As an independent investor, I constantly need to consider how I’m at a disadvantage to professional, institutional investors or hedge funds. Generally, the only way to consistently outperform the market is to exploit information asymmetries. I believe there is more opportunity for information asymmetry in small-cap biotech because of the high degree of technical knowledge and proficiency required to evaluate an investment opportunity, which occasionally leads to market inefficiencies. I have at my advantage a solid training in the life sciences and, more generally, in analytical thinking, from my background in biological research (Ph.D. in Biochemistry and Molecular Biophysics from Caltech). I’ve also worked at the strategic level at several pre-commercial biotech companies, which shaped my perspective of how the technological, clinical, financial, and regulatory components of a company interact to determine value.

On the other hand, my intentionally low overhead limits my access to information. I don’t travel to many scientific conferences to see talks and poster presentations, which may not otherwise be accessible to the public (they are rarely published on company websites). I also have a miserly approach to buying scientific articles. I use some of the more affordable services (ReadCube, DeepDyve, and HighWire) to access publications in their databases, but many articles require a separate $40 credit card transaction (an obnoxious intrusion when one is immersed in an intellectual rabbit hole). I ultimately chose to limit myself to $1000 per month in research purchases. This budget precludes my use of expert networks (e.g. GLG and Guidepoint), which are used by professional investors to connect with academics, physicians, and other domain experts for a consulting fee (typically costing upward of $500/hr for a phone call).

Perhaps most importantly, I would be remiss to ignore the various schemes used by the Wall Street cognoscenti to obtain perhaps the most valuable of information — the private kind.

Now for a little bit of history

Until fairly recently, the sanctity of using private information to enrich oneself in the capital markets was unchallenged. The Rothschild family fortune was founded on advanced knowledge of Napoleon’s defeat at Waterloo, and the John Jacob Astor’s riches were built largely on advanced news of the Ghent Treaty ending the War of 1812. Some of the wealthiest tycoons in American history (Andrew Carnegie, Cornelius Vanderbilt, J.P. Morgan) attained their status by trading the securities of companies they owned based on insider knowledge. The most infamous of practitioners would actively manipulate stock prices — not only by exploiting insider information but by propagating misinformation — to profit at the expense of the unknowing public (e.g. Daniel Drew, Jay Gould, Jim Fisk). It was not until the 1934 passage of the Securities and Exchange Act, during the fallout from the 1929 Crash, that such practices became regulated. Specifically, the 10b-5 rule implemented by the Securities and Exchange Commission (SEC) in 1942 made it illegal for insiders to “omit to state a material fact…in connection with the purchase or sale of any security.”

Oddly enough, for decades this rule went unenforced, except for the most blatant of violations, which would likely have been prosecutable regardless. This leniency was reflective of the tacit cultural recognition that profiting from insider knowledge of one’s company was a crucial incentive for executives to maximize the value of the company’s stock. The event that changed it all was the SEC’s 1966 suit against Texas Gulf Sulphur Company and thirteen of its employees and directors. These insiders, after learning of an unprecedented discovery of zinc, copper, and silver deposits worth $2 billion, made egregious purchases of stock and call options before the finding was announced to the public. In the first judicial test of the rule, the Second Circuit Court of Appeals ruled that these employees and directors traded while privy to nonpublic information material to shareholders and were liable under rule 10b-5.

The classical insider trading scheme, in which an insider (officer or director) at a public company trades in his company’s stock while in possession of material non-public information

SEC v. Texas Gulf Sulphur did not resolve the issue of whether tippees (receivers of second-hand information) could be prosecuted under the rule. At the time, professional stock traders were widely presumed to have an edge precisely because they possessed inside knowledge of some form (or at least believed they did). That scenario was finally illuminated in the 1984 case, Dirks v. SEC, in which the equity analyst Raymond Dirks received a tip from a whistleblower about an ongoing fraud at an insurance company, Equity Funding Corporation of America (EFCA). Dirks learned that EFCA had been fabricating most of its life insurance policies to inflate its revenues and pump up its stock price for almost a decade. While Dirks was seeking to confirm and expose the fraud, he tipped off clients and investors, who reacted by dumping their stakes. When the SEC investigated EFCA at the behest of Dirks and found fraud, they promptly handed Dirks a censure that would have effectively ended his Wall Street career. Dirks, resolved to overturn his conviction, took his case all the way to the Supreme Court. SCOTUS ultimately ruled that Dirks was not liable since the whistleblower who tipped him off did not breach any fiduciary duty to the company in disclosing the information — he did not derive any personal benefit from giving the tip but, rather, sought to expose a massive fraud. Accordingly, Dirks v. SEC established that a tippee is only liable if he has reason to believe that the insider breached a fiduciary duty in disclosing the information.

