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INSIDER TRADING IN THE INFORMATION AGE YESHA YADAV† ABSTRACT

Financial innovation is killing the prohibition against insider trading. The market for credit derivatives like credit default swaps (CDS) profoundly challenges the doctrinal basis on which the prohibition rests. First, this Article shows that CDS, by their very function, break insider trading laws daily. Lenders routinely rely on CDS to transfer the economic risk of a loan or a bond to another financial institution. With access to vast reserves of confidential information on a borrower, the sale and purchase of such credit protection implies a form of insider trading. Unsurprisingly, the CDS market boasts considerable predictive powers to forecast key events in corporate life long before these become public. Secondly, insider trading in CDS challenges the rationales justifying the prohibition – and, ironically, justifications advanced for overturning it. This Article demonstrates that shareholders, rather than demanding protection, have incentives to promote insider trading in CDS, where it allows the company to obtain easy access to credit. Shareholders cede their rights in corporate information to lenders, meaning that any value these rights might have to corporate officers and the firm diminishes. Conventionally, this insider trading should lead to more efficiency. And, to an extent, it does. But, the market is only selectively efficient, prizing information on default almost exclusively. Critically, its efficiencies are shaped by those that participate in the market. Finally, such insider trading brings both costs and benefits. Normatively, it forces a reconceptualization of current insider trading laws to match the realities of innovation. In advancing its proposal, the Article advocates for a new model to control market disruption. This model works to protect and preserve shareholder value alongside the market efficiencies that CDS generate. TABLE OF CONTENTS

Introduction ..................................................................................................... 2  I. Credit Derivatives: Evolution and Economics ............................................. 8  †

Assistant Professor of Law, Vanderbilt Law School….All errors are entirely my own.

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A.  Form and Function ................................................................................ 8  B.  Market Actors and Organizational Structure ....................................... 12  C.  Information and Efficiency.................................................................. 16  II. An Uneasy Fit: Conventional Paradigms in New Markets ....................... 21  A.  Short Primer on the Doctrinal Framework .......................................... 21  B.  Law versus Economics ........................................................................ 24  C.  Why Traditional Doctrine Fails ........................................................... 26  D.  Re-visiting Investor Protection ............................................................ 31  III. The New Economy of Insider Trading .................................................... 35  A.  An Unintended Allocation of Informational Rights ............................ 35  B.  Insider Trading and Efficiency: The Curious Case of CDS ................ 40  C.  Efficiency and the Enforcement Problem............................................ 43  IV. Insider Trading Re-considered ................................................................ 44  A.  Market Disruption as Proxy for Insider Abuse .................................... 45  B.  Lender Liability and the Shareholder’s Bargain.................................. 48  C.  Implications ......................................................................................... 50  V. Conclusion ................................................................................................ 51 

INTRODUCTION

The credit derivatives market breaks all the rules against insider trading. Indeed, it could not have existed otherwise. The prohibition against insider trading has courted comment and controversy since its earliest days. Scholars have long questioned the economic rationales underpinning the law and the logic of its operation.1 Today, it faces a new challenge. In the last two decades, credit derivatives have entirely transformed financial and securities markets.2 Though scholarly debates surrounding insider trading continue,3 the impact of credit derivatives on 1 For helpful summaries, Stephen Bainbridge, The Insider Trading Prohibition: A Legal and Economic Enigma, 38. U. FLA. L. REV. 35, (1986); Charles C. Cox and Kevin S. Fogarty, Bases of Insider Trading Law, 49 OHIO ST. L. J. 353, 354–361 (1988); James D. Cox, Insider Trading and Contracting: A Critical Response to the "Chicago School," 1986 DUKE. L. J. 628; Boyd K. Dyer, Economic Analysis, Insider Trading and Game Markets, 1992 UTAH L. REV. 1; Morris Mendelson, the Economics of Insider Trading Reconsidered, 117 U. PA. L. REV. 470 (1969). 2 For an early observation, Eli Remolona, the Recent Growth of Derivatives Markets, FEDERAL RESERVE BANK OF NEW YORK STAFF QUARTERLY REVIEW (1992) (noting the expansive growth of derivatives instruments). For more recent statistics and development see, BANK OF INT’L SETTLEMENTS, BIS QUARTERLY REVIEW (Dec. 2011), http://www.bis.org/publ/qtrpdf/r_qt1112.htm. 3 See for example, Stephen Bainbridge, Regulating Insider Trading in the Post-Fiduciary Duty Era: Equal Access or Property Rights?, UCLA School of Law, Law-Econ Research Paper No. 12-08 (May

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its jurisprudence and policy has received little, if any, analysis in the literature. This Article fills this gap to demonstrate that the emergence of credit derivatives constitutes a profound development for insider trading law and policy. It argues that the growth of credit derivatives problematizes traditional insider trading jurisprudence like never before.4 With the feasibility of current rules subject to question, this Article advocates for a radical re-conceptualizing of the present regulatory framework for one better suited to modern markets. Ironically, recent years have also seen a pronounced turn to insider trading laws as a way of checking market abuses following the Financial Crisis. A series of high-profile actions for insider trading offenses have demonstrated the bite as well as the bark of existing rules.5 And, significantly for the purposes of this Article, legislation has expanded the reach of the insider trading prohibition to explicitly include the over-thecounter credit derivatives market.6 Pursuant to the Dodd-Frank Act, trading in credit derivatives like credit default swaps (CDS) – instruments that transact in the credit risk of a debt obligation like a loan or a bond – now falls squarely within the purview of the insider trading prohibition.7 Despite scholarly discomfort with the rationales underpinning insider trading laws, and doctrinal uncertainties in their application,8 regulators increasingly view these laws as a key bulwark against market misconduct. 2012) (analyzing the weakening role of fiduciary duty as a controlling factor in determining insider trading liability); Jack Coffee, Mapping the Future of Insider Trading Law: of Boundaries, Gaps and Strategies, COLUM. BUS. L. REV. (2013) (forthcoming) (examining the evolving application of insider trading jurisprudence and its implications). 4 Credit derivatives have witnessed exponential growth in the last two decades, from a relatively small market worth $0.9 trillion in 2001 to one valued at a notional of $62 trillion in 2007. For more detail, Marti Subrahmanyam et. al., Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk, Working Paper (December 2011), available at, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1976084; BANK OF INTERNATIONAL SETTLEMENTS, SEMIANNUAL OTC DERIVATIVES STATISTICS (2011), http://www.bis.org/statistics/derstats.htm. 5 Shahien Nasiripour, SEC Enforcement Chief Steps Down, FIN. TIMES (Jan. 9, 2013) (noting the focus of the SEC’s enforcement unit on bringing cases for insider trading, including high profile cases against Raj Rajaratnam and Rajat Gupta); See also, John Gapper, Hedge Funds’ Reputation in the Balance, FIN. TIMES (Mar. 17 2013) (discussing SEC enforcement actions against and Justice Department prosecutions of hedge funds for insider trading). 6 The market for trading credit derivatives has been over-the-counter, rather than on-exchange. As a result of various political and policy pressures in the late 1990s, credit derivatives traded largely outside of federal oversight. Commodities Exchange Act, 7 U.S.C § 2(g); Gramm-Leach-Bliley Act, 15 U.S.C. § 206A; Commodities and Futures Modernization Act, Pub. L. No. 106-554, 114 Stat. 2763, Title I (2000). For a detailed discussion of the legislative history leading to the deregulation of credit derivatives, Roberta S. Karmel, The Future of the Securities and Exchange Commission as a Market Regulator, 78 U. CIN. L. REV. 501 (2009). 7 Dodd-Frank Wall Street Reform and Consumer Protection Act Title VII (to be codified at 15 U.S.C. [hereinafter Dodd-Frank Act]. The Dodd-Frank Act explicitly extends the reach of Rule 10b-5’s insider trading provisions to credit derivatives trading under §753 and §763(g). 8 For an excellent summary, Donald C. Langevoort, What Were They Thinking? Insider Trading and the Scienter Requirement, Georgetown Public Law and Legal Theory Research Paper No. 12111 (2012), 1-3. See also, Jonathan R. Macey, INSIDER TRADING: ECONOMICS, POLITICS AND POLICY, 3-7 (1991).

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First, this Article shows that the extension of the insider trading prohibition to credit derivatives markets is unworkable: these markets are characterized, even defined, by a form of insider trading as traditionally understood. Credit derivatives enable a lender that makes a loan to a company to shift the risk of this loan to another firm that wishes to assume it.9 A lender can purchase credit derivative protection for any number of reasons. But, when it does so, a lender is usually privy to detailed and confidential information regarding the debtor company. More often than not, the debtor company has no idea that its lender has purchased credit protection in the derivatives market. And, lenders are not in the business of disclosing such details to their customers for fear of losing goodwill.10 Conventionally speaking, lenders are firmly in sight of insider trading liability when trading CDS. At their core, insider trading rules prohibit trading based on information procured at an unfair advantage by those in a privileged relationship to a company. In the universe of credit derivative trading lenders buy and sell credit protection based, at least in part, on information they obtain in their relationship with the borrower. This, after all, is the very nature of the market. Finance scholars have long recognized that credit derivative markets showcase an unmistakable tendency towards insider trading, at least in a functional sense.11 This, they argue, is evidenced by the uncanny ability of credit derivative indices to forecast corporate events several months (and sometimes years) before these are formally announced.12 The access to information that lenders enjoy, alongside their influence on management and corporate direction,13 9 For more detail, Frank Partnoy & David A. Skeel, Promises and Perils of Credit Derivatives, 75 U. CIN. L. REV. 1019 (2007), 1021 (discussing the important characteristics of credit derivatives); René M. Stulz, Demystifying Financial Derivatives, THE MILKEN INST. REV. (2005), at 20-25. See also, M. Todd Henderson, Credit Derivatives are not Insurance, 16 CONN. INS. L. J. 1 (2009) (analyzing the reasons why this arrangement should not be regarded as insurance). The Dodd-Frank Act states that credit default swaps are not to be defined as “insurance contract,” Dodd-Frank Act §767(4 (to be codified at 15 U.S.C. § 78bb(a)(4)). 10 This market has been characterized by a high degree of confidentiality. Traditionally, as discussed in the Article, credit derivatives have traded over-the-counter and enjoyed exemption from the usual disclosure accompanying exchange trading. As a result, market participants have undertaken trades with the benefit of confidentiality and anonymity. For an excellent discussion of the lack of transparency in the credit derivatives market and the complexities of disclosing CDS data, Robert Bartlett III, Inefficiencies in the Information Thicket: A Case Study of Derivative Disclosures during the Financial Crisis, 36 J. Corp. L. 1 (2010). 11 Viral Acharya & Timothy Johnson, Insider Trading in Credit Derivatives, 84 J. FIN. ECON. 110 (2007), 115-120; Viral Acharya & Timothy Johnson, More Insiders, More Insider Trading: Evidence from Private Equity Buyouts, 98 J. FIN. ECON. 500; Lars Norden, Why do CDS Spreads Change before Ratings Announcements? Working Paper, WFA Meetings 2009 (2011), available online at, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1138698. 12 See also, Thomas Daula, Do Credit Default Swaps Improve Forecasts of Real Economic Activity? Working Paper (July 2010), available at, http://dss.ucsd.edu/~jhamilto/Daula_Forecasting_with_CDS.pdf. (arguing that the CDS markets constitute an important forecasting tool). 13 Douglas Baird & Robert Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. PA. L. REV. 1209 (2006) (noting the influence of lenders on management), Fred Tung,

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manifests in the ability of lenders to exit their investment using a CDS quickly and cheaply. The law ordinarily requires a pre-existing fiduciary relationship as a condition precedent to liability.14 But, over time, this grounding in a necessary finding of fiduciary status has weakened in favor of a broader construction.15 Notwithstanding, lenders can usually meet this test and can face liability as “temporary insiders” given their usually close proximity to corporate affairs, information and management.16 In this way, extending traditional insider trading jurisprudence to cover credit derivatives falls well short of the mark: this market is defined by the very offense the rules are designed to check. Secondly, the insider nature of the credit derivatives market profoundly impacts the economic theory undergirding conventional insider trading liability. Scholars have analyzed insider trading liability as one better understood through the prism of property rights in information and their allocation within the firm. Using this lens, insider trading liability attaches to protect a company’s property rights in its own information. On one side of the debate, the property rights rationale supports the prohibition as a means of safeguarding shareholder entitlement to the value of the information.17 Other scholars argue that this prohibition is a blunt tool. In seeking greater efficiencies, scholars argue that a company should be permitted to contractually allocate its property rights to actors, like a company’s managers, that promote better information flows across the market and thereby improve price efficiency and overall market liquidity.18 The assumptions underlying this debate are challenged by credit derivative trading. The existence of a market in a company’s CDS transforms the allocation of property rights in information within and Leverage in the Board Room: the Unsung Influence of Private Lenders in Corporate Governance; 57 UCLA L. REV. 115 (2009) (discussing the detailed access to management that lenders routinely enjoy). 14 SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969); Matter of Cady, Roberts & Co., 40 S.E.C. 907, 912 (1961) (setting out the basic disclose or abstain rule); United States v. Chiarella, 588 F.2d 1358, 1365 (2d Cir. 1978), rev'd, 445 U.S. 222 (1980) (requiring the existence of a fiduciary relationship as a controlling factor in determining liability). 15 See for example, SEC v. Cuban, 634 F. Supp. 2d 713 (N.D. Tex. 2009) (stating that, in principle, insider trading under Rule 10b-5 could be premised on a breach of contract); United States v. Whitman, No. 12-CR-125, 2012 U.S. Dist. LEXIS 163138, at 15 (S.D.N.Y. Nov. 14, 2012) (stating that insider trading liability could be grounded in federal law, rather than in state law notions of fiduciary duties). See also, SEC v. Yun, 327 F.3d 1263, 1273 (11th Cir. 2003) (stating that a breach could be found in a breach of any agreement designed to maintain confidentiality). See also, Donna M. Nagy, infra note [ ]. 16 For insightful discussion see, Jesse M. Fried, Insider Abstention, 113 YALE L. J. 458, 459 (2004) (noting that temporary insiders that come into possession of confidential information can be held liable for insider trading). 17 See sources cited infra note [ ]. 18 Dennis W. Carlton & Daniel R. Fischel, the Regulation of Insider Trading, 35 STAN. L. REV. 857 (1983) (arguing for a firm to have the ability to contractually allocate rights in information to managers); Zohar Goshen & Gideon Parchmovsky, On Insider Trading, Markets and “Negative” Rights in Information, 87 VA. L. REV. 1229 (2009) (arguing, unlike Carlton and Fischel, that property rights in information be allocated outside the firm to investment analysts rather than to managers). See also, Macey, supra note [ ], 4-5.

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outside the firm. Simply put, where a company is subject to CDS trading on its debt securities, it cedes its property rights in information to its lenders. Lenders acquire these rights through their access to company books and their close relationship to a borrower. And, the CDS market allows lenders to transact using these rights. Certainly, any lender routinely acquires access to information through its dealings with a company. The credit derivatives market radically impacts this bargain by making the property rights that lenders acquire freely transferable. Lenders are able to optimize their informational advantage and transact in insider information by buying and selling credit protection. The signaling effects of their trading may be profound where they reflect insider and expert determinations19 of a company’s future creditworthiness.20 At first blush, this new allocation of property rights in information seems detrimental for shareholders. After all, shareholders are most probably unaware that they cede valuable rights in information to lenders when their company takes out a loan. But, unlike insider trading in company stock, where investor protection concerns are paramount in justifying the prohibition,21 insider trading in CDS provides another perspective. This Article shows that shareholders possess incentivizes to encourage insider trading in CDS as a means of coaxing lenders to extend credit to the company cheaply. This enables shareholders to profit in the short-term from debt-based growth, with creditors largely internalizing the downside risk.22 Additionally, where lenders acquire rights in information and can exercise them through CDS trading, these rights can lose value for directors and officers of a company. Where lenders derive maximal benefit from the timely exercise of these rights, the temptations these hold out to corporate officers can diminish. If insider trading by corporate officers represents a loss for shareholders, this re-allocation of informational rights to lenders outside a company confers a benefit. On the other hand, where shareholders wish to allocate these rights within the firm to their managers as compensation, for example, then the fact of their early allocation to lenders is clearly a cost they must internalize. Thirdly, insider trading in CDS trading nuances our understanding of the efficiency rationales that are often proposed to relax the general prohibition. Scholars have long criticized the insider trading prohibition as 19 Kathryn Chen et. al., An Analysis of CDS Transactions: Implications for Public Reporting, Federal Reserve Bank of New York Staff Report No. 517 (2011), 5-8 (showing that the CDS markets includes as a routine matter 50-100 market participants trading daily in single-name CDS and around 135 trading daily in indices of CDS. More than half (approximately 60%) of all activity is dominated by the largest G14 dealers). 20 George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive Corporate Governance, 83 CAL L. REV. 1073 (1995) (noting the signaling value of exit). 21 See sources cited infra note [ ]. 22 See sources cited infra note [ ].

