[In]Securities Guest Blog: Something Built to Last by Aegis Frumento Esq

February 20, 2020


Something Built to Last

A few years back I received a gift of The Complete Cartoons of The New Yorker. This 650-page collection of thousands of New Yorker cartoons from 1925 through 2006 is a time capsule, a peek into what was considered funny (at least by New York sophisticates) in the course of the 20th Century. Those of the '20s and '30s can be surprisingly risqué, and all of them poke fun at the rich, the famous and the pretentious through the decades. Two in particular are relevant here. 

One, from 1937, shows a waiter in white tie and tails, holding a serving platter, entering the kitchen where the staff is busy cooking for what looks to be a private party in the dining room beyond the threshold. He leans over whispers to a kitchen colleague, "Tell 'em to dump their industrials. Further details later." 

The second, from 20 years later, shows a building engulfed in flames, with hook-and-ladders and firemen manning hoses trying to douse it. The sign on the building says "Fenwick Chemical Co." A short distance away, a man has jumped out of his car, leaving the door open, and into a phone booth. With phone in hand, he looks at the flames and says, "To hell with a balanced portfolio. I want you to sell my Fenwick Chemical and sell it now."

We find both cartoons funny because we know something's amiss. Both protagonists are exploiting non-public information to profit at the expense of other traders. But here's the real funny part: The waiter is arguably guilty of insider trading; the guy driving past Fenwick Chemicals in flames is not.

That the law treats these two differently has bothered securities law theorists for years. The reason is that insider trading is built on the idea of fraud. When the waiter overhears his dining businessmen, he is pilfering information that the diners expect to keep to themselves. But that Fenwick's on fire is an open and notorious fact, and our passerby learns it innocently. That's why he's free to trade, and the waiter isn't. Mere possession of non-public information is not enough. The key ingredient of the first example that's missing in the second is some bit of deceptive conduct.

Many would just as soon get rid of fraud as the linchpin of insider trading. They suggest your only duty is not to take advantage of your fellow traders. Anything more just makes insider trading law complicated and confusing, forcing us to parse who exactly our waiter defrauded and how. Not to mention the kitchen staff who thereafter trades on his tip.

Admittedly, it can get complicated. However, the securities laws require fraud and deception by statute (section 10(b) of the Exchange Act of 1934), so the only way to change it is by new legislation. 

The recently published Report of the Bharara Task Force on Insider Trading
Bharara+Task+Force+on+Insider+Trading.pdf ends up recommending just that. Former U.S. Attorney Preet Bharara put together a blue-ribbon panel "to review and assess the current state of insider-trading law and to explore proposals to improve it." It's not entirely clear who, if anyone, asked him to. Still, it's a high-caliber team, including a couple of renowned law professors, a gaggle of former DOJ colleagues, and United States District Court Judge:

Preet Bharara, Chair
Joon H. Kim, Vice-Chair
John C. Coffee, Jr.
Katherine R. Goldstein
Hon. Joseph A. Grundfest
Melinda Haag
Joan E. McKown
Hon. Jed S. Rakof 

The Task Force concluded that insider-trading law needed to be reformed, and that the only way to do that was to enact a new statute. "[A]ny steps short of a new statute will continue to be burdened by the uncertainty that accompanies existing common law." The Report then goes on to expound Four Principles that should govern the new statute. They stand there like Buddha's Four Noble Truths:

First: aim for clarity and simplicity. That seems noble enough. Good luck with it.

Second: expand liability to those who act "wrongfully."  

Third: hold tippers liable even if they gain nothing from having tipped. 

Fourth: require mere "awareness" that the inside information was "wrongfully" obtained, willfully for criminal liability and recklessly for civil liability.

All this conjures the old joke: If I had to do it over I wouldn't make the same mistakes; I'd make worse ones. 

There are two fundamental problems here. The first is that we don't really understand why we don't like insider trading as a thing in itself. There is a lot of academic literature suggesting it doesn't really do any harm. So much of it that the Report, in its footnote 2, mentioned a couple of leading articles and then gave up with an academic shrug: "This topic has been debated for decades and we cannot cover the full literature here." In today's fast-moving markets, the insider's advantage can't be that great, and sometimes not at all. Whether insider trading is good, bad or indifferent for the markets is an ongoing conversation. Since we don't agree on why or even if insider trading should be outlawed, we can't craft a best way to outlaw it in its own terms.

The second problem is that any statute can be gamed, and the more precise it is, the more loopholes it creates. Insider-trading law is not complex because the law is complicated. Insider trading cases can be complicated because human beings, ever trying to get one over on each other, have an unlimited imagination. To think that a new statute, with new concepts and inherent ambiguities (what does "wrongful" mean, really?), would fare any better at keeping human avarice under constraint is a fool's errand. 

Stewart Brand, best known as the author of The Whole Earth Catalog of the 1970s, said this about biological systems:

How genetics and development actually work, it's a mess. It consists entirely of hacks and patches all the way down. It's not modular. It's not agile. It's not anything that an engineer would recognize; it's just crap that runs. So when you go to try to reverse-engineer it, you can't. It's no good, because it was never engineered in the first place.

That is true of anything that grows organically rather than by design. In his 1994 work, How Buildings Learn, Brand used that idea to explore how buildings change after they are built to accommodate the needs of future users. Over time, porches are built, then they are enclosed and then they become additions. What once were factories can become lofts, offices and indoor malls. Big houses are split into smaller ones. But buildings designed to rigid specifications for too specific purposes are too difficult to modify for new uses. They are demolished if they don't rise to the level of a historic artifact. That's why the simple rectangular colonial house, to which you can tack an addition to the back, and then another to the side, has survived and will outlast the faux-château McMansion to which nothing can be done without making it look sillier than it already does. To be built to last is to be protean.

The Report bemoans "the uncertainty that accompanies existing common law," calling it a "burden," a bug, if you will. Its authors forget that, as Oliver Wendell Holmes so aptly put it, "The life of the law has not been logic, but experience." Seventy-five years of experience have given us a common language for discussing why we don't like insider trading, the language of fraud. To seek instead to condemn insider trading because it is bad for the markets or because it is "wrong" will get us nowhere, because we'll never agree on the truth of the first or the meaning of the second. But we all know what fraud is and why we don't like it. Insider trading law has lasted as long as it has precisely because it is rooted in fraud, of which we have so common an understanding that Dante considered it the most uniquely human of sins. Contrary to the Report's conclusion, to base insider trading on fraud is not a bug; it is the most salient feature of a jurisprudence that is built to last.


Aegis J. Frumento

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of BrokeAndBroker.com Blog.