The use of insider information in CDS trading also reverses conventional scientific theories about the damage caused by insider trading. These competing positions represent opposing pillars arguing for and against the ban on insider trading.
CONVENTIONAL THEORIES OF INSIDER TRADING
THE LAW, POLITICS, AND POLICY OF INSIDER TRADING
MANNE, INSIDER TRADING AND THE STOCK MARKET (1966) (arguing that banning insider trading makes markets inefficient); Roy A. Schotland, Dangerous at All Costs: A Reply to Manne, Insider Trading and the Stock Exchange, 53 VA.
DOCTRINAL AMBIGUITIES UNDERLYING INSIDER TRADING
AN INSIDER'S MARKET: A PRIMER ON CREDIT DERIVATIVES
This section introduces credit derivatives and the challenge they pose to traditional insider trading jurisprudence.78 Credit derivative instruments that trade the credit risk of a debt instrument as a loan pose a particularly difficult conundrum for insider trading laws. . It reveals the tension between this market's ability to easily commoditize confidential information and the insider trading laws intended to ensure its integrity.
FORM AND FUNCTION
The economic risk of the loan is transferred to the credit insurance seller; however, all legal rights and benefits that the Lender has under the Loan Agreement with the Borrower shall remain intact and unaffected. First, the lender wants to ensure a cleaner balance sheet and remove the loan risk from its books. The ability of lenders to purchase credit insurance for their exposures illustrates the hedging function of the credit derivatives market.
This ability to buy and sell credit protection on reference assets that neither side actually owns speaks to the speculative side of the CDS market. A large part of the CDS market refers to corporate debt and often the debt of a single company.
MARKET ACTORS AND ORGANIZATIONAL STRUCTURE
Credit providers: Banks and investment banks have historically led the way in developing the market as both buyers and sellers of credit protection. In the early days, banks and investment banks held 63% of the market as buyers and 81% of sellers of credit protection in 2001. The participation of hedge funds has varied over time to reflect their changing assessment of market conditions.
This study notes that the use of CDSs in mutual funds is increasing and especially as net sellers of credit protection. notes the participation of hedge funds in the distressed debt market); Marcel Kahan & Edward Rock, Hedge Fund Activism in the Enforcement of Bondholder Rights, 103 Nw.
INFORMATION AND EFFICIENCY
But the agreement reflects the different judgments of the buyer and seller of the protection regarding the underlying credit risk and the costs that both parties must internalize. Scholars note that CDSs were also early predictors12 2 of the 2005123 bankruptcies of General Motors and Ford, as well as their collapse. Langevoort, Taming the Animal Spirits of the Stock Markets: A Behavioral Approach to Securities Regulation, 97 Nw.
analyzing the impact of the issuer-paid model on the performance of credit rating agencies); Roger Lowenstein, Triple-A Failure, N.Y. Acharya et al., Liquidity Risk and Correlation Risk: A Clinical Study of General Motors and Ford Downgrade May 2005 (unpublished manuscript November).
EXTENDING TRADITIONAL DOCTRINE TO CREDIT DERIVATIVES
IMPLICATIONS FOR THE THEORY OF INSIDER TRADING
This section begins by showing that CDSs challenge the traditional doctrine that CDS markets appear to encourage insider trading by their very design. He then argues that the use of insider information in CDS markets challenges the classical notion that shareholders always lose in the face of insider trading. He points out that shareholders can benefit when lenders use confidential information in CDS trading and allow debtor companies access to loans at lower costs.
Finally, this section develops these insights to analyze the impact of CDS markets on the traditional tension between fairness and efficiency. While efficient, the inherent biases of CDS markets pose a risk to the underlying companies and market stability, necessitating a more nuanced approach to reforms in this area.
THE CHALLENGE TO DOCTRINE
The Classical Theory
Classic insider trading liability according to Dirks and Chiarella prohibits insider fiduciaries from trading on material, nonpublic information without first disclosing their intentions to the company and its shareholders.14 2 Otherwise, these traders must refrain from trading. It is not easy to establish that lenders owe fiduciary duties to their borrowers under the classic insider trading doctrine. Ordinarily, the law has been reluctant to impose a fiduciary relationship between a lender and its legal debtor.
Occasionally, lenders have been found liable as fiduciaries, where these lenders actively participate in the governance of their borrowers.14 3 But such cases are rare, and lenders must cross a high threshold of activism to ground a fiduciary relationship.1 4 simply: the classical theory of insider trading provides a weak basis on which to base liability.
The Misappropriation Theory
Its scope may cover a range of secondary actors who obtain confidential information knowing that it may have been obtained through misappropriation by a fiduciary.148. Indeed, in a pre-Dodd-Frank test, the SEC sought to punish insider trading in CDSs using the misappropriation theory in its argument. Although ultimately unsuccessful, the SEC's effort underscored the challenge of applying traditional insider trading doctrine to CDS markets.
Rorech argued to the SEC that a Deutsche Bank employee breached his fiduciary duty and misappropriated confidential information by encouraging a client to trade specific CDSs.149 In Rorech, a high-yield bond seller for Deutsche Bank allegedly passed on confidential information about Deutsche Bank's client VNU N.V., to Renato Negrin, a former trader at a hedge fund, Millennium Partners. Based on this information, Negrin made nearly $1.2 million by trading CDSs on VNU bonds.1 5 0 In dismissing the claim, the court concluded that the information exchanged between Rorech and Negrin was not confidential and of the type was routinely exchanged between sellers and traders in the US. debt markets.