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an obstacle to the free flow of information and as an impediment to market efficiency.23 The transfer of insider information by a company’s lenders via the CDS market constitutes a counterbalance to encourage the freer exchange of information and greater efficiency in the trading of a company’s securities. To those scholars privileging market efficiency as a goal of securities regulation, CDS trading offers a solution to some of the costs of insider trading laws. But, this solution is a partial one. The CDS market is efficient only with respect to information that lenders value most: news that impacts a company’s ability to repay its debt. Understandably, its focus is sharpest on negative news that hints at increased risk for a debtor company. This negative tilt to the market is problematic where efficiencies in the CDS market signal bad news to the market as a whole. This increases the costs to a company to counterbalance the negative signaling with any positive news it might possess. Investors may have to inject more capital into a company to showcase a positive trend to balance a more negative tilt in information coming from CDS trading. Where such negatives cannot be overcome, this can result in a variety of unwanted externalities, including the possibility of attacks by investor activists or takeover specialists. The higher efficiency of the CDS market also raises an enforcement problem. The ability of CDS to disclose information early can make it costlier for regulators to punish insider trading generally by corporate officers. Where lenders disclose information through CDS trading, regulators must contend with a more complex notion of confidentiality with respect to corporate information. As the line between private and public blurs through the CDS market’s efficiencies, the checks and balances that prevent insiders from trading can weaken considerably. In concluding, this Article advocates for a thorough re-evaluation of the insider trading prohibition. It offers a proposal to cure the negative externalities arising from lender misuse of corporate property rights in information, for example, to exaggerate their negative views of a borrower company. It relies on two key prongs: the first, to more carefully police market disruption; and the second, to hold lenders liable under common law lender liability rules. The thrust of this proposal relies on partially restoring the value of property rights in firm information back to shareholders. In this way, it seeks to bolster the investor protection rationale of insider trading liability, without necessarily compromising the efficiency gains that the market has come to offer. This Article is structured as follows. Part I provides a primer on the credit derivatives market to explain its key functions and its increasing 23

See sources cited in infra infra notes [ ]. This is discussed in Part [ ].

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importance as a means of conveying information to the market. Part II situates the development of credit derivatives market within existing debates surrounding insider trading. Part III develops this interrelationship to examine its broader impact on insider trading laws. Part IV proposes a new paradigm for controlling market misconduct. Part V concludes.

I. CREDIT DERIVATIVES: EVOLUTION AND ECONOMICS

This Part provides a primer on credit derivatives, the key players and their role in conveying information in the market.24 The focus here lies in analyzing those features of the market that are most relevant to understanding their interaction with insider trading jurisprudence. An analysis of credit derivatives in the context of the Financial Crisis, for example with respect to collapse of the American International Group (AIG), falls largely outside the scope of this analysis.25

A. Form and Function

A derivative is a contract that “derives” its value from an underlying reference entity, benchmark or asset. The category types that derivatives can reference are vast.26 Credit derivatives are contracts that 24 See Yesha Yadav, the New Market in Debt Governance, Working Paper, available online at, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2225524 (discussing the key features of credit derivatives and their relationship with corporate governance). 25 For discussion, Gretchen Morgenson, Behind Biggest Insurer’s Crisis, a Blind Eye to a Web of Risks, N. Y. TIMES, Sept. 28, 2008, at A1; Robert O’Harrow, Jr. & Brady Dennis, Downgrades and Downfall, WASH. POST, Dec. 31, 2008, at A1; FIN. CRISIS INQ. COMM’N, Financial Crisis Inquiry Report (January 2011), 237-239; William K. Sjostrom Jr., The AIG Bailout, 66 WASH. & LEE L. REV. 66 943, 97582 (2009) (analyzing the AIG bailout). For analysis see, Michael Barr, Speech to the Pew/NYU Stern Conference on Financial Reform: Dodd-Frank Act, One Year on (June 27, 2011), transcript available at http://blogs.law.harvard.edu/corpgov/2011/07/21/the-dodd-frank-act-one-year-on/ (discussing the role of OTC derivatives in fostering the Financial Crisis); Erik Gerding, Credit Derivatives, Leverage, and Financial Regulation’s Missing Macroeconomic Dimension, 8 BERKELEY. BUS. L. J. 101, 110–11 (noting the role of speculative derivatives trading in increasing macroeconomic risk); Lynn. A. Stout, The Legal Origin of the 2008 Financial Crisis (UCLA Sch. of Law, Law-Econ Research Paper No. 11-05, 2011), available at http://ssrn.com/abstract=1770082 (discussing the growth of OTC derivatives as a key driver of the Financial Crisis), Yesha Yadav, the Problematic Case of Clearinghouses in Complex Markets, 101 GEO L.J. 387 (2013) (critically examining the risks credit derivatives pose to clearinghouses). 26 See for example, SCHUYLER K. HENDERSON, HENDERSON ON DERIVATIVES (2010), 5 (“A derivative is…a financial arrangement the value of which is ‘derived’ from another financial instrument, index or measure of economic value.”). See also, Partnoy & Skeel, supra note [ ], at 1019; Rene M. Stulz, Credit Default Swaps and the Credit Crisis, 24 J. ECON. PERSP. 73 (2010), 20-31. The assets that derivatives may reference are considerable, and can include commodities such as wheat, sugar, or oil as well as such more esoteric indices such as inflation, or the weather and other environmental variables. See,

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derive their value from changes in the credit risk of an underlying debt instrument such as a loan or a bond.27 In their short history, credit derivatives like credit default swaps (CDS) have grown enormously in popularity.28 In 2001, the notional value of credit derivatives outstanding stood at just $0.7 trillion dollars. By 2007, this figure had climbed to $62 trillion. Although the market contracted significantly following the Financial Crisis, it has revived at a pace and in 2010 stood at a notional value of approximately $32 trillion.29 The rationale driving this popularity is easy to understand. Credit derivatives allow lenders to enjoy considerable flexibility in managing the credit risk on their books. Investors gain by being able to invest cheaply in the underlying debt. And the corporate and financial sector can enjoy competitively priced credit. These advantages become readily apparent when examining a basic credit derivative transaction. A lender that has made a loan to a company can buy credit protection on the risk of this loan using a CDS. For a periodic fee, the lender contracts with another financial firm for credit protection. This protection is designed to pay out in case the debtor company defaults on its debt. The premium a lender pays can change through the term of the CDS reflecting the varying risk-profile of the underlying company: the riskier the company, the higher the premium a lender must pay for protection. Importantly, the CDS is entirely separate legally from the underlying loan arrangement between the lender and the debtor. Indeed, the debtor company may well never know that its lender has purchased credit protection on the debt.30 The CDS creates a dramatic disconnect. The economic risk of the loan moves to the credit protection seller; however, all the legal rights and benefits that a lender possesses through its loan contract with the debtor remain intact and untouched.31 The lender can continue to derive the Norman Menachem Feder, Deconstructing Over-the-Counter Derivatives, 2002 COLUM. BUS. L. REV. 677, 687-688 (discussing the variety of assets that derivatives can reference, such as weather derivatives). 27 For a discussion of credit derivatives in particular see, Kristin Johnson, Things Fall Apart: Regulating the Credit Default Commons, U. COLO. L. REV. 167 (2011). 28 There are several types of credit derivatives such as credit-linked notes, total return swaps or credit spread options. Fundamentally, these all work to trade the credit risk of reference underlying debt. This Article focuses on credit default swaps, which constitutes the most dominant and largest market of all credit derivative instruments. For detailed discussion, David Mengle, Credit Derivatives: An Overview, Federal Reserve Bank of Atlanta Economic Review (2007), 1-2 (noting that CDS constitute the most popular category of credit derivative). 29 Marti Subrahmaniyam et al., supra, note [ ] (noting the astronomical growth of credit derivatives and its impact on the corporate debt market), Bank of International Settlements, supra note [ ]. 30 See for example, JP MORGAN, THE JP MORGAN GUIDE TO CREDIT DERIVATIVES, RISK (1999). 31 This phenomenon has come to be termed debt decoupling and extrapolated through the work of Professors Henry T.C. Hu and Bernard Black. See, Equity and Debt Decoupling and Empty Voting II: Importance and Extensions, 156 U. PA. L. REV. 625 (2008); Henry T.C. Hu & Bernard Black, Hedge

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benefit of its client relationships even though it contracts away the economic risks of these relations to another firm using a CDS. Equally, a credit protection provider enters into a beneficial bargain. The protection seller invests in the underlying company “synthetically.” It assumes the risks that the underlying company might fail, but this exposure comes with the promise of regular premium payments from the lender. The protection provider gains an investment opportunity at low cost, where it does not have to actually buy the underlying loan or bond. The capital costs of purchasing the underlying loan or a bond can be high, entailing search costs, up-front capital outlay and the opportunity loss where this capital cannot be used for making other investments. By selling credit protection, a firm reduces these costs considerably. For the underlying debtor company, the benefits are clear. With a CDS market in ready reach, lenders can extend credit without internalizing the full costs of retaining this risk on their books for the long-term. As a result, lenders can extend credit more cheaply and potentially to a broader range of debtors, with greater variation in their credit profiles.32 Lenders possess a variety of incentives that drive their decisions to purchase credit protection. As a first matter, the lender wishes to ensure a cleaner balance sheet and to remove the risk of the loan from its books. It may determine that the debtor is becoming more dangerous and likely to default. A lender may wish to diversify its portfolio of loans, for example, if it is over-invested in one or other industry or sector. It may face high capital charges on the credit that it extends, with increased credit protection helping to alleviate these capital costs.33 Critically, a lender has a key advantage in deciding whether or not to purchase credit protection on its loans. It usually possesses vast reserves of information on borrowers and potentially on the industry to which a borrower belongs. Scholars are increasingly seeing the influence of lenders in corporate life. More than shareholders, lenders come to possess detailed information on the life of debtor companies. As discussed fully below, the data that lenders acquire may be deeply granular, some argue, equal in depth and detail to that held

Funds, Insiders, and the Decoupling of Economic and Voting Ownership: Empty Voting and Hidden (Morphable) Ownership, 13 J. CORP. FIN. 343 (2007). See also, Yesha Yadav, the New Market, supra note [ ] (discussing the impact of debt decoupling on the incentives of protection sellers). 32 See for example, Erik Gerding, supra note [ ]. HAL SCOTT & ANNA GELPERN, FINANCE: TRANSACTIONS, POLICY AND REGULATION, 890–95 (2011) (for an overview of the credit derivative market). But see, Adam Ashcraft and Joao Santos, Has the Credit Default Swap Market Lowered the Cost of Corporate Debt?, 56 J. MONETARY ECON. 514 (2009) (arguing that CDS have not reduced the costs of obtaining credit for most corporates). 33 Brooke Masters, Tracey Alloway & Shahien Nasiripour, Banks Face Removal of Capital Loophole, FIN. TIMES (Mar. 24 2013) (noting the use by banks of CDS to reduce capital costs and proposed rule changes to better reflect the cost of credit protection in the capital costs that banks face).

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by directors and senior management.34 Certainly, this information is helpful for lenders as a means of controlling their risk, for example, by providing input on how much capital they must keep.35 Additionally, this information also provides key indicia for determining the most optimal timing for purchasing credit protection. The ability of lenders to purchase credit protection on their exposures exemplifies the hedging functionality of the credit derivatives market. This means that lenders are able to use the credit derivatives market to cover their existing risk. This cover may not be exact. But, it helps to safeguard the lender from the externalities of borrower default by shifting the costs of this risk to a firm theoretically better able to bear it. However, the CDS market is also innovative in more creative ways. It lets lenders and protection sellers trade credit risk on exposures that they do not hold. 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. The speculative and hedging functions of credit derivatives can easily combine. Lenders can purchase far greater levels of protection than the value of their underlying loans. This means that they may protect their exposure but also benefit where they obtain additional payments in case of borrower default. Similarly, protection sellers can agree to protect debt speculatively in the knowledge that lenders do not actually own any or some of the underlying exposure. In this sense, the agreement represents a pure bet for both sides.36 The composition of assets that serve as references for credit derivatives is broad. Following the Financial Crisis, analysis has largely focused on the complex mortgage-backed securities that lost value and triggered a web of repayments on CDS across the market.37 But the CDS market also has a simpler constituency. A large swathe of the CDS market references corporate debt, and often the debt of a single company. Twothirds of CDS trading occurs on CDS that reference the debt of a single entity, notably, sovereign countries as well as single corporations.

34 Fred Tung, Leverage in the Board Room: the Unsung Influence of Private Lenders in Corporate Governance, 57 UCLA L. REV. 115, 130-140 (2009) (noting that lenders possess vast reservoirs of information on their borrowers, often equivalent to those of senior management). 35 Daniel Tarullo, BANKING ON BASEL: THE FUTURE OF INTERNATIONAL FINANCIAL REGULATION (2008), 150-155 (discussing the Basel II methodology and the Advanced Internal Ratings Based Approach that requires details on claims as a means of determining capital levels). 36 Scholars have argued that the speculative side of the market has deleterious effects where it permits parties to bet on large levels of exposure that is far in excess of the value of the underlying portfolio of debt. See for example, Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives, 48 DUKE L.J. 701 (1999). 37 See for example, Gretchen Morgenson, Behind Biggest Insurer’s Crisis, a Blind Eye to a Web of Risks, N. Y. TIMES, Sept. 28, 2008, at A1; Robert O’Harrow, Jr. & Brady Dennis, Downgrades and Downfall, WASH. POST, Dec. 31, 2008, at A1.

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Approximately 57% of these CDS reference a corporation.38 Unsurprisingly, the companies whose debt becomes subject to CDS trading belong to a variety of sectors across Main Street to include the automotive industry, pharmaceuticals, chemicals and the financial industry. In short, CDS trading occurs on debt across industries and markets, privileging specialist knowledge on these areas for those wishing to trade on the risks of this debt.39

B. Market Actors and Organizational Structure

As a whole, credit derivative traders comprise some of the largest and best-known firms on Wall Street.40 This is no surprise. Historically, legislation has restricted the firms that could trade credit derivatives to a handful of select, sophisticated firms deemed sufficiently expert to understand the risks and to withstand them.41 The credit derivatives market has largely operated over-the-counter (OTC), with parties transacting bilaterally directly with one another. Given the high levels of risk that parties have assumed on one another, the market has only opened its doors to those able to demonstrate institutional competence and creditworthiness. There is however another explanatory factor for this specialization. Credit derivatives are most relevant to those firms that are in the habit of making loans and extending credit to the markets. Bank lenders, investment banks and investors in the debt capital markets have emerged as the main users of credit derivative instruments. CDS trade almost exclusively amongst financial firms and their end-users do not include non-financial entities42 such as large companies or even sovereigns.43 In 38 Chen et al., supra note [ ], at 7-8; CDS FAQ, INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, http://www.isdacdsmarketplace.com/about_cds_market/cds_faq#who_holds_risks_of_cds (last visited [ ]). 39 See for example, Marti Subrahmaniyam et al., supra note [ ], 47-50 (for a list of sample companies in the dataset that extend across a variety of industry types and corporate types for size and market share); 2009: What a Year for Distressed Debt, DISTRESSED DEBT INVESTING, http://www.distressed-debt-investing.com/search/label/cds%20auctions. 40 Chen et al., supra note [ ]. 41 Commodities Exchange Act, 7 U.S.C § 2(g); Gramm-Leach-Bliley Act, 15 U.S.C. § 206A; Commodities and Futures Modernization Act, Pub. L. No. 106-554, 114 Stat. 2763, Title I (2000) (this deregulatory initiative allowed banks to essentially operate on a self-regulatory basis when transacting in OTC derivative). For discussion of the historical background and the rationales, Daniel Awrey, FSA, Integrated Regulation and the Curious Case of OTC Derivatives, 13 U. PENN. J. BUS. L. 101 (2010); Daniel Awrey, Towards a Supply-Side Theory of Financial Innovation, J. COMP. ECON. (forthcoming) (2013); Roberta Karmel, supra note [ ]. 42 As a contrast, see statistics with respect to interest rate derivatives as well as currency derivatives. For these instruments end-users include a range of actors such as companies, governments, as well as financial institutions. BANK FOR INTERNATIONAL SETTLEMENTS, SEMIANNUAL OTC DERIVATIVES STATISTICS AT END-DECEMBER 2011 (2012), http://www.bis.org/statistics/otcder/dt1920a.pdf.

