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ARE CHINESE WALLS THE BEST SOLUTION TO THE PROBLEMS OF INSIDER TRADING AND CONFLICTS OF INTEREST IN BROKER-DEALERS?
Fordham Journal of Corporate & Financial Law, 2004 by Gorman, Christopher M
INTRODUCTION
The once-thriving "new" American economy is a thing of the past with the bursting of the dot-corn bubble. After the huge losses in the financial markets, investors and the Securities and Exchange Commission ("SEC") have focused on cases of fraud in the financial markets. The SEC has continued its long-standing focus on insider trading in broker-dealers, but it has now begun to concentrate on conflicts of interest, particularly conflicts of securities analysts.1 "Chinese Walls" are an important element of broker-dealer regulation because they attempt to resolve both of these problems. Traditionally, a Chinese Wall has been an information barrier that prevents insider trading.2 Recently, the SEC and Congress have advocated the use of a Chinese Wall as a structural technique to help reduce analysts' conflicts of interest.3
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Chinese Walls may partially control conflicts of interest and insider trading; however, this success comes with some significant costs. There may be more efficient and effective techniques available to deal with the problems of insider trading and conflicts of interest. This Note will begin by exploring the statutory basis for the prohibition of insider trading and its evolving definition. Part I will then explain why conflicts of interest exist in broker-dealers. Part II will discuss the origin of Chinese Walls, give examples of the policies and procedures they typically employ and discuss their advantages and disadvantages. Part III will present additions to Chinese Walls and alternatives that may better prevent insider trading and reduce conflicts of interest. Finally, this Note will conclude that Chinese Walls, whether used conceptually to prevent insider trading or structurally to prevent conflicts of interest, are inefficient, largely ineffective and have more shortcomings than advantages. Chinese Walls will only prevent insider trading at the broker-dealer level, but instances of insider trading by insiders and their tippees will continue to occur. In addition, the best solution to analysts' conflicts is a scheme where investors are given the ability to make their own fully informed decisions.
I. BACKGROUND ON CONFLICTS OF INTEREST AND INSIDER TRADING
A. Insider Trading: Statutory Basis for the Prohibition and Developing Case Law of its Definition
A Chinese Wall is the primary weapon used to prevent insider trading.4 Insider trading is the illegal trading of a security based on material, nonpublic information.5 In a multi-service broker-dealer, the investment banking department usually obtains this material, nonpublic information through its relationship with corporate clients. The investment banker then shares this information with the firm's retail brokers, who make trade recommendations to their customers based on this information. For example, a corporate client may disclose to an investment banker that it will be making a tender offer for another corporation.6 The investment banker may then share this inside information with a retail trader, who will then recommend that his customers purchase shares of the target firm's stock. Once the news of the tender offer is released to the public, the client will then be able to sell the shares for a profit.7 This is a classic example of insider trading.
The prohibition of insider trading is principally based on four statutory sources. These sources are: (1) Section 10(b) of the Securities and Exchange Act of 19348 (hereinafter "Exchange Act") and SEC Rule 10b-5 passed thereunder;9 (2) Section 16 of the Exchange Act; 10 (3) Section 14(e) of the Exchange Act11 and SEC Rule 14e-3 passed thereunder;12 and (4) statutory amendments passed in the 1980s to the Exchange Act.13 The most important source is Rule 10b-5, which makes it unlawful:
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.14
There is no specific reference to insider trading anywhere in the rule. The prohibition is based on the fact that the person who trades on inside information is either using a scheme to defraud in violation of subsection (a) or is engaging in a fraudulent act in violation of subsection of (c).15 The fraud is based on the failure of the party in possession of the inside information to disclose it to the other party.16
Since there is no explicit statutory definition of insider trading, it has been established through controversial case law. One important issue is the definition of inside information. Inside information initially meant information concerning a company's assets or earning power that affected the stock price.17 Thus, traditional insider trading usually involved trading by directors, officers, and employees of the corporation.18 This definition has expanded over time to include "market information," which is any information that affects the market for a company's security, not just information affecting the company's assets or earning power.19 This more expansive definition of inside information has led to individuals besides traditional insiders being found guilty of insider trading.20 Today, courts do not make the distinction between these two types of information.21 Therefore, trading based on traditional inside information as well as outside information is considered insider trading in violation of Rule 10b-5.22
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