Academic journal article Stanford Law Review

Substitutes for Insider Trading

Academic journal article Stanford Law Review

Substitutes for Insider Trading

Article excerpt


The securities laws clearly prohibit an executive from using nonpublic information about her company to profit from trades in the securities of that company. But suppose the executive uses the same nonpublic information to profit from trading in the stock of another company. Suppose, for example, that an executive of Intel learns that her company will report higher than expected earnings because of higher than expected chip demand. Can she profit from this knowledge by purchasing the stock of other companies that she knows are likely to benefit from the same increased demand? For example, can she purchase the market basket of companies (other than Intel) that compose the Philadelphia Semiconductor Index? The stock of personal computer manufacturers or retailers? The stock of software companies whose products are complementary with personal computer sales? Under the right circumstances, such companies can all be thought of as stock substitutes for Intel. A strategy of trading in stock substitutes with nonpublic knowledge of Intel earnings will produce a supranormal return.

Profits from such trading can be substantial. To cite but one example, Intel on November 10, 1998 did in fact report higher than expected quarterly demand (by 4% or so) for its microprocessor. On the day following the announcement, Intel's stock rose about 5%, for a rise in market value of about $7 billion. Intel's announcement was interpreted in the financial press as indicating strong demand for personal computers generally. The stock of other companies in that industry, and the market baskets of stocks in that industry (such as the Philadelphia Semiconductor Index), rose between 2.5% and 5%. The stock of Intel's downstream customer, Compaq, rose 4%, a dollar rise of over $2 billion in market value. The price of short-term call options in Compaq increased dramatically. (1) Analysis linked the increase in stock value of Compaq and other companies to the increased demand for PCs, as suggested by Intel's strong earnings report. (2)

In this Article, we will focus on circumstances where an informed insider (or a corporation itself) could trade profitably in its own stock but for Securities and Exchange Commission Rule 10b-5's (3) traditional prohibition on insider trading. To avoid a clear-cut Rule 10b-5 violation, the insider might instead want to substitute trade in other stocks whose price will be predictably affected by the same information. (4) Such substitute trading could potentially take a variety of forms. Particular types of information will cause the price of a stock substitute to predictably move in the opposite direction of the price of one's own company. Information that would make an insider want to buy shares of his or her own company will sometimes induce the insider to want to sell another company's shares. For example, if an insider of Genentech realizes that Genentech is likely to win the race in cloning a particularly useful monoclonal antibody, then selling rivals' stock short may be a close substitute for buying Genentech shares long.

The impetus for substitute trading will not be limited to corporations that sell substitute products. Supranormal returns may also be realized in trades on the stock of upstream suppliers and downstream customers. For example, an executive of Ford Motor Company may hear from her engineers nonpublic information about an assembly-line robotic device tested by Ford but manufactured by another company. Or substitute trading in the stock of complementary products may become profitable. A corporation, rather than its employees, may trade in stock substitutes. In the above examples, supranormal profits may be available to Intel, Genentech, and Ford.

Substitute trading, if legal, could threaten to undermine the effectiveness of insider trading prohibitions generally. Yet legal scholarship has not focused squarely on the problem. (5) In Part I of this Article, we examine the economics of trading in stock substitutes. …

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