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addition to credit providers, the market also includes specialists in risk valuation. These comprise insurance firms like AIG, as well as specialist institutional investors such as pension and mutual funds, private equity houses as well as hedge funds.44 The market breaks down as follows.45 Credit Providers: Banks and investment banks have historically led the way in developing the market as both purchasers as well as 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. This market share shifted quickly with the arrival of hedge funds and other specialists. The participation of hedge funds has fluctuated over time to reflect their changing assessment of market conditions. From a modest start in 2001, the market share of hedge funds grew rapidly to comprise approximately 28% of the market as buyers of credit protection and 32% as sellers in 2006.46 With the growth of hedge funds in the market, the dominance of banks and investment banks has correspondingly eroded over time to 59% of buyers and 44% of sellers in 2006.47 Following the Financial Crisis, banks and hedge funds have emerged as net buyers of credit protection. Net sellers of credit protection include mutual funds,48 pension funds and also insurance firms with a history of expertise in riskvaluation.49 These statistics indicate approximate trends: all players do both buying and selling as part of their credit derivatives business. The significance of these trends however is clear. For credit providers, benefits accrue in purchasing (or selling) timely credit protection on exposures. With lower levels of risk on their books, banks and investment banks have room to expand their lending business.50 Moreover, they are best positioned to optimize the value of information 43 BANK FOR INTERNATIONAL SETTLEMENTS, SEMIANNUAL OTC DERIVATIVES STATISTICS AT END-DECEMBER 2011 (2012), http://www.bis.org/statistics/otcder/dt1920a.pdf. 44 Id. See also, Lisa Pollack, Meet the Credit Derivative End Users, FIN. TIMES, Dec. 13, 2011, http://ftalphaville.ft.com/2011/12/13/794201/meet-the-credit-derivative-end-users/; Houman Shadab, Hedge Funds Transfer Risk to Derivatives Dealers, LAWBRITRAGE, Dec. 13 2011, http://lawbitrage.typepad.com/blog/2011/12/hedge-funds-transfer-credit-risk-to-derivatives-dealers.html. 45 For discussion, Yesha Yadav, the New Market, supra note [ ]. 46 The British Bankers Association (BBA), BBA Credit Derivatives Report, 17-18 (2006). 47 FIN. CRISIS INQUIRY COMM’N, supra note 3. 48 Tim Adam & Andre Guettler, The Use of Credit Default Swaps in Fund Tournaments (FIRS 2011 RESEARCH PAPER, 2012), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1744978 (this study notes that the use of CDS by mutual funds is increasing and especially as net sellers of credit protection). 49 BANK OF INT’L SETTLEMENTS, BIS QUARTERLY REVIEW (Dec. 2011), http://www.bis.org/publ/qtrpdf/r_qt1112.htm; see Lisa Pollack, Meet the Credit Derivative End Users, FIN. TIMES, Dec. 13, 2011, http://ftalphaville.ft.com/2011/12/13/794201/meet-the-credit-derivative-end-users/; Houman Shadab, Hedge Funds Transfer Risk to Derivatives Dealers, LAWBRITRAGE, Dec. 13 2011, http://lawbitrage.typepad.com/blog/2011/12/hedge-funds-transfer-credit-risk-to-derivatives-dealers.html. 50 BEVERLY HIRTLE, CREDIT DERIVATIVES AND BANK CREDIT SUPPLY, FEDERAL RESERVE BANK OF NEW YORK STAFF REPORT NO. 318 6-7 (2008) (CDS use increased lending in commercial and industrial sectors).

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they garner as lenders. That is to say, they can reduce the costs of purchasing credit protection by acting on the intelligence they acquire through their lending business. This means that they can purchase credit protection on those businesses with a higher potential for default. Alternatively, they may even sell protection on debt that constitutes a safe bet and unlikely to default. The speculative side of the market allows banks and credit providers to tailor their exposures to maximize the value of the information they acquire. That is to say, where a company looks shaky, a credit provider can seek out more protection than the value of exposure that it holds. This promises yield where, if the CDS pays out, the credit provider triggers repayment on existing as well as synthetic exposures. Selling credit protection on safe and creditworthy companies brings its own advantages, where a seller garners a regular income stream with little likelihood of suffering a future pay-out. Credit Specialists: Apart from usual credit providers, the expert nature of market actors also points to a better informed cohort of actors. This is discussed more fully below. Hedge funds, mutual funds, pension funds for example enjoy a reputation as engaged, activist investors.51 This is particularly true for hedge funds that have garnered a reputation as informed, aggressive and ambitious investors that invest in procuring information for trading.52 Though such investors might not be credit providers in the strict sense, data acquired as equity investors or in private equity can be highly informative for CDS trading. Moreover, credit protection providers and sellers usually engage in some analysis of the underlying exposure whose risk is being bought and sold.53 This can entail some transfer of borrower information between lenders and credit protection sellers as part of the risk-analyses that both parties undertake. The informational advantage is most likely skewed in favor of lenders that possess high reserves of information. And, each side is ultimately 51

Henry T.C. Hu & Bernard Black, Hedge Funds, Insiders, and the Decoupling of Economic and Voting Ownership: Empty Voting and Hidden (Morphable) Ownership, 13 J. CORP. FIN. 343 (2007); Michelle Harner, the Corporate Governance and Public Policy Implications of Distressed Debt Investing, 77 FORDHAM L. REV. 101 (2008), at 123-125 (noting the participation of hedge funds in the distressed debt market); Ed Rock & Marcel Kahan, Hedge Fund Activism in the Enforcement of Bondholder Rights, 103 NW. L. REV. 183 (2009) (discussing hedge fund activists in the bond market). 52 Marcel Kahan & Ed Rock, Hedge Funds in Corporate Governance and Corporate Control, 155 U. PENN. L. REV. 1021 (2007) (analyzing hedge fund activism in comparison with the involvement of a variety of institutional investors and noting the incentives pushing hedge fund activism in terms of paystructures of managers); Alon Brav et al., Hedge Fund Activism, Corporate Governance and Firm Performance, 63 J. FIN. 1729 (2008) (empirically showing that hedge fund involvement results in higher performance by companies). The dark side of this pursuit of information has been seen in increasing enforcement against hedge funds for insider trading. This is seen in high-profile cases against founders of the Galleon Fund, as well as SAC Capital amongst others, John Gapper, Hedge Fund Reputation Hangs in the Balance, FIN. TIMES (Mar. 17 2013). 53 David Mengle, supra note [ ], 4-5 (discussing the credit analyses that protection buyers and sellers undertake).

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responsible for its own risk analysis. However, this analysis between protection sellers and protection buyers results in the fine calibration of credit protection costs. In such cases, the bargain reflects the differing judgments of the protection buyer and seller with respect to the underlying credit risk and the costs that each side requires to internalize. Without some transfer of information between protection buyers and sellers, protection sellers may charge high fees for the trade or otherwise refuse to entertain the bargain. Regulatory Environment: Market structure and convention in the credit derivatives market has been shaped by considerable immunity from regulation since 2001. The traditional strictures of securities regulation, such as prohibitions against insider trading and securities fraud, have either not applied, or otherwise failed to bite. A lack of clarity in legislative scope and enforcement of securities rules, set alongside weak incentives of members of this small group to litigate against one another have resulted in self-regulation54 over state-sanction of market practices.55 Notably, traditional anti-fraud, anti-manipulation jurisprudence under section 10b of the Securities and Exchange Act 1934 and its Rule 10b-5 has entirely ignored this market, and perhaps for good reason. Even applying these conventional rules may have resulted in very little effect on market behavior given the particularities of CDS trading. Indeed, the few past attempts to apply insider trading and securities fraud jurisprudence to credit derivatives markets have met with failure.56 The Dodd-Frank Act nevertheless subjects swaps trading to the conventional rules against securities fraud and insider trading, expressly extending the application of Rule 10b-5 in this regard.57 54 See for example, Frank Partnoy, ISDA, NASD, CFMA, and SDNY: The Four Horsemen of Derivatives Regulation? (U. of San Diego Sch. of Law Pub. Law & Legal Theory Working Paper, Paper No. 39, 2002), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=293085 (discussing, the private regulation of the derivatives market through ISDA) (showing the rise of master agreements that standardize definitions to reduce the transaction costs that parties face in bilateral and international deals). 55 Commodities Exchange Act, 7 U.S.C § 6(c). The Commodity Futures Modernization Act, Pub. L. No. 106-554, 114 Stat. 2763 (CFMA), applied the antifraud and anti-manipulation provisions of the Securities Act of 1933 and the Securities Exchange Act 1934 to ‘security-based swap agreements,’ as defined in Section 206B of the Gramm-Leach-Bliley Act. However, the CFMA prohibited the SEC from generally regulating security-based swap agreements and excluded security-based swap agreements from the definition of “security” under the Securities Act and the Exchange Act. For all intents and purposes, these swap agreements therefore fell outside of the purview of Section 10b and Rule 10b-5. 56 It has proved notoriously difficult to bring insider trading cases in the CDS market. In 2009, the SEC charged a hedge fund manager and a bond salesman with insider trading CDS in the securities of VNU N.V., a Dutch media conglomerate. In Securities and Exchange Commission v Rorech (SDNY Civil Action 09 Civ-4329), the District Court held that, while insider trading provisions of Rule 10b-5 could apply to CDS trading, there was insufficient proof in this case to meet the various elements of Rule 10b-5 to establish insider trading. 57 §762 Dodd-Frank Act repeals restrictions in section 206B in the Gramm Leach Bliley Act that has prevented securities anti-fraud liability from attaching to swaps. The Securities and Exchange Commission has proposed Rule 9j-1 in order to extend, with some medication, Rule 10b-5 to security-based swaps. Modifications from the original Rule 10b-5 in Rule 9j-1 are designed to ensure that anti-fraud

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Though private self-regulation in swaps trading now takes second place in policing misconduct, it continues to remain relevant. In place of the bilaterally OTC market, post-Crisis consensus mandates that parties migrate to organized exchanges to strike deals and settle trades.58 A push away from the bilateral market to multilateral trading facilities and settlement systems centralizes data and helps in collecting information on trades.59 While the main purpose of derivatives exchanges and settlement mechanisms primarily lies in reducing the risks of trading, informational reservoirs can help track transactions and should help to provide evidence of suspicious trades in real-time.

C. Information and Efficiency

Traders in credit derivatives constitute both consumers as well as suppliers of information to the financial market. The significance of information for this market is easy to appreciate. The CDS market trades the default risk of underlying assets. It estimates the likelihood of a company failing and defaulting on its debt. This estimation determines the price of buying CDS protection. Ensuring that this calculation is correct generates efficiencies: (i) companies benefit from credit that is properly priced; (ii) CDS protection sellers understand the risk that they take and charge for their exposure; and (iii) parties accurately stipulate the amount of collateral under the contract, too much collateral becoming costly to a protection seller and too little costly to the buyer. High-quality information is the essential ingredient in this calculus. It is also a key output of trading by the informed players in the CDS market. Information Supply: the CDS market transacts in information pertaining to the credit risk of underlying debtors. The unique feature of this market, perhaps more so than any other, is that many those supplying information to this market enjoy special access to its most important sources. Many of the main players in the CDS market constitute providers

provisions capture the recurring payments made under swaps as well potential fraud with respect to the underlying security. For more detail, Paula S. Greenman & John W. Osborn, SEC Anti-Fraud Rule Under Title VII of Dodd-Frank, Skadden Arps Skate Meagher & Flom Publication (Nov. 2010). 58 G-20 PITTSBURGH SUMMIT, LEADERS’ STATEMENT: THE PITTSBURGH SUMMIT 7 (2009), available at http://ec.europa.eu/commission_2010-2014/president/pdf/statement_20090826_en_2.pdf (“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”). It also requires that parties settle their trade using clearinghouses as a means of bringing safety and certainty to trades. 59 Exchanges and clearinghouses are purveyors of information to those using them given their role in centralizing data. For discussion and examples see, Yesha Yadav, the Problematic Case, supra note [ ], 408-413.

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of credit to corporate borrowers.60 Banks, investment banks, hedge funds and private equity houses garner considerable insight as lenders into the inner activities of the borrowers to which they supply capital. This is entirely to be expected. Loan agreements usually require borrowers to provide their lenders with detailed information regarding their business, management and credit history.61 In addition, they allow lenders to have on-going monitoring rights as well as access and influence to a borrower’s management apparatus. Indeed, scholars argue that lenders can possess exceedingly detailed information regarding a borrower and its organization. In the first instance, this information is helpful to lenders to monitor the borrower. But, additionally, it also provides a basis for the lender to negotiate with the borrower for influence over how the company is run and the composition of those who are charged with running it.62 Emerging literature notes that lenders are becoming increasingly pro-active in making their presence felt in corporate boardrooms across the country. There are myriad advantages that lenders enjoy through better access to their borrowers. Most obviously, they can better manage the risks they assume by bringing their expertise to help a borrower preserver the value of the capital. Importantly, lenders can benefit by charging higher fees for an array of ancillary financial services as well as, in some cases, by acquiring equity in a borrower to capture the upside of future growth.63 Where lending relationships offer the promise of fees and influence, lenders possess powerful motivations to invest in procuring good quality information on the borrower. Lenders that wish to trade in credit protection do so enjoying a form of subsidy. That is to say, they are able to buy (or sell) credit protection with a low information deficit on the borrower’s future creditworthiness. The relatively absence of information asymmetry in this

60

Kathryn Chen et al., supra note [ ]. See for example, Greg Nini, David C. Smith & Amir Sufi, Creditor Control Rights, Corporate Governance, and Firm Value, at 34–37 (Nov 2009) (unpublished manuscript), available at http://ssrn.com/abstract=1344302 (noting that lenders can stipulate intensive control rights in loan agreements, which when broken, provide a way to re-negotiate loan terms and for the lender to bargain for more control and fees subsequent to breach). But, see also, George Triantis and Albert Choi, Market Conditions and Contract Design: Variations in Debt Covenants and Collateral, N. Y. U. L. REV. (forthcoming 2013) (arguing that loan covenants tend to be light or go unenforced in good market conditions). 62 See in particular, Fred Tung, supra note [ ]. For insightful discussion, Douglas Baird & Robert Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. PA. L. REV. 1209 (2006) (arguing that lenders have important influence on management and key decisions in the life of a company); George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive Corporate Governance, 83 CAL L. REV. 1073 (1995) (noting the ability of lenders to exit as a signal of their negative outlook of a company’s governance). 63 See for example, Michelle Harner, the Corporate Governance and Public Policy Implications of Distressed Debt Investing, 77 FORDHAM L. REV. 101 (2008) (highlighting the role of distressed debt specialists and their deployment of “loan-to-own” strategies, at 123-130. 61

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relationship reduces the uncertainty risks that they face – at least in terms of predicting the likelihood of borrower default. This does not mean that the CDS transaction becomes risk-free. A lender bears the risk that the protection seller (or buyer) goes bust or otherwise cannot meet the terms of the bargain. A further factor is also significant. Influence that lenders enjoy permits them to take such actions as may reduce (or maybe increase) the risks that a borrower creates.64 This ability to access the borrower’s organizational apparatus can help assure continuing access to debtor information and even the ability to shape key events that generate this information for an underlying corporation. The CDS transaction thus provides a channel for information on this private information between the borrower and the lender to filter into the public trading space. The lender possesses considerable stores of information that inform its trades. The CDS trade, the price at which the lender is able to buy or sell protection and the overall liquidity of the CDS market, constitutes important signaling. Professors Triantis and Daniels have highlighted the significance of “exit” and “voice” in credit relationships. Lenders use the “exit” option as a means of conveying their negative opinion on a borrower and its governance.65 The CDS market amplifies the informational impact of exit. Exit is cheap in a market that is generally more liquid than the loan-sales market.66 More significantly, CDS also allow lenders to express their opinion forcefully. Recall, that where lenders wish to signal the riskiness of the borrower, they can buy more exposure than the value of the debt they hold. The message here is powerful – and more powerful than simply selling a loan to another firm. Taking on a speculative exposure in the CDS market can quickly alert the market to the risks that a borrower presents. Indeed, lenders may have already sold their loan in the loan-sales market and still purchase protection on underlying debt to underscore their negative viewpoint. Beyond traditional lenders, the CDS market actively involves other informed investors, such as hedge funds, that are well-known for aggressively pursuing informational gains. Overall, the CDS market has historically comprised a cohort of highly informed players, some of which have enjoyed special access to reservoirs of information through credit or

64 Henry T.C. Hu & Bernard Black, supra note [ ] (discussing that lenders are often reckless in relation to borrowers where they have purchased credit protection and may pro-actively work towards pushing a borrower into default and triggering repayment on the CDS). To reduce borrower risk, for example, lenders may recommend ways in which a borrower can best use its capital to fund acquisitions, transfers, mergers or the better use of collateral that the lender relies on to protect itself. 65 George G. Triantis & Ronald J. Daniels, supra note [ ]. 66 Christine A. Parlour & Andrew Winton, Laying off Risk: Loan Sales v Credit Default Swaps 4-5 (Apr. 23, 2009) (unpublished manuscript).

