‘Inside Information’
“Securities in corporations whose directors are known to be trading in and out of the stock on special information for their own personal profit are coming more and more to be looked upon askance by investors.”
I.
The roaring bull stock market of the last few years and the fortunes reported to have been made on 'inside tips' on the market make pertinent the examination of some of the interesting legal and ethical problems involved.
At a directors' meeting of a corporation the president reported the negotiations for the sale of an unusually large quantity of the company's product at an extraordinary profit. He stated that he believed the contract would shortly be closed, but that if the negotiations were known to competitors they might not be successful. The meeting adjourned. Brown, one of the directors, Smith, the counsel for the company, who was present at the meeting, and the president's personal secretary, all felt sure that the completion of the contract would make the stock of the company more valuable. They at once separately bought more stock in the corporation.
Did any of them violate any duty, legal or moral? If they made a 'killing' on the purchases, was it 'tainted money'?
This sort of question is being asked more frequently every day in the business world, and there is no easier way to start a heated argument than by asking it.
There are almost infinite possible variations of the problem. For example, the methods of purchase may have been different. Does it make any difference whether the purchases were made on the New York Stock Exchange, or as a result of offers to stockholders privately, or by private tenders of stock to the purchasers at a definite price with no questions asked by the seller?
If there are satisfactory answers to these questions, we shall find still further difficulties when we try to deal with 'tips' on the market.
What if the purchase had been made by a friend to whom the director told in confidence the story of the negotiations? And would it make any difference if the friend had not been told the complete facts, but had been told by the director merely that the stock would, in his opinion, go up?
The extent and importance of the information must have some bearing in all of the cases suggested. If, instead of information as to the sale of the company's product, the insiders bought on information that all of the directors had informally agreed to increase the dividend at the next meeting, or that an agreement had been closed for the company to join a merger which would make the stock worth $100 per share, although it was then selling on the market at only $50 per share, the purchases seem more and more open to objection. If, however, the extent of the information was merely that the company's business had in general substantially improved since the last previous public report of operations, few would complain.
There is no active misrepresentation in any of the suggested cases, but if directors and counsel had withheld the information by agreement, in order to give them an opportunity to buy stock at low prices, we have still another problem.
We are walking on the edge of ethics and of the law. The problem of purchase by a director in its legal aspects has been discussed in the law journals for twenty years, and I shall not undertake an analysis of the legal decisions.
The result of permitting the director and his friend and certain employees to buy freely in all the above cases is to make special information a perquisite of directorship and confidential employment, and an asset peculiar to the directors and those with whom they share it.
The result of forbidding a director and his friend to buy in any one of the suggested cases is to keep them out of the market a large part of the time, putting them in a position less favorable than that of any other stockholder; and if we extend the prohibition from a moral to a legal one, a director would hardly dare buy stock at any time for fear that a judge or twelve wise men might be convinced by able counsel arguing with the advantage of 'hindsight' that the director always had special information affecting values, not possessed by the other stockholders.
The law courts are absolutely divided in their approach. In some jurisdictions—which, however, do not include the large securities markets—courts say that directors cannot purchase stock from a stockholder without giving him the benefit of any official knowledge they possess which may increase the value of the stock. In others, courts say that a director may buy and sell stock like an outsider, provided he does not affirmatively misrepresent facts.
Courts rest their decisions in general upon the statement that a director is or is not a trustee for shareholders, and if he is considered a trustee they apply the ordinary rule that a trustee may not buy from his beneficiary without full disclosure.
II.
First consider the alleged duty of disclosure. Much has been said about the duty of directors to tell stockholders what is happening in corporations. Professor Ripley's arguments for corporate publicity in Main Street and Wall Street have a wide following, but there are important limitations. Information cannot always be disclosed; for example, negotiations pending, the details of a secret process, sometimes even the existence of a secret process, lists of customers, prices received and paid.
