem to date because the "excused" insider trading has always been a one-off, non-repeatable type of situation, e.g., the trader who overhears inside information on a plane and profits from it. Prior to Sharesleuth.com, there has not been, to my knowledge, a "replicable-on-demand" model that avoids the insider trading laws while permitting an investor to trade on nonpublic information.
This is not to say that the Sharesleuth.com business model is necessarily a lay-up. For the model to be profitable, the investigative reporter involved will need to be able to find compelling evidence of fraudulent or questionable public companies that has not yet been discovered. In addition, the publication must generate an audience of critical mass that finds it credible and trades based upon its findings. Assuming all of this can be accomplished, however, the first company that makes its money from legal insider trading will have been created—with a business model that can be duplicated by anyone with similar resources and abilities. If this occurs, Congress and the SEC may need to give serious thought to whether it is time to refine the insider trading laws.
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Comments
How much difference is there between a hedge fund manager selling short a company and then bad mouthing it to anyone who will hear?
Or a fund manager going long and talking up the stock on CNBC?
Cuban is simply formalizing a practice that goes on all the time.
Also, was any information in the first article "nonpublic." From what I read, everything was obtained from public/government records or official sources that anyone has access to. Nothing was secret or confidential.
People just hadn't bothered to look hard at it, including the regulators.
So let's shoot the messenger rather than ask how they heck do shady companies have it so easy.
Posted by: Dominic Jones | August 11, 2006 4:07 PM
While your discourse is interesting, and while sharesleuth clearly inspired it, I think you probably ought to have minimized its role except as inspiration. Cuban-traded or not, their work is not "nonpublic" in any sense of the word I can comprehend. I guess they give away their analysis and disclose Cuban's stake -- which to me sounds like any other blog, just with much better funding. You might as well call Securities Litigation Watch "insider trading," too. Heck, ISS is behind it.
Last, though utterly tangential: Cuban's XNL short position was 10,000 shares, a lot for you or me, but less than a single basis point for a billionaire. I think he simply wants this kind of work out there, and has the money to make it happen.
Seriously: what can sharesleuth *possibly* do that's "insider" in any way?
Posted by: wcw | August 11, 2006 8:43 PM
My comment below is mostly expanding on the previous comments. As you mentioned at the end of your post, there are two conditions that will have to be satisfied before the sharesleuth.com model meets with success. One, solid investigation of companies with strong evidence and two, a wide enough reader base who will trade based on the information. First off, even assuming that sharesleuth.com is successful on both those fronts, I don't think this is even remotely the same as "insider trading," so I disagree that this venture (if successful) would create the first "legal insider trading" model. What really limits sharesleuth.com is legal liability (civil as well as criminal) from false or misleading stories. They expressly acknowledge this on their site. In essence, this potential liability serves as a check on their activities. Furthermore, there is nothing illegal about doing due diligence about a company, which is precisely what the reporter is doing. And unless he violates the law in uncovering the information, he is in the clear. If they post accurate information online about these companies, and people trade based on that information in a way that would seriously affect the stock price, what that shows is that those who are trading based on that information grossly failed to do their due diligence. And if you believe in the efficient market hypothesis, this is unlikely to happen.
This model however, does smell a little like the infamous "pump and dump" schemes, except this is in done in reverse ("dump and pump"). But I think as long as they are extra careful with the information they post, they will have no legal trouble. But realistically, I don't see Mark Cuban being able to use sharesleuth.com as a way to "beat the market."
Posted by: Arvind Radhakrishna | August 14, 2006 12:23 AM
I'd like to make a correction on my last post. I said that the sharesleuth.com model is similar to the "pump and dump" schemes, except it it is done in reverse ("dump and pump"). This is technically incorrect. I didn't literally mean that they follow a "dump and pump" scheme, but rather the process is somewhat backwards. I know that it doesn't make sense literally.
Posted by: Arvind Radhakrishna | August 14, 2006 12:40 AM
I don't see what is non-public about the information that Cuban trades upon? He did his homework, no tipping or violations of duties are involved. The readers are free to agree or disagree with Cuban's analysis, and if they disagree trade against his short. Outlawing this activity would do more harm than good for the efficiency and fairness, yes fairness, of the markets.
Posted by: anona | August 14, 2006 8:17 AM
Am I the only one who finds this article bizarre? I'm stunned that some people apparently think that this should be illegal. Mark Cuban is not an "insider" in any sense of the word. He has no fiduciary duty to the companies he researches. And he is trading off of completely public information! What kind of world do we live in when it is considered unfair for a person to actually get up off the couch and do a little homework for a change?
This is no "Achilles' heel"--it is more like a steel-toed boot ready to kick the real manipulators and criminals in the behind. If there are laws to be tightened up, maybe we should focus on the promotors who are out there jobbing these stocks in the first place.
And don't forget that if Cuban turns out to be mistaken about his assessment of these companies, he runs unlimited personal financial risk (although I note that he is not taking huge positions here--he just seems to be putting his money where his mouth is).
Bottom line--good, bad or indifferent, it is better to have this information out there than not. This is how the system is supposed to work.
Posted by: James Ellis | August 14, 2006 3:16 PM
Insider trading is not an issue with sharesleuth.com. The information provided in the report was public information that anyone can access online.
The only issue with sharesleuth I can see is market manipulation, or a violation of rule 10b-5. A case could be made that Sharesleuth could be a fraudulent scheme to artificially deflate the price of a stock, allowing Cuban to profit by buying it back at a lower price later. I think if Cuban covered into the selling pressure created by a Sharesleuth report (covering within a few days after the release of a report) it would be an obvious violation of rule 10b-5.
However, if Cuban waited a few days to cover untill the selling pressure subsided, and the stock stabilized or rebounded, it seems to me that the SEC's case would weaken substantially.
I would love to hear comments on my theory.
Posted by: Tony | August 15, 2006 11:21 PM
Tony: I think there may be a way to bring such a 10b-5 case, but the substance that is missing is the fraud. Cuban is not "artificially" deflating the price of a stock - he is bringing to light information that everyone could know, but doesn't. It's the truth. So long as the stories are truthful (maybe more accurately: not deceptive), there shouldn't be a problem. At least I don't think.
Furthermore, the stock markets as they exist are not perfectly efficient - they are somewhere near "strong." Anyone who argues that stock markets (even the big ones) are "perfectly efficient" is being foolish -- there is no way the market can "instantly" incorporate "all material information." The Sharesleuth situation highlights this fact. And this fact is what makes Arvind (above poster) incorrect -- that Cuban could NEVER "beat the market." Cuban is taking advantage of the fact that there is publicly available negative information which stock markets either haven't incorporated at all, or have not incorporated completely (in either a temporal or substantive sense). While no one can "beat a perfectly efficient market," people certainly can beat, in theory, a strong-efficient market. Maybe Cuban will turn the theoretical possibility into a reality.
Posted by: guest | September 14, 2006 12:55 AM