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other investing relationships. This supply into the CDS market holds considerable informational value for the broader market as whole. Information Output: the quality of information entering the CDS market reflects in its increasing importance as a predictor of risk for the financial markets as a whole. Indeed, its significance appears to be growing rather than diminishing after the Financial Crisis. Credit rating agencies, long the established supplier of information to the markets, have fallen into disrepute following their well-publicized failures to address the risks of toxic mortgage and asset-backed securities.67 As regulators look for replacement suppliers for information,68 the CDS market has emerged as one credible alternative that, unlike the ratings agencies, succeeded in predicting the Crisis several years before its arrival.69 Studies show that CDS indices were far more prescient regarding the coming Financial Crisis than credit rating agencies. As early as 2007, more than a year before the collapse of Lehman Brothers, CDS indices referencing the debt of troubled financial institutions and mortgage backed securities began reflecting future volatility in the credit markets.70 And, this was not the only show of success for CDS indices. Scholars note that CDS were also early predictors of the General Motors and Ford insolvencies in 200571 as well as the falls of Enron and WorldCom.72 Following the failure of credit rating agencies, it has not taken long for scholars to embrace CDS indices as a possible solution to the pervasive information asymmetries in the financial markets. 67

FINANCIAL CRISIS INQUIRY COMM’N, THE FINANCIAL CRISIS INQUIRY REPORT xxv (2011), 28-30; Roger Lowenstein, Triple-A Failure, N.Y. TIMES MAGAZINE (April 27, 2008); Frank Partnoy, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, 77 WASH. U. L.Q. 619, 665-670 (arguing that CRA methodologies were flawed in their capacity to correctly measure risk). See also, Yair Listokin & Benjamin Taibleson, If You Misrate, Then You Lose: Improving Credit Rating Accuracy Through Incentive Compensation, 27 YALE J. ON REG. 91 (2010) (analyzing the impact of the issuer-paid model on credit rating agency performance). 68 §939A of the Dodd-Frank Act stipulates that statutory references to credit ratings be removed to incentivize a search for alternatives to credit ratings. In the context of banking regulations see, Alternatives to the Use of External Credit Ratings in the Regulations of the OCC, OFFICE OF THE COMPTROLLER OF THE CURRENCY, http://www.occ.gov/news-issuances/bulletins/2012/bulletin-201218.html (Jun. 12, 2012). 69 Mark Flannery et al., supra note [ ] (arguing that CDS constitute a more reliable predictor of default risk than credit rating agencies). 70 Id, at 2097-98; Jerome S. Fons, Shedding Light on Subprime, RMBS J. STRUCTURED FIN., Spring 2009, at 8. For discussion of ABX indices and their early prediction of the Crisis, Gary Gorton, The Subprime Panic 21–23 (Yale Int’l Ctr. for Fin., Working Paper No. 08-25, 2008), available at http://ssrn.com/abstract=1276047. 71 Viral Acharya, Stephen Schaefer and Yili Zhang, Liquidity Risk and Correlation Risk: A Clinical Study of the General Motors and Ford Downgrade of May 2005 (November 2007), available at, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1074783 (reporting on the impact of the General Motors and Ford and the signals in the CDS indices); Michael Simkovic and Benjamin S. Kaminetzky, Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution, C U. COLUM. B. L. REV. 118 (2001) (arguing that credit default swap spread data be introduced in bankruptcy proceedings to determine whether or not fraudulent transfers have taken place in the twilight period prior to bankruptcy). 72 Frank Partnoy & David Skeel, supra note [], at 1022-23.

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The critical enquiry however is what makes the CDS market more efficient in collecting and reflecting information than more conventional market mechanisms. One explanation is straight-forward: the better the information entering the market, the more accurate its output. Given the dominance of lenders and other highly informed investors in the market, its overall efficiency seems unsurprising.73 But, an examination of efficiency in the CDS market reveals a more complex picture. Scholars note that CDS markets appear to be much faster at internalizing “negative” information on an underlying company than positive news regarding its future. A recent study, for example, shows that CDS evidence abnormal changes in the cost of trading CDS protection before negative events like a ratings downgrade rather than before positive events.74 Professors Acharya and Johnson also report that CDS markets incrementally leak non-public information prior to negative events, rather than before positive ones.75 These findings imply that the market anticipates bad news events more actively in CDS prices.76 The negative tilt of the CDS market reflects its essential feature namely, that it measures default risk. Events that are likely to impact this risk will naturally carry more significance for CDS market players.77 More 73

See also, Viral Acharya & Timothy Johnson, supra note [ ]. Lars Norden, Why do CDS Spreads Change before Ratings Announcements? Working Paper, WFA Meetings 2009 (2011), available online at, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1138698, at 2-5. See also, Caitlin Ann Greatrex, the Credit Default Swap Market’s Reaction to Earnings Announcements, Fordham University Economics Discussion Paper No. 2008-06 (March 2008) (reporting that CDS spreads often moved around 90 days prior to an earnings announcement, especially for companies with a lower credit rating); Lars Norden and Martin Weber, Informational Efficiency of Credit Default Swap and Stock Markets: the Impact of Credit Rating Announcements, CEPR Discussion Paper Series No. 4250 (2004). 75 Viral Acharya & Timothy Johnson, Insider Trading in Credit Derivatives, 84 J. Fin. Econ. 110 (2007), 115-120; Viral Acharya & Timothy Johnson, More Insiders, More Insider Trading: Evidence from Private Equity Buyouts, 98 J. FIN. ECON. 500. 76 This Article does not discuss the merits of the Efficient Capital Markets Hypothesis, which suggests that the market quickly and immediately incorporates all publically available information in stock prices. This theory has been the subject of considerable debate and scrutiny. For further discussion on the ECMH, ROBERT SHILLER, IRRATIONAL EXUBERANCE (2nd ed. 2006).; Donald C. Langevoort, Taming the Animal Spirits of the Stock Markets: A Behavioral Approach to Securities Regulation, 97 Nw. U. L. Rev. 135 (2002); For an illuminating discussion, Jonathan R. Macey et al., Lessons from Financial Economics: Materiality, Reliance, and Extending the Reach of Basic v. Levinson, 77 VA. L. REV. 925 1017, 1021-30 (1991) (arguing that markets can be perceived as efficient if they appear to react swiftly to information, not necessarily because they are “efficient,” as traditionally understood in the ECMH). 77 Scholars argue the CDS works much like a put option contract. A put option gives the option buyer the right (but not the obligation) to sell a security for an agreed price and time. Such options control the downside risks that investors face when purchasing a share or a bond. A CDS works much like a put option. It is basically an option taken out by the protection buyer (Lender) to sell the underlying bond back to the protection seller when the borrower defaults. Finance theorists have argued that put options are exceptionally sensitive to negative information. The put option market is interested in any news that might push down the value of a company’s share or bond. Any downward movement in these share prices affects what the put option is worth. The greater the downward movement on a stock or a bond, the greater the value of any put. For more, Charles Cao et. al., the Information Content of Option-Implied Volatility for Credit Default Swap Valuation, Working Paper (2009), available online at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=889867&download=yes (stating that the credit default 74

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significantly, the negative emphasis in the CDS market highlights its function as a channel for lenders to convey “exit.” Lenders enjoy a firstmover advantage in their ability to purchase credit protection. At the first sign of trouble, lenders occupy a front-row seat in determining whether events are sufficiently concerning as to motivate the purchase or sale of credit protection – and how much. The quicker lenders move, the more likely it is that they can obtain cheaper credit protection, at least until the rest of the market catches up. The ability of lenders to enter into swaps without holding actual exposure can amplify the intensity of signaling. The critical feature of the CDS market thus emerges into view: information on corporate life percolates earlier into the CDS market than in others. Unsurprisingly, CDS are fast becoming a supplier of this information across markets in the absence of credit rating agencies.

II. AN UNEASY FIT: CONVENTIONAL PARADIGMS IN NEW MARKETS

Scholarly debates on the insider trading prohibition have long been contentious. As case law has struggled to define the scope and limit of liability for insider trading, so too have scholarly debates, acknowledging the importance of restrictive laws in the area, alongside the significance of informational efficiency. This Part surveys these debates before situating insider trading law and policy in the context of the evolving credit derivatives market. It sets up its central argument: current laws are poorly suited to match the complexity of modern markets and the easy commodification of insider information these allow. In problematizing current doctrine, this Part also problematizes the assumptions that have traditionally framed theory and debate in this area.

A. Short Primer on the Doctrinal Framework

Broadly, the legal framework prohibiting insider trading has progressed along two distinct but related pathways. The basic thrust of the law sought to prohibit corporate insiders from trading on material, nonpublic information in their company’s stock. Such schemes are perceived as a way for insiders to defraud company shareholders and to unfairly use

swap is an out-of-the-money put option that protects against downside risk). My thanks to Professor Margaret Blair for this insight.

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their advantage for private profit.78 With investor protection a prime concern,79 insider trading has evolved from a fairly anodyne practice in state courts and at common law to one now construed as a species of fraud under federal law.80 This analytical move has brought insider trading firmly within the jurisdiction of Section 10b and Rule 10b-5 of the Securities and Exchange Act 193481 and prohibited as a manipulative and deceptive practice.82 In seminal decisions, the court has grounded its finding of insider status on the existence of a pre-existing fiduciary relationship.83 Insiders in a fiduciary relationship to a company and its shareholders must first disclose their insider information to shareholders – or otherwise abstain from trading. With disclosure an unlikely option, insiders cannot generally trade until the information becomes public. Interestingly, insider status can fix beyond just a select group of key managers and officers in a firm.84 Temporary insiders who trade on

78 SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968) (setting out the basic disclose-and-abstain rule, such that anyone with insider information was prohibited from trading without first disclosing this information to the market), Chiarella v. United States, 445 U.S. 222, 223-226 (1980) (imposing the showing of a fiduciary relationship as a pre-requisite for liability), Dirks v SEC, 463 U.S. 646, 654-656 (1983)(re-affirming the Chiarella requirement for a fiduciary relationship); Stephen M. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 WASH. & LEE. L. REV. 1189, 1190-92 (1995); Adam C. Pritchard, Justice Lewis F. Powell, Jr., and the Counterrevolution in the Federal Securities Laws, 52 DUKE L. J. 841, 932-934 (2003) (noting that Justice Powell sought to limit overreaching and a fiduciary relationship provided a limiting principle); For an excellent overview of the literature and the policy debates, DONALD C. LANGEVOORT, INSIDER TRADING REGULATION, ENFORCEMENT & PREVENTION §§ 1:1 to 1:6 (2008); WILLIAM K. S. WANG & MARC I. STEINBERG, INSIDER TRADING, §§ 2:1 TO 2:5 (2D ED. 2005). 79 Joel Seligman, The Reformulation of Federal Securities Law Concerning Nonpublic Information, 73 GEO. L. J. 1083, 1115 (1985) (noting the importance of investor of investor protecting in SEC rulemaking). 80 Goodwin v Aggasiz, 186 N.E. 659 (1933) (in an early decision, the State Supreme Court in Massachusetts held that open-market insider trading could not fall within the definition of fraud); Freeman v. Decio, 584F.2d 186, 191-95 (7th Cir. 1978). But see also, Strong v. Repide, 213 U.S. 419 (1909) (holding a controlling shareholder guilty of fraud for not disclosing an important contract to stockholders). 81 In re Cady, Roberts & Co., 40 S.E.C. 907 (1961). For insightful discussion, Donald C. Langevoort, Re-reading Cady Roberts: the Ideology and Practice of Insider Trading, 99 COLUM. L. REV. 1319 (1999) (analyzing the development of early insider trading regulation and its progression); Richard. Painter, Kimberly D. Krawiec and Cynthia A. Williams, Don’t Ask: Just Tell: Insider Trading after United States v O’Hagan, 84 VA. L. REV. 153 (1998) (discussing the court’s jurisprudence from Chiarella to O’Hagan). It is worth noting that courts initially addressed insider trading through Section 16d of the Exchange Act, rather than through Rule 10b-5. See for example, Gratz v. Claughton, 187 F.2d 46 (2d Cir.), cert. denied, 341 U.S. 920 (1951). 82 Richard Painter et al., supra note [ ], 163-164. 83 Chiarella v. United States, 445 U.S. 222, 223-226 (1980) (but a simple breach of fiduciary duty is insufficient grounds for liability without also a failure to disclose information prior to trading); United States v O’Hagan, 521 U.S. at 665-667 (the court defines a fiduciary relationship as one characterized by trust and confidence); Donald C. Langevoort, The Demise of Dirks: Shifting Standards for Tipper-Tippee Liability, 8 No. 6 INSIGHTS 23, 24-25 (1994); WILLIAM K.S. WANG & MARC STEINBERG, supra note [ ], §§ 5:1-5:2 (underlying the classical conception of a fiduciary relationship as one of trust and confidence). 84 For discussion, John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 VA. L. REV. 717 (1984) (discussing the feasibility of the disclosure system in the context of the slowness with which certain disclosures are reflected in the trading price of securities).

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confidential information can fall within the purview of the “classical” insider trading prohibition.85 The normative goal of the insider trading prohibition has been clear: to prohibit insiders from exploiting their position to profit from trades with uninformed, vulnerable investors. In the absence of this prohibition, mandatory disclosure provisions would have little meaning and, with them, the broader anti-fraud regime punishing sub-optimal disclosure.86 However, courts and policymakers have struggled with the question of how broadly to construe the circle of liability. Critical here is the definition of who constitutes an “insider” and whether individuals entirely unconnected with a company can still be held liable where they trade on confidential information they chance upon unwittingly. In its most significant response to this query, the Supreme Court confirmed a new basis on which to ground liability. Under this theory, any person that misappropriates confidential information by breaching a fiduciary relationship to the source of that information can be held liable. Those who knowingly trade with fiduciaries who have misappropriated information can also fall within the net.87 In forwarding the misappropriation theory of liability, the court has broadened the circle of liability as a means of safe-guarding market integrity on a wider scale.88 Pursuant to this theory, liability can attach to outsiders like lawyers, auditors or accountants who trade on confidential information they obtain through the privileges of their professional access.89 While the misappropriation theory sanctions those that defraud the source of information, traditional liability has sought to protect the investors of the company whose securities are being traded.90 Despite the difference in 85 See for example, Dirks v. SEC, 463 U.S. 646, 650-656 (noting that temporary insiders can include those that enter into confidential relationships of trust with a corporation). See also, Jesse Fried, supra note [ ]. 86 See for example, Roberta S. Karmel, The Relationship Between Mandatory Disclosure and Prohibitions Against Insider Trading: Why a Property Rights Theory of Inside Information is Untenable, 59 BROOK. L. REV. 149, 150-152 (Book Review) (noting that insider trading laws are grounded in the importance of promoting fairness and equity in trading); Donald C. Langevoort, re Cady Roberts, supra note [ ]. For an insightful discussion of the ability of insider trading law to impose expansive construction of liability, Donald C. Langevoort, Words from on High About Rule 10b-5: Chiarella’s History, Central Bank’s Future, 20 DEL. J. CORP. L. 865, 897 (1995) 87 United States v. O'Hagan 521 U.S. 88 Id., 658-659 (arguing that investors would not enter a market were deceptive use of information was rife). 89 In Dirks v SEC, an analyst discovered misfeasance in Equity Funding of America and informed the SEC following a tip from a former officer of Equity Funding. He also informed his clients who subsequently traded on this information. Under misappropriation, it is possible that this analyst could have been held liable for insider trading. See also, A. C. Pritchard, United States v. O’Hagan: Agency Law and Justice Powell’s Legacy for the Law of Insider Trading, 78 B. U. L. REV. 13 (1998) (noting the rejection of the equal access standard in Dirks as a move towards focusing on the agent, rather than on the deception). See also, Stephen Bainbridge, the Iconic Insider Trading Cases, UCLA School of Law & Economics Research Paper Series Research Paper No. 08-05 (2005), 6-10. 90 Stephen Bainbridge, Id., 28-30.

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emphasis, some underpinning in a breach of a fiduciary obligation is theoretically a pre-requisite the claim for insider trading.91

B. Law versus Economics

The normative rationale underpinning the insider trading prohibition speaks to two broad policy goals. Most straightforwardly, restrictions on the use of insider information protect investors who might otherwise lose in trading with a better informed insider-counterparty.92 On this basis, where investors repeatedly lose against corporate insiders, they will either refrain from entering the market, disrupting liquidity, or expect to pay a deeply discounted price for securities.93 Ultimately, this rationale supports issuer companies, particularly those whose insiders do not trade. If investors fail to come to the market or otherwise charge a high premium for their participation, capital formation becomes too expensive to be feasible and issuer companies must instead rely on costlier capital. Secondly, the prohibition is designed to protect the property rights that a company possesses in its own information. In line with this theory, the prohibition against trading on confidential information ensures that the company, rather than any of its managers reap the maximal benefit of its data and information. By punishing those that usurp a company’s information for their private gain, the law safeguards a company’s information from a form of theft of this information. In this way, the law increases the costs to a manager or outside professional that steals corporate information for personal profit, with the costs hopefully greater than the value of the benefit likely to be gained through insider trading. If a company’s information can be easily and cheaply usurped by a small number of insiders and advisors, shareholders will have little incentive to invest in information.94 A small group of officers will enjoy shareholdersubsidized access to markets and investors – and may even debase the value of a company’s shares through opportunistic trading.95 91 The Court’s decision in O’Hagan has been subject to considerable academic analysis and criticism. The literature here is extensive. For discussion see, Richard Painter et al., supra note [ ]. But see, Donna M. Nagy, Insider Trading and the Gradual Demise of Fiduciary Principles, 94 IOWA L. REV. 1315, 1320-21 (2009) (noting that the requirement for fiduciary status is relaxing, particularly in lower courts where courts are returning to an equal access to information standard, per Texas Gulf Sulfur). 92 In re Merrill Lynch, Pierce, Fenner & Smith, Inc., 43 S.E.C. 933, 936 (1968) (noting that insider trading is motivated by the “inherent unfairness involved where one takes advantage’ of information intended to be available only for a corporate purpose and not for the personal benefit of anyone”). 93 See for example, Roberta Karmel, supra note [ ]. 94 Stephen Bainbridge, the Iconic Insider Trading Cases, supra note [ ], 15-16. 95 For example, this may happen if company insiders use their information to short sell a company’s stock, potentially lowering the value of its securities.