A basic tipper/tippee insider trading scenario. Tippee is only liable for insider trading if the insider breaches a fiduciary duty (acting in his/her self-interest) by disclosing the confidential information in connection with tippee’s trade

At around the same time, the definition of insider trading was expanded in SEC v Materia, in which a proofreader at the financial printing firm, Bowne of New York, purchased stock in takeover targets he identified while proofreading confidential tender offer documents. The SEC claimed, and the Second Circuit Court of Appeals affirmed, that Materia’s theft of material non-public information constituted a breach of his fiduciary duty to Bowne and its clients, so his purchase of securities constituted insider trading. The decision extended liability under rule 10b-5 to outsiders who misappropriate (steal) information as fiduciaries for their personal benefit.

The misappropriation theory holds that an outsider can be liable for insider trading if he/she misappropriates confidential information to trade, in breach of a fiduciary duty owed to the source of the information (in this case, Company B)

The misappropriation theory was put to the test in the 1997 case of United States v. O’Hagan. James O’Hagan, a partner at the law firm Dorsey & Whitney, bought call options on Pillsbury stock after learning that a client, Grand Metropolitan, was considering a tender offer for the food maker. O’Hagan claimed that he was not liable for insider trading because neither he nor his firm had a fiduciary duty to Pillsbury. However, the Supreme Court upheld his conviction, arguing that he misappropriated confidential information from his firm and its client to enrich himself through securities trading. The decision further widened the scope of liability to encompass traders who profit through any misappropriation of material non-public information, not requiring a breach in fiduciary duty to the particular company whose stock was traded.

The Supreme Court endorsed the misappropriation theory by arguing that an outsider is liable if he/she misappropriates confidential information to trade, even if the information is not stolen from the company in whose stock he/she trades

Two major loopholes for outsiders

Rule 10b5–1, enacted in 2000, essentially codified that interpretation of the misappropriation theory. However, two critical loopholes were exposed in 2014 with United States v. Newman. In this case, a group of financial analysts obtained information on earnings figures at Dell and NVIDIA, before they were publicly released, via a chain of tips originating from company insiders. The analysts informed the hedge fund managers Anthony Chiasson and Todd Newman, who used the information to trade in the companies’ stocks. The Second Circuit Court of Appeals overturned their conviction of insider trading on the grounds that, as neither trader was aware of the source of the inside information, they did not know whether the insiders were in breach of their fiduciary duty. In fact, the insiders were not in breach, according to the Second Circuit Court, as they had simply shared the information with friends and did not personally benefit. Thus, the burden falls on the SEC to prove that:

(1) There is a meaningful quid pro quo for the insider in giving the tip; and

(2) The trader is aware that the insider committed such a breach.

In this scenario, Tippee 3 (the trader) is only liable for insider trading if Insider derived meaningful personal benefit for the tip, and Tippee 3 is aware that such a breach in fiduciary duty occurred

The 2016 case of Salman v. United States qualified the standard of quid pro quo in (1) above. In particular, the Supreme Court argued that the personal benefit to the tipper need not be financial in nature. Specifically, an intangible personal benefit can be inferred when confidential information is given as a gift by a fiduciary to a close friend or family member (in this case, close brothers-in-law). In other words, giving the gift of a tip to someone you care about implies personal benefit to the gift-giver.

The 10b5–1 plan loophole for insiders

Another loophole emerged from rule 10b5–1 in enabling company insiders to execute pre-planned trades. In particular, company insiders can legally trade while in possession of material non-public information, as long as they originally scheduled the trade before they had the information. Sounds reasonable, right? However, the SEC also takes the position that cancelling a trade while in possession of insider information does not constitute insider trading, as there can be no liability in the absence of an actual securities transaction. For example, the CEO of a biotech company may schedule the sale of a chunk of stock to occur before the results of a clinical trial are announced, as long as the CEO doesn’t know the results at the time the trade is scheduled. Upon becoming aware of the results, though, the CEO could legally profit from that information — by either cancelling the trade if the results are positive (allowing the shares to appreciate in value), or by letting the trade execute if the results are negative (averting any losses he or she would have suffered).