Furthermore, information should, in general, be disclosed at regular intervals from a central source and to all stockholders at the same time. Days must often elapse between the time when the directors are advised and the time when stockholders generally can be notified of corporate developments. Statements by single directors as to company affairs are properly frowned upon. A director making optimistic or pessimistic statements about his company has often seen the truth he has spoken 'twisted by knaves to make a trap for fools.'
A director would often violate important principles if he were to disclose to persons from whom he desired to buy stock all of the facts which might tend to make the stock more valuable.
There is another important angle to this disclosure question. Can directors be trusted to determine the time, the extent and form, of corporate reports when they are buying or selling stock, and when the reports may have an effect on their own profits? It is no simple matter to give a true picture of a company's business in a public statement. The method of corporate accounting and the form of published-earnings statements and balance sheets have a material effect on the market value of the stock. The history of corporations has not been free from reports withheld or colored for the express purpose of helping directors to profit on the stock market. Even the law gives a remedy in many of these cases. The dangers seem to many a sufficient reason for preventing sales or purchase of stock by directors at any time. Few directors, however, would accept this limitation as a penalty for going on the board.
Then we come to the effect of markets. We cannot light-heartedly dismiss the nature of the market as having no bearing on the problem. When stock is bought or sold on the New York Stock Exchange, no representations are made either by the buyer or by the seller, who deal anonymously. The market price is the result of a multitude of economic forces, hopes, information, and so forth, and many feel that on the Exchange the seller takes his chance on any information the buyer may have, and that stockholders are so benefited by having a broad market on which to buy and sell securities that they have no complaint if the buyer or seller knows more than they do.
It is further said that if directors are kept out of the market this limits the marketability of securities, and thereby injures the stockholder. But the most important thing about a broad anonymous market is that in practice it makes disclosure meaningless. To whom can the director make this disclosure unless he makes a public statement? He does not know from whom he is buying. There is a very natural hesitancy to lay down a rule that a director must make what amounts to a public statement of such personal matters as his business transactions in the stock, and all his reasons for buying.
Assuming for the moment that owing to the anonymous nature of the transaction there is no limitation to trading on the Stock Exchange at any time for any purpose and with any knowledge, what shall we say about a local unlisted market where occasional bids and offers are made; where, for example, the purchase or sale of several hundred shares of a special security is a matter of active effort and 'shopping around' among financial houses? If the personal contact between the agent for the buyer and the agent for the seller is more direct, the opportunity for disclosure is better. The more direct the dealing, the more directors hesitate to take advantage of special information. Some take the middle ground that in such cases there should be at least disclosure that it is a director purchasing.
Should the question whether the seller has asked for information from the corporation's officers have any effect? And if a seller has not seen fit to ask questions, has he any right to complain? One court thinks not. But if the fact of inquiry by a stockholder is to control, a director before buying must canvass all officers and other directors to see whether they have been asked questions by any stockholder; must find out whether the inquiring stockholder is the one proposing to sell—obviously impracticable and an impossible burden if the transaction is on a wide market, and anonymous. A more reasonable rule would be that, if a director assures himself that the information upon which he acts is available when requested by a stockholder, he may buy freely.
Those who argue against any limitation on director purchases except in cases of misrepresentation say that the only fiduciary duty owed by a director is to the corporation; that there is no such duty directly to stockholders, and the corporation has clearly lost nothing by a director's purchase or sale. They agree that a director's duty in dealing with his corporation is such that he must use the utmost good faith and must disclose everything, and that he must not act to injure the company. But may he not violate this duty sometimes by buying or selling stock? While there is no direct injury to his corporation, the fact remains that, in general, securities in corporations whose directors are known to be trading in and out of the stock on special information for their own personal profit are coming more and more to be looked upon askance by investors. The market for its securities is of importance to a corporation. That which injures this market injures the corporation. The argument in reply is that directors' purchases create a more active market for the securities, and, therefore, benefit the corporation.