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Despite these laudable motivations, scholars have long critiqued both the law as well as its underlying rationales.96 A powerful line of criticism has emerged from scholars who contend that restrictions on insider trading generate inefficiencies in the market. Drawing notably on the efficient capital markets hypothesis,97 scholars argue that legal obstacles to the free flow of information prevent the market from properly internalizing and pricing corporate securities.98 They posit that optimal regulation – rather than aiming to protect investors through restrictions on trading – works best when it encourages the freest flow of information. This includes insider information, as conventionally understood. In developing this thesis, scholars argue that recognizing the company’s rights in property promotes the value of information, either as compensation to managers,99 or otherwise as a means to encourage greater trading and liquidity in company securities.100 Robust recognition of property rights includes the possibility of allowing companies to use these rights in the way they consider privately optimal. That means that if they wish to transfer these property rights to another party, such as managers or market specialists, then they should be free to do so.101 The market efficiency justification for insider trading has become firmly established in the literature as a counterpoint to the strictures and also the confusion of doctrine and case law in this area.102 In expounding their critiques, scholars have sought to explain existing case law through the prism of economics,103 or otherwise, as a function of better investor 96 See in general, Henry G. Manne, INSIDER TRADING AND THE STOCK MARKET, (1966) (arguing that the prohibition of insider trading makes markets inefficient); Roy A. Schotland, Unsafe at Any Price: A Reply to Manne, Insider Trading and the Stock Market, 53 VA. L. REV. 1425, 1440 (1967) (arguing that insider trading is damaging as a cost to investors); and, Ian Ayres & Stephen Choi, Internalizing Outsider Trading, MICH L. REV. 313 (2002) (an important article on the bargain between outsider traders and the firm); Dennis W. Carlton & Daniel R. Fischel, The Regulation of Insider Trading, 35 STAN L. REV. 857 (1983) (arguing to allow companies to permit their managers to use insider information, for example, to compensate managers); Zohar Goshan & Gideon Parchmovsky, supra note [ ]; David D. Haddock & Jonathan R. Macey, A Coasian Model of Insider Trading, 80 NW. L. REV. 1449 (1986) (arguing for a legalization of insider trading to promote efficiency); But see, Victor Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws, 93 HARV. L. REV. 322, 326-39 (1979) (supporting insider trading laws as a foil against manager misfeasance and to promote equitable trading); James D. Cox, supra note [ ] (providing a strong critique of those calling for a dismantling of insider trading laws). Literature in this area is vast. 97 Eugene Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, 25 J. Fin. 383, 383 (1970) (noting market efficiency as a function of liquid markets incorporating information). 98 For illustration, Henry G. Manne, Id; Jonathan Macey, Id. 99 Dennis W. Carlton & Daniel R. Fischel, supra note [ ]. 100 Zohar Goshen & Gideon Parchmovsky, supra note [ ]. 101 Dennis W. Carlton & Daniel R. Fischel, supra note [ ]; Zohar Goshen & Gideon Parchmovsky, supra note [ ]. For an insightful exposition of outside trading, Ian Ayres & Stephen Choi, supra note [ ]. 102 See for example, Richard Painter et al., supra note [ ]. 103 See for example, Stephen Bainbridge, The Iconic Insider Trading Cases, supra note [ ] (noting that the disclose-or-abstain rule may be interpreted as a way for the courts to recognize and protect a company’s property rights in information – without however making these alienable); Roberta Karmel,

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protection. Though the debate continues, it draws attention to insider trading as a critical nexus where law and economic policy interact. In so doing, it makes clear the significance of linking law with policy to explain the costs imposed both by the misconduct as well as its proposed cures on investors, insiders and the market as a whole. C. Why Traditional Doctrine Fails The Dodd-Frank Act expands the reach of insider trading law and policy to credit derivatives.104 In broadening the reach of Rule 10b-5 and Section 10b, these new rules also import its jurisprudence and underlying policy preferences to the swaps market.105 Indeed, the reach of new rules to the swap markets is comprehensive. With some modifications to the language of Rule 10b-5, the Dodd-Frank Act prohibits insider trading and other fraud over the course of the swap and also with respect to any fraud on the underlying security.106 The extension of traditional anti-fraud liability to credit derivatives seems straight-forward. Swaps constitute securities.107 Applying a uniform and consistent anti-fraud liability regime across the securities market to include stocks, bonds, derivatives and the like appears, on its face, to be a rational regulatory strategy. But, derivatives are different. And, credit derivatives in particular constitute an especially intractable puzzle for insider trading laws. Read alongside conventional interpretations of Rule 10b-5, insider trading liability can easily attach to any number of credit derivatives trades. Indeed, the fundamental function of the market facilitates insider trading and allows for a particular kind of insider information to flow into the market as a whole.

supra note [ ] (arguing that the application of a property rights interpretation is misplaced where the law privileges investor protection as the goal of securities regulation). 104 Dodd-Frank §763(g) (amending Section 9 of the Exchange Act). For background see, supra note [ ]. 105 See Release No. 34–63236; 75 Fed. Reg. 68560-68568 (“Proposed Rule 9j-1 therefore prohibits the same categories of misconduct as Exchange Act Section 10(b) and Rule 10b-5 thereunder, and Securities Act Section 17(a)17 in the context of security-based swaps, and explicitly reaches misconduct in connection with these ongoing payments or deliveries”). It should be noted that new rules include some new wording, for example, the addition of the word “manipulate” to the wording in Rule 10b-5(a). While it adds wording, it does not subtract from the original rule. 106 See SEC Rule 9j-1 that extends anti-fraud liability cover payments made under the swap for its duration as well as fraud with respect to the underlying security. It should be noted that, traditional Rule 10b-5 liability can apply to fraud against the underlying security, as well as Rule 9j-1. 107 Recall that §762 and 768 of the Dodd-Frank Act repeals those provisions of the Commodities and Futures Modernization Act that removed swaps from the definition of “security” for the purpose of anti-fraud liability enforcement. See also, Paula Greenman et al., supra note [ ].

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Disclose-or-Abstain: classical insider trading liability prohibits insider-fiduciaries from trading on material, non-public information in their own stock without first disclosing their intentions to the company and its shareholders.108 Otherwise, these traders must abstain from trading. Those who trade credit derivatives routinely acquire vast reserves of confidential information on underlying borrowers. Bank lenders,109 for example, possess considerable information on their borrowers, obtained through monitoring, pro-active exercise of loan covenants or even close interaction with corporate management.110 Specialist institutional investors, such as hedge funds, have also proved adept at militating for private information, for example, in in the course of making investments as activists in corporate governance.111 The close involvement of lenders and investors in borrower governance is significant. For one, it fits lenders and investors more neatly into the category of temporary insiders, or insiders in a conventional sense.112 The common law has accorded fiduciary status to lenders where these lenders actively participate in the governance of their borrowers.113 But, it is arguable, that even without a high degree of involvement, the power and significance of the borrower-lender relationship confers the fiduciary-insider status necessary for liability and to give the lender the status of an insider. The close involvement of lenders generates considerable data yield to determine whether or not they out to enter into a credit derivative on company debt. Information that lenders and other institutional investors acquire routinely motivates credit derivative trading. Of course, traders use CDS for a variety of reasons and some may be information-insensitive. For example, a bank may have over-invested in a particular sector or it may wish to reduce its capital costs.114 However, traders also use CDS to hedge 108

Chiarella v. United States, 445 U.S. 222 (1980) (setting out the disclose-or-abstain rule); Dirks v. SEC, 463 U.S. 646, 655 (1983). 109 If analyzed as a fraud on the underlying security, there is an argument that a loan is not a security under section 2(1) of the Securities Act 1933. However, one may also argue that the fact that a CDS references a bank loan – and where section 763 of the Dodd-Frank Act expressly contemplates fraud on the underlying asset – this pushes for a bank loan to be construed as a security for the purposes of section 763 liability. 110 See for example, Fred Tung, supra note [ ], 140-150. 111 See for example, William Bratton, Hedge Funds and Governance Targets, 95 GEO. L. J. 1375 (2007) (noting the monitoring role played by hedge funds); Ed Rock & Marcel Kahan, Hedge Fund Activism in the Enforcement of Bondholder Rights, 103 NW. L. REV. 183 (2009) (discussing the vigilance exercised by hedge funds in the bond market as activist investors); Charles Whitehead, The Evolution of Debt, 34 J. CORP L. 641 (2009) (analyzing the impact of liquid credit markets on the use of creditor monitoring covenants). 112 For discussion, Jesse Fried, supra note [ ]; Richard Painter et al., supra note [ ]. 113 Krivo Indus. Supply Co. v. National Distillers & Chem. Corp., 483 F.2d 1098, 1102-07 (5th Cir. 1973); J. Dennis Hynes, Lender Liability: The Dilemma of the Controlling Creditor, 58 TENN. L. REV. 635 (1991); see George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive Corporate Governance, 83 CAL L. REV. 1073 (1995), at 1101–104. 114 Supra, note [ ].

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their risks or otherwise to speculate in the underlying risk. Needless to say information is critical to achieving success in such cases. This raises an interesting query. Does a lender who buys credit protection after receiving confidential information on its debtor commit insider trading by not disclosing the CDS trade to this debtor company? Though such transactions are apparently quite routine to the CDS market, this is not an easy question to answer. For one, traditional insider trading liability usually looks to undisclosed deception on corporate shareholders or prospective purchasers of a company’s stock to ground liability. But, here, the trade is not in stock or a more familiar security. Rather, the trade concerns a swap referencing credit risk – and CDS counterparties are probably the most disadvantaged by the informational advantages that lenders possess. Though, Dodd-Frank extends liability for insider trading to swaps trading, traditional Rule 10b-5 jurisprudence sits uneasily with the complex reality of modern swaps markets. Credit derivatives trade underlying credit risk. That is their core function. The key benefits of this market include high degrees of confidentiality for its participants.115 And, a primary part of its appeal lies in the ability of lenders to trade credit risk without giving the game away to underlying clients.116 Where trades must be pre-disclosed, lenders reveal profitable strategies and perhaps lose clients who realize their lenders have bought protection on the debt. Moreover, where lenders must abstain and retain credit risk on their books, these higher transaction costs can dissuade lenders from extending credit in the first place.117 The Misappropriation Theory: the misappropriation theory provides a further basis for a finding of liability. The emphasis here shifts. The central premise of the misappropriation theory is the deceptive use of confidential information that is obtained by outsiders through their fiduciary access, for example, as lawyers, accountants or auditors.118 This theory punishes fraud on the source of the information, rather than fraud on the company, which is indirect. Lenders, as already noted, acquire critical information on debtor companies and their industries.119 If lenders use such information for private gain without first getting permission from the source of the information, misappropriation of this information may be 115

Yesha Yadav, supra note [ ]. See for example, Christine A. Parlour & Andrew Winton, Laying off Risk, supra note [ ] (discussing the mechanics of trading credit risk using loan sales versus undertaking CDS transactions). 117 Shannon D. Harrington and John Glover, Credit Default Swaps May Incite Regulators over Insider Trading, BLOOMBERG (Oct. 10, 2006); THE ECONOMIST, Pass the Parcel – Credit Derivatives (Jan. 18, 2003) (noting that corporate advisors are encouraging their clients to ask whether their lender has CDS on their securities). 118 United States v O’Hagan, 521 U.S. 642, 652, 655 (1997). 119 Fred Tung, supra note [ ]. 116

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implied. The misappropriation theory can cast a wide net. Its reach can cover a range of secondary actors that acquire confidential information knowing that this might have been obtained through misappropriation by a fiduciary.120 One important qualification to the misappropriation theory is that liability can be negated if the trader gets permission from the source of the information.121 The key fraud according to the misappropriation theory is the deception effected on the source of the information. The law therefore affords some wiggle-room for prospective traders if they first obtain consent from the source. In the CDS market, if traders and investors obtain the consent of their firm and the debtor, they may avoid liability under this heading. It seems straight-forward that lenders should automatically consent to any use of debtor information for CDS trading. Though this seems straight-forward, the picture is more complex than it seems. Even though insider trading is assumed by the market, most financial institutions are loathe to admit the sharing of information between divisions. Establishing Chinese walls between loan officers and CDS traders has been one route institutions take to blunt suggestions of insider trading. And, such scrutiny is only likely to get more pronounced with the implementation of the Dodd-Frank Act.122 Outwardly, such consent cannot be taken for granted as a matter of institutional design. The expansive scope of the misappropriation theory is significant for two key reasons. First, those who trade CDS with corporate lenders can also become liable. Counterparties may suspect that a lender has obtained confidential information by virtue of its professional access and is trading on this intelligence. If these counterparties also use this information for their own onward trading, the law leaves open the possibility of casting a sufficiently wide net for liability. Of course, the CDS market enjoys a high degree of confidentiality. Parties may never come to know with whom they are trading and why the other is trading. But, a broader point remains. The market is well known as an insider’s market.123 It includes a swathe of lenders and informed institutional investors.124 At least in spirit, traders are repeatedly transacting with insiders or investment professionals, and with these trades, acquiring information on the underlying and trading on that 120

For analysis, Ian Ayres & Joe Bankman, Substitutes for Insider Trading, 54 STAN. L. REV. 325 (2001) (noting the possibility that company employees who trade on the securities of a rival firm where explicitly prohibited by their employer may be liable under O’Hagan). 121 United States v. O’Hagan, 521 U.S. 642, 652-654 (1997) (stating O’Hagan traded Pillsbury stock “in breach of a duty of trust and confidence he owed to his law firm . . . and to its client”). 122 Viral Acharya & Timothy Johnson, supra note [ ], 1-4 (discussing the Chinese walls that have been established to avoid any implication of insider trading in the market, whilst also noting the existence of such trading). 123 Viral Acharya & Timothy Johnson, supra note [ ]. 124 BANK OF INTERNATIONAL SETTLEMENTS, supra note [ ].

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basis. Whether this might or should imply some constructive knowledge that a counterparty is likely a fiduciary constitutes an open question. Second, the CDS market allows traders to transact with considerable flexibility. A lender to a risky company can purchase CDS protection on that company’s debt knowing this company is likely to fail. But, armed with this information, the lender can also purchase CDS protection on companies in the same industry, perhaps likely to be equally risky.125 Or maybe, the lender purchases protection on the risky debtor’s counterparties in the supply chain.126 If the debtor defaults, then the supply chain is affected negatively. Perhaps one or other company in that chain collapses, triggering repayment on that CDS as well. The permutations are manifold. Substitute trading – that is to say, trading in the CDS of companies related to the original debtor – constitutes a distinct possibility in the credit derivatives market. In short, if an insider of professional fiduciary cannot legally trade in the swaps of one company, can it trade in the securities of a company with an equivalent risk-profile? Whether substitute trading constitutes a violation of insider trading laws under the misappropriation theory has always been a difficult question to answer.127 The complexity of this question only grows with the expansion of insider trading liability to the credit derivatives market. As a first matter, confidential information on an underlying company can inform a range of trading possibilities. These include trading in the CDS of related companies, or perhaps companies tied to a debtor company through supply chains and close commercial relationships. Importantly, CDS allow traders to enter into swaps speculatively, that is to say, without having to actually buy a loan or a bond.128 This means it is usually a great deal cheaper to enter into a swap and assume synthetic exposure than to lay out the capital expenditure of buying bonds, bank debts or even shares. With lower transaction costs, CDS traders can maximize the gains from their access to confidential information on underlying debtors and issuers of debt.

125 Viral Acharya, Stephen Schaefer and Yili Zhang, Liquidity Risk and Correlation Risk: A Clinical Study of the General Motors and Ford Downgrade of May 2005 (November 2007), available at, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1074783 (discussing correlation risks in credit markets and showing that their failures also impacted CDS prices across related industries). See also, Phillipe Jorion and Gaiyan Zhang, Good and Bad Credit Contagion: Evidence from Credit Default Swaps, 84 J. OF FIN. ECON. 860 (2007); Phillipe Jorion and Gaiyan Zhang, Information Transfer Effects of Bond Rating Downgrades, 45 FIN. REV. 683 (2010). 126 For analysis see, Michael Hertzel et al., Inter-firm Linkages and the Wealth Effects of Financial Distress along the Supply Chain, 87 J. OF FIN. ECON. 374 (2006) (showing that the failure of a large enterprise can create large losses for suppliers through lost contracts, competitive effects where clients defect to other clients). 127 Ian Ayres & Joe Bankman, supra note [ ]. 128 For example, David Mengle, supra note [ ].