Liability Under Rule 10b5-2
These include: (i) ensuring that traders obtain permission from the information source and (ii) trading in the securities of a company other than the borrower. But armed with this information, the lender can also purchase CDS protection on companies in the same industry, which may be equally risky.1 6 0 The lender may decide to purchase protection on the risky obligor's counterparties in the supply chain. Lenders may thus engage in substitute trading in the CDSs of companies associated with the obligor, rather than in the obligor's securities.
In other words, if an in-house or professional fiduciary cannot trade one company's swaps, then it may attempt to trade securities of a company with an equivalent risk profile. For example, Professors Ayres and Bankman note the challenges of using insider trading laws to sanction traders who use non-public information about one company to trade securities of related companies.16 2 There is usually a lot of room for argument.
RECONCEPTUALIZING THEORIES OF FAIRNESS AND HARM
Shareholders as Winners
INSIDER TRADING IN DERIVATIVES MARKETS. able to contractually prevent their lenders from substitute trading in a related company's CDS. When CDS traders use inside information in the CDS market, such trading can be seen as beneficial to shareholders, at least in the near term. Timely use of inside information by lenders may make it less attractive for corporate officers and managers to engage in insider trading of a company's securities.
Where lenders are able to move markets the fastest, insiders may not have the time and inclination to engage in insider trading. If insider trading by managers represents a net loss for shareholders, as according to the classical account, the use of inside information by CDS traders can be positive.
Shareholders as Losers
Scholars have long recognized the economic importance of maintaining confidentiality either as a protection for shareholders17 3 against insider embezzlement,1 74 or as an asset to be commoditized by the company through the lifting of the ban on insider trading.1 7 5 A company may allow its managers to trade inside information as a motivation for better performance.1 7 6 Professors Goshen and Parchmovsky propose the sharing of information rights for investment analysts to encourage them to competitively extract the maximum value from inside information and promote market efficiency.1 7 7 After all, these analyzes are classical Coasean. Professor Scott also points out that the property rights analysis, although not comprehensive enough to cover all cases, provides "clear guidance" on the function of prohibiting insider trading. Haft, The Effect of Insider Trading Rules on the Internal Efficiency of the Large Corporation, 80 MICH.
considering the importance of banning insider trading as a way to preserve company value through better organizational decision-making). considering the wealth creation effects of insider trading for investors); Michael Manove, The Harm of Insider Trading and Informed Speculation, 104 Q.J.
The Market Impact of Trading on Insider Information
The logistical challenge of tracking trading in the CDS markets likely makes shareholder monitoring of lenders theoretical in this context. Even where gains and losses do not disappear over time, the agreement between lenders and protection sellers is generally at arm's length between sophisticated institutions. From this point of view, it can be argued that those who are repeatedly disadvantaged may exit the market or otherwise price in the costs of the weaker position in the bargain.
REEVALUATING MARKET EFFICIENCY
POLICY IMPLICATIONS AND EXTENSIONS
Insights into the use of insider information in CDS markets profoundly change traditional notions of fairness, efficiency and shareholder harm.
THE BORROWER-LENDER BARGAIN
A possible "solution" to the doctrinal problems presented by credit derivatives is contractual within the confines of Rule lOb-5. That is, borrowers and their corporate lenders can agree in advance to allow borrowers to enter into CDSs on the underlying debt.2 11 Similar to a Rule 10b5-1 plan, the loan can be structured to enable borrowers set to hedge without having to explain their decision to the company every time. Bargaining around liability represents a fairly efficient solution to the problem of the use of inside information in credit derivative markets.
Without this deeper push for reform, a lasting and meaningful resolution of the doctrinal contradictions seems unlikely. How to prevent damage to the value of their assets, while ensuring that the flow of credit does not become prohibitively expensive.
THE CONTINUING ROLE OF DISCLOSURE
Furthermore, the borrowers cannot use their information themselves to trade CDSs and counter harmful disclosures on the CDS market. Companies that find their lenders are trading in CDS markets can end up facing disrepute. Worryingly, announcements from lenders may prompt company insiders to take steps to protect their private wealth in light of possible lender exits.
Insiders may quickly sell their shareholdings or otherwise take risky steps in hopes of reviving the company's image. Even after disclosure, Main Street firms cannot easily curb borrower misconduct, nor can they protect themselves from borrower opportunism without also suffering significant harm in the form of increased credit and reputational costs.
ALIGNING DERIVATIVES AND EQUITY MARKETS
In other words, where shareholders or managers cannot act on their data to signal positive news, while lenders and others are able to act on default-related data early, shareholders may face disproportionately higher costs to balance the news in the market. Based on this evidence, critics of the current ban may argue that restrictions on insider trading in the stock market are also being relaxed in order to promote market efficiency. In other words, there may simply be too much information in the market, necessitating analysis to determine what information is relevant to profitable trading.
Where retail investors face costs and where they have to work hard to make money and beat managers and other insiders, they may have less to gain from being in the market. The delay of insider trading in the credit derivatives market shows that doctrine and policy have not kept pace with these innovations.