This type of gaming is easier said than done, though, as executives don’t always know when material results will be available, and only have four days to issue a press release once they have it. So what is the evidence that these insiders are gaining an unfair advantage by using 10b5–1 plans? A study from the Stanford Graduate School of Business found, after analyzing over 3,000 planned insider trades, that insiders tend to execute planned stock sales more than would be expected by random chance prior to negative news, and tend to terminate planned sales more than would be expected ahead of positive news. Similarly, a study from the Harvard Business School determined, after analyzing two decades of irregularly timed insider trades, that these trades outperform the market by an average of 21.6% per year. Thus, the evidence strongly suggests that insiders have the ability to strategically use 10b5–1 plans to their advantage.

Today’s uncharted waters

A final example to illustrate the ambiguity and downright capriciousness of insider trading rules is squarely in the grey area. In this hypothetical scenario, a physician, involved in a Phase 3 clinical trial of an antibody against a target believed to be important in the etiology of Crohn’s disease, is a consultant to a hedge fund investor. During a routine meeting, the physician unintentionally reveals to the investor that the trial in questions is unlikely to meet its primary endpoint. Realizing his gaffe, the tipper asks tippee to keep the information confidential and not to trade in the stock of the big pharma company running the trial, ABC Pharma. The investor readily agrees, knowing in any case that news of the trial’s failure is unlikely to move ABC’s stock in any meaningful way. However, he buys put options on the stock of XYZ biotech, a clinical stage company that has a similar antibody in development against the same target. When the news of ABC’s failure is released, ABC stock sheds a couple percentage points, but XYZ shares tank, as their Crohn’s disease antibody is their lead asset, and tippee’s in-the-money puts allow him to reap sizable profits.

A plausible argument can be made that no one in the example above breached a fiduciary duty in connection with tippee’s trade in XYZ. Although tipper divulges non-public information about trial results, he does not receive any personal compensation for the intel, and extracts a promise from tippee to not trade in ABC stock. Not knowing of the potential for the information to affect other companies, he believes himself to have upheld his fiduciary duty. Tippee does not misappropriate the information in the strict sense, as he knows that tipper did not breach his fiduciary duty and upholds his duty of trust to tipper. It is his specific expertise of the dynamics of the biotech markets that allows him to profit from the information.

So, is tippee in the clear? It turns out that rule 10b5–2, also passed in 2000, extends the definition of fiduciary duty to those under expressed or implied confidentiality. Because tipper asked tippee to treat the information as confidential, his use of the information to profit from a securities trade constitutes misappropriation under the rule, meaning tippee would be liable. However, it has been argued that a confidentiality agreement is not sufficient to establish a fiduciary duty, and that the SEC has overreached their regulatory authority with rule 10b5–2.

Historically, such overreach has been reigned in by the judiciary, and the first major judicial test of rule 10b5–2 — SEC v Cuban — was a loss for the SEC. This case revolved around billionaire Mark Cuban and his sale of a 6.3% stake in Mamma.com after learning of an imminent stock offering from the company’s CEO (Cuban’s trade allowed him to avoid $750,000 worth of losses). The CEO claimed that he had an oral agreement of confidentiality with Cuban, meaning, under rule 10b5–2, his stock sale makes him liable by the misappropriation theory. However, Cuban’s role as a shareholder does not entail a fiduciary duty, and the First District Court argued that extending fiduciary duty to those under confidentiality agreement via rule 10b5–2 was beyond the SEC’s authority. The First District Court’s ruling was appealed by the SEC, and the case ultimately came down to whether there was evidence Cuban agreed to abstain from trading in Mamma.com stock. Cuban was ultimately exonerated, and although the Fifth Circuit Court of Appeals never explicitly invalidated rule 10b5–2, neither did they affirm its validity. The SEC preserved its ability to pursue cases resting on violations of 10b5–2, but the validity of the rule should not be assumed, and a future judicial battle will likely determine its fate.