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But, the range of possibilities does not end there. CDS traders can also use their confidential access to trade in shares, bonds, warrants, or to make other opportune investments in the market. Confidential information from the debt market, its granularity, depth and the influence that lenders enjoy over management, improve investment opportunities across markets. For example, a CDS trader that knows a debtor is likely to go into default, may benefit from making early purchases in its distressed debt. This can perhaps enable the trader to maximize the chances of profitable loan-toown deals that give such traders a lucrative foothold in the company’s equity.129 Early and accurate information enables the trader to make its move before other competitors, and perhaps more cheaply than if it did not have access to a borrower’s confidence. In an important paper, Professors Ivashina and Sun have noticed that the use of confidential information by lenders and institutional investors is an important phenomenon in the securities markets. They show that investors that take part in loan renegotiations often make investments in the shares of the debtor company. And, such investors usually enjoy abnormal returns compared with other managers.130 D. Re-visiting Investor Protection The extension of insider trading liability to the swaps market reflects a consensus view to bring this market more fully into the regulatory fold.131 New derivatives markets have not given rise to new laws. And, Rule 10b-5 and its policy-preferences apply to credit derivatives just as they have done to other types of securities.132 The prohibition against insider trading reflects key policy goals that have remained largely unchanged over time.133 Classic insider trading liability and the misappropriation theory reflect a deep unease with anointed professionals securing private advantages at the expense of uninformed 129 Michelle Harner, supra note [ ] (discussing the various loan-to-own deals that have grown in popularity in recent years, especially in the wake of the Financial Crisis). 130 Victoria Ivashina & Zheng Sun, Institutional Stock Trading on Loan Market Information, Working Paper (2010), 2-4, available online at, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=972044 (discussing the entry of institutional investors in the loan market, their participation in negotiation and subsequent strategic purchases in a debtor company’s stock). 131 G-20, PITTSBURGH DECLARATION, supra note [ ]; Sean J. Griffith, Governing Systemic Risk: Towards a Governance Structure for Derivatives Clearinghouses, 61 EMORY L.J. 1153, 1175-1178 (2012) (discussing the reform of the derivatives market post-Crisis); Yesha Yadav, the New Market (examining the impact of CDS on corporate governance). 132 See in general, Release No. 34–63236; 75 Fed. Reg. 68560-68568. 133 Donna Nagy, supra note [ ] (noting the importance of judge-made law in insider trading jurisprudence in the absence of a statutory statement of policy objectives).

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investors and shareholders.134 However, as argued in this Article, the application of old laws and their policy emphases to the credit derivatives market is problematic. Fundamentally, the CDS market comprises insiders who are, in many cases, engaged in insider trading, traditionally defined, on a regular basis.135 Insider trading liability imposes a cost on insiders. It seeks to diminish their likely gains with the offsetting prospect of liability. Ordinarily, shareholders lose out when insiders succeed in their stock trading strategies.136 Insiders maximize the value of information in welltimed trades. Shareholders must invest more in information and expertise to overcome this asymmetry. Within a dispersed investor base, one or other shareholder is unlikely to command the resources or the will to make that investment. As a result, insiders can effect a wealth transfer to themselves at the expense of shareholders. If undetected, such incremental gains can leave shareholders worse off and potentially more likely to demand a discount in deciding whether or not to purchase equity. To avoid these cost consequences, shareholders possess powerful incentives to monitor managers and others with privileged access to information. Where corporate governance constraints are unable to capture incidents of managerial bad behavior ex ante,137 statutory liability provides an ex post check on insider wrong-doing. The incentives of shareholders to monitor insider trading in CDS markets are weak - considerably weaker than those at play to prevent more classical insider trading practice in ordinary stock trades.138 Also, not only are there fewer incentives to invest in monitoring this species of insider trading, but the ability and access of shareholders to the key insiders involved are usually at too great a remove to be effective. Incentives to Monitor Insider Trading: when insider trading occurs in the CDS market, the harm to shareholders is more difficult to calibrate. In fact, giving CDS traders flexibility to transact can be beneficial for shareholders, at least in the near term. First and foremost, CDS can increase the supply of financing for a company by allowing lenders to 134 United States v. O’Hagan, 521 U.S. 642, 652 (1997) (“The two theories are complementary, each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities.”). Joel Seligman, The Reformulation of Federal Securities Law Concerning Nonpublic Information, 73 GEO. L. J. 1083, 1115-1118 (1985) (noting the importance of market integrity and investor protection as a driving goal of the insider trading prohibition). 135 See also, Viral Acharya & Timothy Johnson, supra note [ ]. 136 See discussion, Jesse M. Fried, Insider Abstention, supra note [ ], 459-461. 137 Rule 10b-5(1) allows pre-existing plans by managers to stand. 10b5-1(c)(1)(i)(A)(1)–(3). See for example, SEC v. HealthSouth Corp.,261 F. Supp. 2d 1298, 1322 (N.D. Ala. 2003) (“[I]t is a defense to an allegation of violation of Section 10b and Rule 10b5-1, if the person making the purchase or sale demonstrates that the purchase or sale that occurred was made pursuant to a plan.”). 138 However, see discussion in Part III(D) on the losses that shareholders may suffer where CDS trading increases the costs to regulators of policing insider trading.

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hedge their risks. The intuition appears to be borne out in empirical evidence. Scholars argue that companies that have CDS traded on their securities generally have higher levels of debt and that this debt is usually of a longer duration, meaning they have a longer time to pay the debt off.139 In addition, such firms are able to maintain their leverage even through credit supply crunches, such as the ones seen in 2008, suggesting that lenders continue to lend to these firms ahead of those that do not have CDS traded on their debt. Moreover, CDS trading can also enable riskier companies to obtain debt financing. Lenders are able to move in and out of this risk using credit derivatives and to engage in complex investment strategies, motivating them to extend credit to shakier companies.140 Cheaper credit and higher leverage can prove wealth-maximizing for shareholders in the short-term. Scholars observe that shareholders benefit from high corporate debt and are incentivized to increase these debt-levels to pursue growth in their investment. The argument is straightforward. Shareholders enjoy equity appreciation through credit-fuelled investments. The downside is borne by creditors whose can debts end up unpaid and locked in the bankruptcy process, with shareholders wiped out in any event.141 It makes sense for shareholders to encourage CDS trading on their company’s debt and with this to hopefully coax lenders into extending more credit on favorable terms. On this account, if lenders garner privileged access to information, then so be it. Access to CDS Traders: alongside weak incentives to monitor CDS trading by lenders, shareholders are unlikely to ever come to know who is trading in their CDS, when and why. Shareholders can, at least in theory, claim to exercise some control over misbehaving managers.142 The check 139 Alessio Saretto and Heather Tookes, Corporate Leverage, Debt Maturity and Credit Default Swaps: The Role of Credit Supply, Working Paper (March 2011), available online at, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1660515; See also, Adam Ashcraft and Joao Santos, Has the Credit Default Swap Market Lowered the Cost of Corporate Debt? 56 J. MONETARY ECON. 514 (2009) (arguing that the introduction has not reduced the costs of obtaining credit for corporates, so that they are paying the same for the credit as they did before); Beverley Hirtle, Credit Derivatives and Bank Credit Supply, 18 J. FIN. INTERMEDIATION 125 (2009) (showing that banks that used CDS extended more credit); Mitchell Peterson and Raghuram Rajan, The Benefits of Lending Relationships: Evidence from Small Business Data, 49 J. FIN. 37 (1994) (showing that hedging strategies can increase the supply of credit to small businesses). 140 For a detailed discussion, Haitao Li, Weina Zhang, Gi Hyun Kim, The CDS-Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns, Working Paper (2011), available at, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1572025. 141 Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 HARV. L. REV. 1151, 1182–91 (2010); see also Richard Squire, Strategic Liability in the Corporate Group, 78 U. CHI. L. REV. 605 (2011) (discussing “correlation seeking” behavior on the part of shareholders, to maximize the gains from leverage in the knowledge that downside risk is largely absorbed by creditors). 142 The literature here is vast. For analysis, FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 91-92 (1991); North American Catholic Educational Programming Foundation v. Gheewalla, 930 A.2d 92 (Del. 2007) (“it is well established that the directors owe their fiduciary duties to the corporation and its shareholders.”).

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of legal fiduciary duties, reporting requirements143 and the power to discipline managers give shareholders tools to solicit information on insider activities and to check abusive practices they do not support. Scholars argue that investors can also take action through their pocketbook where corporate insiders are found to be taking unfair advantage of their access. For example, investors may put extra capital into the company to better assure its success, reducing both uncertainty and the likelihood that managers profit from their advantage. Alternatively, investors can exit or otherwise reduce their investments. This can act as a powerful signal of their disapproval of managerial rent-seeking. Or, investors can wait and see and over or under-invest depending on the particular scenario that they face after an analysis of the cost-benefit trade-offs at work.144 But, the ability of investors to garner information on CDS trading on corporate debt is limited. As noted in this Article, the credit derivatives market has operated behind a veil of opacity and complexity.145 Traders enjoy considerable anonymity, creating near insurmountable hurdles for investors and others seeking to determine who is trading CDS on company debt, the timings of their trades and with these uncertainties the motives that drive trading behavior. The logistical challenge facing investors and even regulators to track trading behavior in the CDS markets renders shareholder monitoring and discipline entirely theoretical. This then raises the obvious question: why should shareholders care about CDS and insider trading in these markets? Superficially, they should not. But, considered more deeply, CDS trading and the insider trading intrinsic to it, is quickly transforming how companies exercise ownership of confidential information, its use, and the rights they covet to control the use of this information by third party market actors.

143 See for example, Rule 10b-5(1) plans that managers must complete to set out their preagreed trades in company securities. 144 Lucian A. Bebchuk and Chaim Fershtman, Insider Trading and Managerial Choice, 29 J. FIN. & QUAN. A. 1(1994) (discussing whether lifting the insider trading prohibition can encourage insiders to be less risk-averse); Jesse M. Fried, Reducing the Profitability of Corporate Insider Trading through Pre-trading Disclosure, 71 S. CAL. L. REV. 303 (1998) (highlighting the importance of advance disclosure of trades as a disciplining device on managers); Hayne Leyland, Insider Trading: Should it be Prohibited? 100 J. POL. ECON. 859 (1992) (noting wealth generative effects of insider trading for investors); Michael Manove, The Harm from Insider Trading and Informed Speculation, 104 Q. J. ECON., 823 (1989) (discussing that investors can act in a variety of ways depending on the scenario and where over-investment might not achieve any gains, investors may better pursue under-investment strategies). 145 See for example, Robert Bartlett III, supra note [ ].

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III. THE NEW ECONOMY OF INSIDER TRADING

The law and economics of insider trading pivot around a central theme: safeguarding a company’s proprietary rights in its confidential information. On all sides of the debate, recognizing a company’s ability to maintain the confidentiality and security of its information is seen as critical.146 It protects shareholders from unauthorized use of a company’s confidences. It also constitutes a valuable asset in the hands of a company from which it can derive enormous economic benefit.147 This Part shows that the foundation underpinning this key rationale is fast eroding. It argues that companies easily cede their rights in information to their lenders, perhaps without realizing. With lenders able to transact on the basis of this information through CDS, its fullest value passes to lenders, rather than resting with shareholders and the company as a whole. This Part moves to question whether this allocation of informational rights is optimal. In explaining this new economy, the Article notes that this redistribution of rights outside of the company affects insider trading liability more broadly, not only with respect to liability in the CDS market.

A. An Unintended Allocation of Informational Rights The significance of a company’s rights in the confidentiality of its information can hardly be over-estimated. Scholars have long recognized their economic salience: sometimes as assets to be protected against

146

For overview and analysis, DONALD C. LANGEVOORT, supra note [ ]; JONATHAN MACEY, supra note [ ]. Dennis W. Carlton & Daniel R. Fischel, supra note [ ]; Zohar Goshen & Gideon Parchmovsky, supra note [ ]. See also, Nasser Arshadi & Thomas H. Eyssell, supra note [ ]; Roberta Karmel, supra note [ ] (suggesting that investor protection is the guiding rationale of the SEC in fashioning insider trading liability rather than protection of property rights). 147 Lucian A. Bebchuk and Chaim Fershtman, supra note [ ] (explaining the role of these property rights in compensating risk-averse managers); Dennis W. Carlton & Daniel Fischel, supra note [ ] (noting that such rights, if transferable, may be used to compensate managers; Zohar Goshen & Gideon Parchmovsky, supra note [ ] (showing that transferring rights to analysts can generate competition for seeking efficiencies in information gathering and dissemination).

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misappropriation by insiders,148 or otherwise as assets to be commoditized by the company through a lifting of the insider trading prohibition.149 The argument against the insider trading prohibition has made frequent reference to the normative significance of a firm as owner of its information. Scholars argue that it deprives the firm of the full value these rights can generate. And, allowing insider trading benefits a firm in important ways. Where it can allocate its rights to those best able to deploy them, this allocation of informational privileges generates market efficiencies, making securities trading more informative and liquid.150 Moreover, a company can permit its managers to trade on insider information as motivation for better performance. By being able to trade on insider information, managers may adopt more profitable trading practices, for example, by shunning needless risk aversion in favor of savvier approaches.151 In the literature, scholars have usually encouraged the allocation of informational insider trading privileges to actors within the firm (e.g. managers). By contrast, Professors Goshen and Parchmovsky advocate a broader approach that proposes their allocation to investment analysts. These expert actors, they argue, are best positioned to competitively derive maximal value from this inside information and thereby promote market efficiencies.152 Ultimately, these analyses are classically Coasean.153 In the absence of transaction costs, the exercise of property rights in information will fall to be allocated to those that can use them most efficiently.154 Modern market developments however are rendering these debates increasingly theoretical. In reality, a company allocates its property rights in information outside the firm early and probably without realizing it has

148

See for example, Kenneth Scott, Insider Trading: Rule lOb-5, Disclosure, and Corporate Privacy, 9 J. LEGAL. STUD. 801, 814-815 (1980) (“In this view, the wrong committed is essentially that of theft or conversion. The information belongs to the firm, but an employee appropriates it for his own use and gain.”). Professor Scott also states that the property rights analysis, while not comprehensive to cover all cases, provides “clear guidance” on the function of the insider trading prohibition. See also, Robert Haft, The Effect of Insider Trading Rules on the Internal Efficiency of the Large Corporations, 80 MICH. L. REV. 1051 (1982) (noting the importance of the insider trading prohibition as a way of preserving corporate value through better organizational decision-making). 149 Dennis W. Carlton & Daniel Fischel, supra note [ ]; Zohar Goshen & Gideon Parchmovsky, supra note [ ]; JONATHAN MACEY, supra note [ ], 4-5. 150 Notably, Henry Manne, supra note [ ]. 151 Dennis W. Carlton & Daniel Fischel, supra note [ ], 875-876. Other scholars have noted that this is not an optimal approach. Professor Easterbook argues that encouraging insiders to trade can result in economic waste where insiders exploit the value of their information to take on riskier projects where this value is likely to prove most advantageous. See, Easterbrook, Insider Trading, Secret Agents, Evidentiary Privileges, and the Production of Information, 1981 SUP. CT. REV. 309, 332-333. 152 Zohar Goshen & Gideon Parchmovsky, supra note [ ]. 153 Ian Ayres & Stephen Choi, supra note [ ]. 154 Ronald H. Coase, The Problem of Social Cost, 3 J. L. & ECON. 1 (1960) (proposing that, absent transaction costs, parties will assign rights in ways that are most efficient).

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done so. The availability of the loan sales market155 and now the credit derivatives market make these rights freely transferable, allowing confidential information to percolate out from the company and into the light of public markets. Allocating Rights to Lenders: allocating informational privileges to lenders is routine for companies seeking credit. Lenders acquire vast reserves of information on debtor companies and enjoy this access for the duration of the loan.156 Scholars show that lenders acquire almost as much access to information directors. And this is significant.157 While directors cannot trade on the basis of the information that they acquire, lenders are in a different position entirely: a company’s lenders can trade credit derivatives on this access. Indeed, this feature gives the credit derivatives market its appeal and much of its public legitimacy, especially if it serves in helping lenders to manage their risk. But, in so doing, the credit derivatives market unlocks confidential information from its strictures and allows that information to enter the CDS market. The value of these informational privileges for lenders is enormously significant. First and foremost, it gives lenders a first mover advantage in taking favorable positions on a company’s future creditworthiness. Lenders can easily counter the possibility of bad news on the horizon by buying credit protection on a company’s debt. If the company goes into default, the lender can still expect a return on its investment. As far as the company is concerned, nothing changes in its relation with its lender. In terms of preserving harmony in client relations, the CDS market lets lenders move quickly and silently. If a company survives, lenders can continue to service its client as before. The first-mover advantage a lender enjoys raises an important issue with respect to possible costs that its CDS counterparties must internalize in this trade. If others in the CDS market are unaware of impending trouble, then credit protection should come at a cheaper price. Other CDS protection traders are clearly disadvantaged vis-à-vis the lender, just like shareholders are in the case of classical insider trading in stock markets. A lender is almost always likely to be better informed than its counterparts in the CDS market and best placed to optimize the benefit of the information it acquires from the company. The issue then is whether this represents an equivalent level of inequity as seen where shareholders lose against more informed directors and other insiders. On the one hand, insider trading prohibitions protect a principle: insiders should not, as a normative matter, 155

Victoria Ivashina & Zheng Sun, supra note [ ]; Christine A. Parlour & Andrew Winton,

supra note [ ]. 156 157

Fred Tung, supra note [ ]; Douglas Baird & Robert Rasmussen, supra note [ ]. Fred Tung, supra note [ ], 130-140.