Quite apart from the fact of possible injury or benefit to a corporation by purchases and sales of stock by a director, the more rigid moralists contend that the information a director acquires as director is really held by him as trustee for the corporation, and is in its nature a kind of property of the corporation. If, therefore, this is turned into private profit for the director, he should be accountable to the corporation. To support this, the case is cited where a director who is paid money to vote for a certain transaction is compelled to disgorge for the benefit of the corporation, even though it is proved that the transaction would have been consummated regardless of his vote. Is it easier to find a trusteeship of a director's vote than of his information? If a director sold special information acquired as a director, one's moral sense would be shocked.
III.
This brings us to the general question of tips to friends. The giving of a tip to a friend is not tarred with the money brush, but what if directors in two different corporations swap tips over the luncheon table? If tips are valuable, the director has exchanged information for something of value.
If we try to apply any general prohibition against tips we are confronted with the problem of what is a valuable tip, and how much information be given; and any general prohibition would in practice almost keep a man from speaking with any enthusiasm about any company of which he was a director. Prohibition of tips would be more difficult to enforce at the bar of public opinion than prohibition of alcohol. It is hard to imagine a rule of law which would be even fairly workable.
The right of a director to sell his stock presents somewhat different considerations. Of course, if there are misrepresentations by the director, there is no room for argument. But suppose the director knows that the regular dividend will not be declared at the next meeting, and says nothing and sells the stock. It is common knowledge that the market price of a stock not paying dividends is often much lower than one paying dividends, far lower usually than the actual asset value of the corporation warrants, for circumstances force many people to sell at a sacrifice non-dividend-paying securities. There is a general feeling in the business community against a director's 'unloading' on the unsuspecting public a stock about to pass its dividends. Yet, in the absence of any misrepresentation, it is hard to see what obligation is due to the purchaser if the doctrine that the buyer must beware still has any force at all. The instinctive dislike of the transaction is the entirely creditable dislike of betting on a sure thing. The purchase and sale of securities is often considered, and not unreasonably, as a kind of gamble. If two men wager on the result of a horse race which has, in fact, been run, and if the result is known in advance to one of those making the wager, all bets are off. If this is good gambling ethics, should it not be good business ethics? One difficulty is that the number of sure things in this world is almost nil. Hindsight may regard as a sure thing anything which has happened, even though the result was, in the minds of the parties concerned, in the lap of the gods. It is extremely hard to draw the line as to what kind of knowledge is so sure to increase or decrease the value of a stock that to act on it amounts to playing with stacked cards.
The practical difficulties of the problem of purchases and sales on inside information, the lack of any general agreement, and the dangers of distorting innocent transactions to the injury of honest men, lead to the conviction that the law should only try to deal with the flagrant cases amounting to active misrepresentation and possibly those involving a conspiracy of silence, leaving the borderland cases to the business conscience of the community.
The developments in business ethics have been amazing, and a man's standing in the community is more and more affected by the standards he sets for himself in these matters.
An admission that the law cannot and ought not to deal with the problem except in clear cases of misrepresentation does not answer the questions for a man with a specially sensitive conscience. If for practical reasons disclosure is impossible, and if he believes the information he possesses as director so important that it probably will greatly affect values, he will feel that he should keep out of the market, and he will not take comfort in hiding behind the anonymous nature of a stock-exchange transaction. If he ever wants to buy or sell he will struggle with the questions of practicable disclosure, importance of information, probable effect on markets and market values; and the very reasons of self-interest which make him want to buy or sell will be the reasons why, as a matter of conscience, he will feel he ought not to buy or sell.
If such a person wants peace of mind, he had better plan to buy stock before he becomes a director, and hold it until he resigns. Meanwhile the average business man will go ahead as at present, drawing his own line according to his nature.
Tips will still fly around business offices like gossip at a ladies' luncheon, and purchases of stock will be made every day as they are now on inside information, some of which will, to the secret satisfaction of the more sensitive, result in financial disaster to the insider and his friends.