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The paradox of proof… one law, two standards?
Feb 9th, 2008 by admin
By: Kenneth D. Gartrell
I am not a lawyer. So, maybe a lawyer can explain to me how in our securities law under Section 10-(b) we can abide different standards of economic analysis to arrive at judgments about essentially the same thing. I was confronted with this paradox of proof for the first time when working as an expert in an insider trading criminal trial. Let me relate the issues briefly for now. I will be able to return a detailed case study at a later time when all the follow-on maters are decided.
THE INSIDER TRADING CASE
I have previously worked in 10b-5 class actions. I have been a financial economist all my life, so it seemed logical to me to examine the issues in this case from the perspectives of the tools, techniques and concepts common under the Section 10b-5. I was frustrated in my efforts. I am puzzled why such seeming scientific inequities would exist.
In this insider-trading case, where the “material” value of alleged insider information was essential to the facts, a verdict was reached on circumstantial evidence related primarily to patterns of document access, phone calls between the alleged tipper and tipee and selected trades of the alleged tipee. The relevance and worth of the information was either inferred or established by testimony of fact witnesses not obviously familiar with the type of research done in financial economics and the conclusions reached from it.
For reasons of legal strategies, time pressures and judicial discretion, the jury in this case never had the benefit of an economic analysis of the rich, but sophisticated, information environment where the alleged tips occurred. They also did not have the benefit of an assessment of the “market value” of the information in the proprietary investment bank documents from which the alleged tips had been taken. And, finally the jury never had the benefit of an informed independent economic analysis of the tipees trading patterns as it pertained to the backdrop of the mix of information on the market.
CONTRAST WITH CLASS ACTIONS
In 10b-5 class actions for “fraud on the market” the materiality of disclosed or undisclosed information to the market would be evaluated by the “event study” methodology and related analysis of cash flows and accounting — wherein materiality means that such information moves price by more than expected compared to daily unexplained variations due to chance.
In this one insider trading case at least, the concept of materiality was left broadly undefined for the jury to decide. I have to infer this happened because there is no similar precedent of measurement in insider trading cases that parallels class action cases.
The disparity between the insider trading cases and the class actions promotes a somewhat stark realization. A seemingly competent and promising financial professional, for instance, could go to jail for much of his life on the basis of providing information (assuming he did as the jury found) that most financial economists would agree could not sustain damages in a civil class action.
I do understand that the question of harm is examined separately as a matter for sentencing in a criminal case. I believe, nevertheless, that a careful information-based analysis in this particular insider trading case would have cast a large dark shadow of doubt on the more basic questions of guilt or innocence. Understanding fully the true nature of the information that had been allegedly conveyed from the tipper to the tipee, the jury may have viewed all the surrounding circumstantial evidence in different light and accepted more innocent alternative explanations for it.
Aside from a technical consideration of legal precedent, perhaps the other bigger issue is that we have come too far in the criminalization of business conduct. The thrust of the current wave of FCPA and Sarbanes Oxley investigations — coupled with potential for misplaced, ambitious and politically motivated prosecutorial conduct — risks abuse to our market systems. From the point of view of an economist, the process we have now, complete with the kind paradox observed in this one insider trading case, suggests hastily proliferated, over-blunt regulations. It will be up to lawyers and judges who practice in this area to bring rationality and discipline. My suggestion is that we look for consistent applications of economic analysis between criminal and civil matters as one way to alleviate potential anomalies.
http://management.about.com/cs/businessethics/a/InsiderTrade702.htm
http://www.sec.gov/answers/insider.htm
http://www.sec.gov/news/speech/speecharchive/1998/spch221.htm
http://www.washingtonpost.com/wp-dyn/content/article/2007/06/13/AR2007061302197.html
http://www.nypost.com/seven/10262007/business/sec__insider_trading_rampant.htm
http://blogs.wsj.com/law/2007/05/09/talkin-insider-trading-with-former-sec-top-cop-harvey-pitt/
http://www.law.uc.edu/CCL/34ActRls/rule10b5-1.html
http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=ayngJ4XBYwTg
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