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be permitted to profit from their privileged access to information.158 Whether those wronged are other CDS traders should not factor into determining how to conceptualize wrong-doing in this case. But, there may be another perspective. With the relatively small number of market players in the CDS market, their relative informational advantages and disadvantages wash out over time. As set out earlier, the CDS market largely comprises lenders in one form or another, whether they be banks, investment banks, or specialist investors in the form of hedge funds or private equity houses.159 Each buys and sells credit protection with the other. In some cases, one party may win owing to its superior access to information on an underlying debtor. In other cases, another market participant enjoys the advantage.160 Over time, the informational gains cancel each other out to even out the relative bargaining position of the market players involved. This is not to say that certain actors are not disadvantaged. Regular protection sellers argue forcefully in favor of prohibiting lenders from enjoying their informational privileges.161 But, even where gains and losses do not wash out over time, the bargain between lenders and protection sellers is generally at arms-length between sophisticated institutions. On this basis, those repeatedly disadvantaged can exit the market or otherwise price the costs of their weaker position into the bargain. Expressive Property Rights: the allocation of informational privileges to lenders is critical to credit formation. Without deep informational reserves, lenders cannot gauge the risks they assume. But, the transferability of this information through the CDS market brings added benefits. Scholars note that a liquid CDS market motivates lending into the corporate sector, encouraging the flow of credit, often into riskier areas of the economy that might not be able to access debt.162 The early exercise of informational rights lets lenders protect their position in two key ways. First, these offer lenders an opportunity to exit the investment quickly and cheaply. This exit protects the actual exposure that lenders assume on the underlying company. But, more than this, it also offers lenders an expressive advantage. That is, the information the CDS 158 Kenneth Scott, supra note [ ], 804-805 (describing the Fair Play rationale justifying the insider trading prohibition). 159 See Kathryn Chen, supra note [ ]. 160 Yesha Yadav, the New Market, supra note [ ] (discussing the mutual reliance of CDS market participants that incentivizes cooperation between them). 161 THE ECONOMIST, Pass the Parcel – Credit Derivatives (Jan. 18, 2003). 162 BEVERLY HIRTLE, CREDIT DERIVATIVES AND BANK CREDIT SUPPLY, FEDERAL RESERVE BANK OF NEW YORK STAFF REPORT NO. 318 6-7 (2008) (showing that CDS were shown to increase credit to the commercial and industrial sector); Bernadette A. Minton, René Stulz, & Rohan Williamson, How Much do Banks Use Credit Derivatives to Reduce Risk? (Fisher College of Business Working Paper 200603-001, 2006) 4-5 (banks that used CDS had shallower capital reserves).

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market conveys to other traders and the financial markets at large can work to the benefit of lenders. The negative signaling conveyed by exit can indicate growing risk in a company,163 and in so doing, potentially trigger a reaction from the company itself. In this way, an early exercise of informational rights can act as a timely prompt to the company to become a safer enterprise and make changes that reduce risk and remedy its credit profile. In short, exit and information from the CDS markets acts work as a disciplining check on corporate conduct, nudging the company to action. On a market wide level, signaling from the CDS market can impact the actions of other lenders and investors by indicating growing risk in the company. As noted earlier, CDS indices are acquiring increasing importance as purveyors of information to the market, particularly after the gap left by credit rating agencies.164 The expressive benefits of CDS markets can help the market to better price capital and to alert market professionals to investigate a company to more fully understand the risks that underlying debtors pose. The Misuse of Expressive Property Rights: while exit can generate positive externalities, the expressive potential of this information can also incentivize poor conduct by lenders. This can result in high costs for the company and its investors. Property rights in information carry high value. Those that hold them rationally wish to maximize the benefits they offer. Lenders are better placed than most to optimize their value and to amplify the expressive potential in a company’s information to achieve a desired outcome. Here, the CDS market offers special advantages. Recall that the speculative side of CDS trading allows traders to buy or sell more CDS protection than the value of the underlying asset.165 Traders do not actually need to own the underlying asset, meaning that signaling gains can be achieved at low-cost without the capital expenditure needed to buy the reference asset such as a loan or a bond. If a lender possesses valuable information, the road to making the most of this information is clear: buy or sell more credit protection than necessary. Certainly, some cost is necessary. But, lenders can achieve considerable pay-offs where they benefit from the expressive effect of the signaling in the market. For example, if a lender has purchased credit 163

George G. Triantis & Ronald J. Daniels, The Role of Debt, supra note [ ] Mark Flannery et al., supra note [ ]. 165 Here, the classic case of Delphi Corporation is illustrative. At the time that Delphi defaulted, it had $28-billion worth of CDS outstanding on $5.2-billion of its bonds and loans on bankruptcy. For discussion, Nick Bunkley, After 4 Years, Delphi Exits Bankruptcy With Sale of Assets to Lenders and G.M., TIMES (October 6, 2009), transcript available at, N.Y. http://www.nytimes.com/2009/10/07/business/07delphi.html?_r=1; Satyajit Das, The Credit Default Swap (“CDS”) Market—Will it Unravel?, WILMOTT, http://www.wilmott.com/blogs/satyajitdas/index.cfm/2008/5/30/The-Credit-Default-Swap-CDS-Market-Will-It-Unravel (May 30, 2008 7:23 am). 164

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protection on an underlying company, it can benefit from this company going into default.166 This triggers repayment on the CDS and helps the lender to exit the investment quickly. In this scenario, a lender can benefit from strong negative signaling in the CDS market to indicate that a company is risky. The more persuasive the signal, the greater the likelihood that a company falls out of favor with its other lenders, faces increased credit costs, and generally has a tougher time recovering from the negative spiral that a bad reputation in the market generates. Strategic signaling helps lenders achieve private profitable outcomes. Arguably, these results reflect a rational trading strategy to the extent that it maximizes the value of information that a lender possesses and results in greater pay-offs for a lender. However, as is perfectly evident, while privately beneficial, such conduct can also be seen as having the potential to destroy value in the company and generate heavy losses for its shareholders and creditors.167

B. Insider Trading and Efficiency: The Curious Case of CDS Insider trading in the CDS markets provides a valuable test case as to whether such trading actually makes for more efficient markets. Scholars seeking reform of insider trading laws argue that strictures on information flow reduce market efficiency and liquidity.168 Incomplete information on a company’s securities can result in their mispricing or surprises169 when hidden events emerge suddenly, revealed only through mandatory disclosure. Moreover, such releases of information can be gamed. Disclosure of bad news may be strategically timed by a company to coincide with the positive, muting its impact and misleading investors. By permitting insider trading, scholars argue, information emerges into the

166 Henry T.C. Hu & Bernard Black, supra note [ ] (noting the perverse incentives that hedged lenders harbor to see a borrower fail and thereby to trigger repayment under the CDS). 167 Marti Subrahmanyam et. al., Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk (December 2011) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1976084 (investigating a sample of 900 companies with CDS traded on their debt to show that these generally evidence a tendency towards a fall in their credit quality or towards outright default); See also, Patrick Bolton & Martin Oehmke, Credit Default Swaps and the Empty Creditor Problem, 24 REV. FIN. STUD. 2617 (2011) (demonstrating the play of the empty creditor hypothesis and its impact on destroying economic value). 168 See Henry Manne, supra note [ ]. 169 On the efficient capital markets hypothesis see for example, Eugene F. Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, 25 J. FIN 383 (1970) (“a market in which prices always ‘fully reflect’ available information is called ‘efficient’). See also, Ronald J. Gilson & Reinier H. Kraakman, the Mechanisms of Market Efficiency, 70 VA. L. REV. 549, 549-53 (1984) (noting the impact of the efficient capital markets hypothesis on securities regulation); Henry Manne, supra note [ ].

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market more accurately and in a timely manner that reflects events impacting the on-going life of the company.170 CDS Markets as Efficient: at first blush, a study of the workings of the CDS market supports traditional criticisms of the insider trading prohibition. Trading in credit derivatives – long the preserve of wellinformed lenders – exhibits high degrees of efficiency. Indeed, the efficiency of these markets constitutes a reason why they have gained enormously in popularity as key purveyors of information.171 This function has proved significant in two key ways. First, Part I noted that CDS markets have shown themselves to be highly attuned to key events in a company’s life. Often these reveal themselves in the CDS market before others, such as in equities or bonds, and do so many months or sometimes years in advance of formal disclosure.172 The cases of the 2005 General Motors and Ford insolvencies are well-documented.173 But, there are other examples. Take the $15.1 billion takeover of Harrah’s Entertainment by Texas Pacific Group and Apollo Management. While equity and bond markets stayed silent on this deal, its impact was felt in the CDS market weeks before the takeover was formally announced. Similar such trends were detected in the case of the leveraged buy-out (LBO) of the Hospital Corporation of America (HCA) some weeks before the news became public. And, of course there are others instances of the CDS markets proving far more revelatory than those for equities or bonds.174 Secondly, this efficiency makes other markets more informative. Scholars note that information emerging from the CDS market impacts trading in other markets, such as those for stocks and bonds.175 This might suggest that investors in shares, share options or bonds benefit through lower information asymmetries, where CDS traders reveal information early. The costs of obtaining information can be lower on a net basis for the market as a whole. That is to say, CDS traders have easiest access to corporate information and they obtain rights in this information promptly and with accuracy. They can reveal this information at low transaction costs through the CDS market, in turn leading other markets to become 170 Take the classic insider trading case of SEC v. Texas Gulf Sulphur Co). Here, the defendant, a mining company, discovered important ore and precious metal deposits. Prior to the formal announcement, insiders were trading in Texas’ securities and its price started rising, almost doubling in value prior to the opening. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968); Stephen Bainbridge, Iconic Insider Trading Cases, supra note [ ], 3-4. 171 Mark Flannery et al., supra note [ ]; Thomas Daula, Do Credit Default Swaps Improve Forecasts of Real Economic Activity? (Apr. 18, 2011) (unpublished manuscript). 172 Viral Acharya & Timothy Johnson, supra note [ ]. 173 Viral Acharya & Timothy Johnson; Michael Simkovic, supra note [ ]. 174 Shannon D. Harrington and John Glover, Credit Default Swaps May Incite Regulators over Insider Trading, BLOOMBERG (Oct. 10, 2006); THE ECONOMIST, Pass the Parcel – Credit Derivatives (Jan. 18, 2003). See also, Viral Acharya & Timothy Johnson, supra note [ ], 2-5. 175 Lars Norden, supra note [ ].

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more efficient in the process. On this basis, traditional critiques of the insider trading prohibition seem persuasive. With strictures in place, markets can face high costs in terms of information asymmetry and reduced efficiency and liquidity in the market. Selective Efficiency: however, the revelatory power of the CDS market discloses a selective form of efficiency at play. The CDS market is not globally efficient. Rather, it reflects the kinds of efficiency prized by those who principally use this market – the lenders and specialist investors that provide credit to companies. Scholars report that the CDS market assimilates and reflects negative news quicker than it does positive news. In a leading study, Professors Acharya and Johnson demonstrate that the CDS market leaks negative news on a company usually before it suffers an adverse credit event, such a downgrade.176 The more CDS trading a company tends to have trading its debt, the greater the chances of these leaks occurring into the marketplace. These leaks are also more pronounced the more lenders a company tends to have.177 The takeover of Harrah’s Entertainment and HCA’s LBO, two events clearly reflected earlier in the CDS market before others, exemplify this selective efficiency. Importantly, both events were considered by the CDS market as adding riskiness to each company’s profile. And, the costs of buying credit protection on their respective debt securities sky-rocketed prior to formal announcements revealing the news. Harrah’s suffered a rating’s downgrade soon after news of the bid became public.178 Similarly, the prescient efficiency in evidence with respect to General Motors, Ford and even Enron was primarily attuned to the increasing riskiness of each of these companies prior to the crises that eventually befell them.179 As discussed in Part I, the basis for this heightened efficiency of the market to negative news is unsurprising. It measures default risk and events likely to impact that risk carry greatest salience for its participants. The point is simply this. Insider trading in the market reveals a partial form of efficiency. This partial efficiency is born from the particular perspective and profile of CDS market participants. Insider trading in the CDS market proves a telling experiment. For those advocating for greater market efficiency, the CDS market proves both vindication and disappointment. In fact, it is arguable that the experiment might prove more disappointing than affirming. The CDS market has grown to be 176

See also, Marti Subrahmaniyam, supra note [ ] (noting that, in a sample study, companies with CDS traded on them exhibit a greater tendency towards credit deterioration or default). 177 Viral Acharya & Timothy Johnson, supra note [ ], 3-5. See also, Caitlin Ann Greatrex, supra note [ ]; Lars Norden & Martin Weber, supra note [ ]. 178 Shannon D. Harrington and John Glover, supra note [ ]. A LBO generally led by a private equity house tends to add a great deal of debt to a target’s books in order to enable the deal to proceed. 179 Viral Acharya &Timothy Johnson, supra note [ ].

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enormously influential, in part, owing to its predictive power. Its influence and its perspectives can impact other markets, including those for bonds and equities. Where the CDS market might impart more negative information to the market, owing to its own biases, this might increase the costs that others face to redress the balance towards a more holistic picture. Lenders in the CDS market acquire property rights in information quickly and at low cost. This enables the CDS market to react quickly to any indications of distress, and potentially impact other markets with its negative bias. This means that other traders may have to invest more capital into the equity market, in options or otherwise in bonds to try and move the market towards a fuller picture of its overall risk. Certainly, the CDS market is well-established as a useful source of data. However, it measures one risk-type, albeit a significant one. A bigger picture still remains to be filled. For others, the costs of completing the picture may increase where the CDS market becomes the dominant voice in the market owing to its higher efficiency in assimilating and conveying default risk. Where the negative weight of the information is too expensive to counter, incentives to invest in bringing positive news to market may weaken, reducing aggregate efficiency gains.

C. Efficiency and the Enforcement Problem At first glance, insider trading in credit derivatives might seem like a tempest in a tea-pot. After all, credit derivatives constitute just a small part of an otherwise large and formidable market for OTC derivatives.180 However, the impact of insider trading in credit derivatives extends well beyond the narrow purview of this market alone. Rather, it impacts insider trading laws in general and the costs regulators face in pursuing more classical cases of insider trading offenses. Insider trading laws target the unauthorized disclosure of material, non-public information by insiders. Regulators expend vast resources to detect and the action offenses and to determine the extent of wrong-doing within a company.181 Insider trading in the CDS market can make it harder for regulators to pursue successful actions. The allocation of informational rights to lenders can vastly increase the transaction costs that regulators 180 In terms of notional value, the credit derivatives market constitutes a small part of the OTC derivatives market, with interest rate derivatives dominating, followed by currency derivatives. See, BANK OF INTERNATIONAL SETTLEMENTS, supra note [ ]. 181 See for example, George Packer, A Dirty Business, NEW YORKER (Jun. 27, 2011) (noting the time and effort expended by the SEC and the Justice Department in the groundbreaking prosecution of the founder of the Galleon Group, Raj Rajaratnam).

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face to pursue cases – and with these costs, their incentives to pursue winnable cases can diminish. The efficient operation of the CDS market raises concerns for regulators. That is, companies that have CDS traded on their security can end up benefitting from partial protection against insider trading actions. If lenders have better informational access than directors or other corporate insiders, the aggregate effects of insider trading by corporate officers and managers can be weaker if CDS traders have already traded on that same information. If lenders have already used confidential information to trade in the CDS market, then the CDS market reflects the effects of that trading. This presents a problem for regulators. If the CDS market reflects the impact of the information, then is this information still confidential when corporate officers use it to trade in stocks and bonds? Corporate insiders could be aware of their company’s CDS spreads. But, the question is whether their awareness makes any difference. If some in the market are aware of the information, as seen in the CDS market, then this can make it harder for regulators to show that the information is still confidential when corporate directors and officers use that same information to trade. Importantly, this raises the costs that regulators face ex ante in deciphering the nature of the information driving insider trading and whether this information is already reflected by CDS trading. These costs can shift the cost-benefit trade-off of pursuing a case.182 Arguably, such costs are likely to be more salient if the inside information is bad news. The CDS market is more active in assimilating such news versus positive news. If corporate officers have traded (e.g. sold stock) owing to impending negative news, then they may be said to enjoy a modicum of immunity owing to the efficiencies of the CDS market.

IV. INSIDER TRADING RE-CONSIDERED

This Article argues that conventional paradigms in insider trading law and policy are becoming increasingly unworkable. Scholarly debates have subjected the current regulatory design to much scrutiny for its economic utility or welfare-enhancing capacities. But, against the backdrop of financial innovation over the last decade, current laws struggle 182 For example, there may require to be greater reliance on expensive event studies to show whether or not news and information was showing in the CDS market prior to any insider trading by a corporate manager or officer in the company’s stock. Event studies are notoriously expensive to produce and also often contentious between experts. For discussion, Sanjai Bhagat & Roberta Romano, Event Studies and the Law - Part I: Technique and Corporate Litigation, Yale Law & Economics Research Paper No. 259 (2001) (noting the complexities of event studies and the cost entailed in their production).

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to achieve either goal. This Part provides a survey of options for reform. Its focus is primarily on the credit derivatives market and the externalities that insider influence generates for underlying corporates. However, its central aim is straight-forward: to advocate for a deeper change in the law to better reflect the modern reality of interconnected, complex markets.

A. Market Disruption as Proxy for Insider Abuse Insider trading is part and parcel of the credit derivatives market. Lenders acquire vast reserves of information on their customers. That they use this information to trade in credit derivatives and to hedge their risk comes as no surprise. However, this insider influence can extract a pernicious price from shareholders and also other CDS traders. As noted, insiders can purchase CDS protection strategically to amplify the signaling they wish to convey. This gives such traders considerable edge in the market, not only to bring about a desired outcome (e.g. to make the company default) but to do at lowest cost (e.g. well-timed traded in protection). The disruptive power of CDS and the ability of insiders to optimize this functionality to their private advantage suggest that the law must shift focus. A Focus on Market Disruption: currently, regulators look for smoke, when they would do better searching out fires in the market. That is to say, rather than seek out instances of insider information feeding trading behavior, a more efficient approach begins by seeking out instances of market disruption from instances of insider trading in CDS.183 As detailed in this Article, insider trading in CDS is almost inevitable. Focusing on rooting this out is bound to fail, unless the broader goal is to eliminate much of this market altogether. However, the externalities the market can generate can be tackled and with it some of the advantages that insiders possess in trading on corporate debt. Instead of searching for a cause, the focus starts with observing cases where the CDS market displays abnormalities in trading, or otherwise by unexpected disruptions faced by an underlying reference company or other traders. Such market instability may be seen where the costs of buying protection sky-rocket in a short space of time without a corresponding rise in the riskiness of the underlying company. Signs of potential trouble can 183 Separately, in the context of securities fraud, Professor Steve Thel has also argued for a more objective market manipulation standard for the offense under Rule 10b-5. Steve Thel, The Original Conception of Section 10(b) of the Securities Exchange Act, 42 Stan. L. Rev. 385 (1990)(arguing that Congressional intent, as revealed in the text of the 1934 Act as well as in discussions surrounding the Act, pushes for a conception of Rule 10b-5 as a broad anti-manipulation, anti-deception provision).

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also reveal themselves where the notional exposure in CDS on a company’s debt far exceeds the actual amount of debt outstanding. Where lenders have engaged in heavy trades of speculative CDS, either as purchasers or as sellers of protection, this can point to the likely use of information unknown to others for opportunistic gains. It might also suggest that such lenders harbor incentives to trigger specific outcomes that maximize the value of their position in the CDS market.184 Traditionally, monitoring the ebbs and flows of such exposures has been a challenge in the CDS market.185 However, pursuant to the Dodd-Frank Act, with provisions to bring transparency to the market and the mandate that trades shift to exchanges and clearinghouses, the task of regulatory scrutiny has become much easier. Such disruptions also emerge through more brazen lender behavior. Take the case of lenders refusing to participate in restructurings or other incidents of debt governance, simply to precipitate default.186 Or, otherwise, lenders may use their insider role to advocate for solutions that appear poorly-suited for an underlying company, for example, in proposing a sell-off of key assets or unnecessary changes in management. Observing disruptions in the market for corporate debt governance can be critical where signs in the CDS market are difficult to decipher. This might happen if there is high volatility in trading that makes an understanding of effects and lender motivations hard to gauge.187 Preserving Investor Protection: exploiting insider influence in the CDS market is likely to result from and contribute to negative events in a company’s life. Positive news holds little salience for a market exclusively geared towards measuring default. With strong probability, visible incidents in the CDS market reflect impending trouble for investors in the underlying company, its shareholders as well as creditors likely to suffer if insolvency comes to pass. While investors of all stripes can benefit from

184 Shannon D. Harrington and John Glover, Credit Default Swaps May Incite Regulators over Insider Trading, BLOOMBERG (Oct. 10, 2006). 185 See for example, Robert Bartlett III, supra note [ ]; THE ECONOMIST, Pass the Parcel – Credit Derivatives (Jan. 18, 2003). 186 THE ECONOMIST, Pass the Parcel – Credit Derivatives (Jan. 18, 2003) (discussing the attempt by a lender to Xerox arguing that a restructuring clause had been triggered). See also, Michael S. Rosenwald, Plagued by Debt, Six Flags Faces its Own Wild Ride, WASH. POST, Apr. 19, 2009, http://www.washingtonpost.com/wp-dyn/content/article/2009/04/12/AR2009041202152.html (noting that some lenders appeared reluctant to partake in restructuring). For analysis of empty creditors, Henry T.C. Hu and Bernard Black, supra note [ ]. 187 CDS markets may be volatile where a crisis or high riskiness leads to panic buying or selling of protection. Take the case of the GM and Ford insolvencies in 2005 that led to considerable volatility in CDS spreads across industries. For more detail, Viral Acharya, Stephen Schaefer & Yili Zhang, Liquidity Risk and Correlation Risk: A Clinical Study of the General Motors and Ford Downgrade of May 2005, (Nov. 18 2007) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1074783.

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CDS trading on their company’s debt in the short-term,188 opportunistic conduct in the CDS market can damage shareholder and creditor wealth in the long term. It makes sense to better monitor and control disruptions likely to result in unnecessary loss of wealth for an underlying company, depleting the enterprise of its potential to remain viable for the purposes of possible restructuring. Robust monitoring of opportunistic trading in CDS – for example, lenders buying large amounts of credit protection, well above the value of exposure they actually have – can incentivize better behavior across the board. Though CDS traders have often expressed dissatisfaction at insider opportunism,189 systematic monitoring has been scarce in the market owing to its opacity and uncertainties regarding the power regulators have had in practice to monitor and discipline its participants. With greater focus on pursuing visible manifestations of opportunism in the market, participants may act to self-discipline ex ante as well as to be become more confident about raising possible incidents of misfeasance with regulators. Also, with a clearer focus, shareholders and creditors can better understand the externalities that CDS trading can create, monitoring lenders to curb the potential for excess while cultivating the benefits of CDS trading. Market Efficiency: focusing on curbing abusive manifestations of insider access retains the efficiency gains that the CDS market can provide. As noted, while the CDS market is not efficient in all senses, it appears to intuit adverse news about a company well ahead of other markets. This functionality may be useful, where it allows the market to prepare itself ahead of a possible crisis, as seen for example, in the case of Enron, the auto-industry insolvencies as well as the Financial Crisis more generally.190 Losing this functionality – now that it has become wellestablished in the market and increasingly relied upon after the failure of credit-ratings – seems undesirable. Similarly, given the enormous reliance that financial markets and their regulators are placing on CDS spreads and indices, ensuring the accuracy of information is more significant than ever. As a result, a first step is to impose costs on those that seek to tamper with and amplify the signaling value of their trading for private gain. The impact of this misconduct can be considerable, not just in terms of skewing the indicia of risk attaching to an underlying company. Rather, it can generate path dependencies that can become enormously costly for a company. Where a company is perceived to be more risky than it may in 188 See for example, Richard Squire, supra note [ ]. Creditors benefit from CDS as they can then hedge their risks or otherwise enjoy outsize influence where hedged lenders have disengaged from debt governance. 189 Shannon D. Harrington and John Glover, supra note [ ] ( 190 See also, Frank Partnoy & David Skeel, supra note [ ], at 1021 (noting that CDS allowed lenders to protect themselves against massive losses stemming from the Enron and WorldCom collapses).

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fact be owing to amplified signaling, it becomes costlier for traders to alter that risk perception towards a more accurate profile. As a result, traders must invest more capital to showcase positive news to counter-balance the effects of amplified signaling in the market. Where these costs are too large, traders will simply not bother and exit the market. They may even seek out ways to profit from the gloom surrounding the company, for example, through short selling. The point is simply this. News coming from the CDS market can encourage negative spirals in the value of a company’s securities. This can impact its ability to raise capital, retain managers, appease investors as well as, more broadly, to maintain market confidence. These costs are born out of market efficiency gone awry and gamed by those who can do so at relatively low cost. It makes sense to check conduct that contributes to skewing the efficiencies of the market. Resource Efficiencies: it is no secret that insider trading cases entail significant expenditure of regulatory resources. In the case of CDS, pursuing traditional insider trading is likely to be even more resourceintensive and ultimately futile, where such trading is intrinsic to the market.191 It makes sense to expend prized resources to challenge instances of misconduct that result in losses to shareholders in the underlying company, mispricing of risk and disruptive negative spirals. Spotting the fire is less resource-intensive than chasing smoke at high investigative and prosecutorial cost. Moreover, the primary focus is on checking misconduct that results in losses for shareholders and creditors as well as damages market integrity. Certainly, pursuing smoke can be effective, where it ends up preventing misconduct from occurring in the first place. But, it is a costly endeavor in a market where insider trading is par for the course, and where chasing ever lead might lead to many blind alleys.

B. Lender Liability and the Shareholder’s Bargain A company needs credit but it is not powerless against its lenders. Still, it looks very different at first glance. Companies cede their property rights in information to their lenders and have little control in how these rights are exercised. This allows lenders free rein in deploying confidential information for private gain through CDS trading. Even though this yields beneficial results for lenders in their ability to hedge risk, generate efficiencies as well as help companies to get credit, it leaves shareholders 191 See for example, SEC v Rorech, supra note [ ]. The key case testing insider trading in CDS met with considerable headwinds in terms of making the prima facie case and further was ultimately unsuccessful for the government.

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in an underlying company exposed. With little ability to impose costs on lenders, shareholders have limited ability to control the use of how confidential information is used by those that have private access to it. However, at common law, lenders have been held liable where they come to exercise unduly intrusive authority over a company. That is, where lenders become too active in directing company affairs, for example, by becoming overly influential over management, then the law imposes duties of diligence and care on lenders.192 Lenders can be held liable for a breach of this duty that creates costs for the borrower. This raises the possibility of whether such lender liability might also attach where lenders misuse their access to insider information to trade improperly in company CDS. If lenders take actions that are designed to disrupt, for example, by amplifying the negative signaling in the market, or by blocking actions in debt governance, new markets might benefit from an expanded lender liability regime. Under such a regime, shareholders have the right to sue their lenders in case their CDS trading is abusive or disruptive. The goal is give shareholders a stronger bargaining chip to control the exercise of property rights in the information that lenders acquire from the company. As Professors Ayres and Choi argue, outsiders trading on a company’s insider information do not fully internalize the costs of the trade. This can generate negative externalities for a company which must assume the full costs of how others trade with their confidential information.193 Imposing liability costs on lenders can improve the shareholder’s bargain. Lenders that face the prospect of liability for misuse of corporate information and misconduct in the CDS market internalize some of the costs of their own conduct. This changes the cost-benefit trade-off of the shareholder-lender bargain. Lenders must off-set possible gains in the CDS market against the costs that might arise from possible liability and shareholder scrutiny. With this new calculus in place, lenders may be less willing to misuse confidential information for private gain and inflict unnecessary losses on shareholders. That is not to say that these suits are likely to be common. As Professors Triantis and Daniels note, lender liability suits at common law are rare.194 It is not hard to see why. Companies desire credit at lowest cost. Lenders as providers of credit constitute key players in the life of a company. In addition to capital, lenders can offer expertise, advice and 192 Krivo Indus. Supply Co., 483 F.2d at 1105; Gay Jenson Farms Co. v. Cargill Inc., 309 N.W.2d 285 (Minn. 1981); In re Adelphia Commc'ns Corp., 365 B.R. 24, 63 (Bankr. S.D.N.Y. 2007). 193 Ian Ayres & Stephen Choi, supra note [ ] (Professors Ayres and Choi discuss the Coasean bargaining structure between outsider traders and shareholders and note the externalities that outsider trading can impose on shareholders that evidence the limited bargaining rights that shareholders possess). 194 George G. Triantis & Ronald J. Daniels, supra note [ ], at 1100–102.

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investment direction to borrower companies.195 As noted earlier, shareholders can acquire considerable benefit from CDS trading on their debt. They enjoy access to credit more cheaply and benefit where they can keep their lenders happy. Lender liability rules are unlikely to function as a sword to be wielded against lenders with insider information. Owing to the capital they offer companies, shareholders are unlikely to have much interest in pursuing their lenders aggressively or even frivolously. If they do, such companies will soon become unattractive borrowers. But, lender liability works as cost on lenders, irrespective of whether the cost materializes in practice. The threat of liability and loss of reputation can nudge lenders towards better behavior and discourage opportunistic trading practices. Lender liability recognizes that lenders acquire property rights in information and can trade on these rights with ease. The goal of a broader liability helps to shore up the shareholder’s bargaining position and encourages lenders to better internalize the costs of their conduct.

C. Implications Insider trading in the credit derivatives market raises profound questions for insider trading liability as a whole. Traditional laws must eventually yield to the reality of modern markets. For one, as this Article shows, insider trading in credit derivatives creates a new complexity in determining when information is confidential to a company and when it emerges into the public domain. Efficiencies in the CDS market suggest that confidentiality increasingly rests on a continuum, where private information leaks incrementally through CDS trading by lenders. This raises the stakes for those seeking to discipline opportunistic directors and officers who trade on information that may be slowly leaking into the CDS markets. Where serious uncertainties emerge in evidencing the offense and its enforcement – and the attendant costs these imply – the effectiveness of insider trading laws is subject to question. The rationale underpinning the prohibition rests on protecting shareholders from unfair rent-seeking by corporate insiders. Where corporate insiders trade on confidential information that is leaking into the CDS market with impunity, the weakness of current laws as a check on opportunism becomes painfully clear. Simply put, the usual investor protection rationale breaks down unless an alternative basis for imposing liability can be found.

195

Fred Tung, supra note [ ]; Douglas Baird & Robert Rasmussen, supra note [ ].

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In this regard, the fiduciary relationship has long operated as a pivotal notion in insider trading liability. It may again re-emerge as a guiding concept – problematic though it might have been in the past – to control misuse of insider information by corporate officers and directors where reliance on well-established definitions of confidentiality can no longer be assured. If confidentiality becomes a more malleable concept in modern markets, another element of the offence will have more work to do. Insider trading liability may become more effective where construed more as a breach of fiduciary duty than strictly a question of unauthorized trading on confidential information. While somewhat counter-intuitive given the offense, greater reliance on fiduciary duties constitutes one option to counter the transaction costs created faced by an increasingly complex notion of confidentiality in corporate information. In any event, some re-thinking is necessary. Greater reliance on fiduciary responsibility is just one option but far from the only one. There are other possibilities, for example, to ground liability in more fact-intensive examinations of the degree of leakage of confidential information, the breadth of disclosure of information, to determine how “public” this information may be. Such findings of fact are invariably going to draw blurry doctrinal lines. But, another normative question is significant. Why should one set of insiders be allowed to trade on insider trading while another set cannot? If lenders and other credit specialists can trade on confidential information through the CDS market, one might ask why another set of persons – corporate officers and directors – are not able to under current parameters of insider trading liability. In time, this may become a distinction without a difference. It may be that, over coming years, corporate officers gain entry into the CDS market, able to enter into swaps like financial institutions. The broader question remains. The uneven application of insider trading liability between lenders on the one hand and corporate officers on the other may eventually become untenable. Where both groups constitute fiduciaries in one form of another, imposing differential costs on each group under the same head of liability will likely prove problematic for all.

V. CONCLUSION

Innovative financial markets are rapidly collapsing tried-and-tested notions of insider trading liability. Just as regulators turn to old laws for new problems, an examination of market practice reveals that conventional paradigms no longer provide an easy fit, if they ever did. The latency of insider trading in credit derivatives market – and perhaps others – reveals

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that doctrine and policy have not kept pace with these innovations. As lenders acquire powerful property rights in information, and are able to trade on these rights with considerable freedom, a new approach is necessary. With greater focus on market disruption as a guidepost, liability may yet return to its focus to preserving corporate value and the interests of shareholders – while safeguarding the efficiency gains that have long eluded traditional doctrine.

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