Insider trading is bad and other quaint notions

From Matt Levine's newsletter.  

OpenSea was, and as far as I can tell still is, a big marketplace for trading nonfungible tokens. These tokens had a vogue in crypto a few years ago, when NFTs from popular series like Bored Ape Yacht Club would sell for millions of dollars. Anyone can create NFTs, and they generally have no intrinsic value; their value is strictly memetic. If a lot of people have heard of Bored Apes and think they are cool, then they will be valuable; if not, not.

Given this, OpenSea played an important role in the NFT boom. Specifically, OpenSea has a website, and it would feature some NFTs prominently on its homepage. People would go to OpenSea’s website to buy NFTs, and they would see the NFTs featured on the homepage, which would make them more likely to buy those NFTs, so those NFTs’ prices would go up. So if you could buy an NFT before it was featured on the homepage, and then sell it after it was featured, you could pretty reliably make money. It is hard to convey how weird 2021 was.

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But today the US Court of Appeals for the Second Circuit overturned his conviction. Here is the opinion. “Insider trading,” I like to say, “is not about fairness, it’s about theft.” Lots of people trade securities with an information advantage; you are very much allowed to trade while knowing things that other people don’t know. What makes insider trading illegal in the US is mostly that you are misappropriating that information from someone else. [1]  As I put it last year:

In the US, most of the time, it is illegal to trade on inside information about a company not because that’s unfair to everyone else who doesn’t have the information, but because you have some duty to somebody else not to misuse their information. So if you work for a public company, you have a duty to the shareholders not to trade on inside information before disclosing it to them. Or if you are the spouse or golf buddy or therapist of an executive at a public company, and she tells you about an upcoming deal, you have a “duty of trust or confidence” to her not to go trade on it, and if you do that’s a crime.

 The same logic applies to wire-fraud insider trading in NFTs. Chastain’s alleged crime is not quite “he ripped off NFT holders by trading on inside information.” It’s “he ripped off OpenSea by misusing its confidential information.” The wire fraud statute forbids “any scheme or artifice to defraud, or for obtaining money or property by means of false or fraudulent pretenses, representations, or promises.” You might think “yes, insider trading on NFTs is a scheme to defraud the people on the other side of your NFT trade,” but that is not how lawyers apparently think about it. Insider trading on NFTs is a scheme to steal OpenSea’s property, which is its confidential information about which NFTs will be featured on the website.

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Two points here. One, this is a strange result, because obviously the information about which NFTs would be featured on the website was valuable. You can tell because Chastain (1) traded on it and (2) made money. OpenSea itself did not regularly exploit this value — it didn’t itself insider trade on its homepage picks — presumably because it thought it was better business not to. [2]  This is a weird feature of “insider trading is not about fairness, it’s about theft”: Chastain was charged with stealing something from OpenSea (information about its homepage) that obviously had value (he made money from it), but the theft didn’t obviously cost OpenSea anything (it wasn’t making money from the information). Chastain didn’t exactly make his $57,000 at the expense of OpenSea; he made it at the expense of other NFT traders. And insider trading laws do not protect other traders.

Two: What does this mean for actual insider trading law? Maybe nothing; the wire fraud statute is different from the securities fraud statute. But there are connections. [3] And I wonder a little whether, in this more fraud-friendly era, courts will be more hesitant to convict people of crimes for misusing corporate inside information. In particular, I wonder if this decision will mean anything for “shadow trading” cases, where an insider at a company gets information about that company (a merger, earnings, etc.) and uses that information to make trades in another, correlated company’s stock. Does that deprive the insider’s company of a “traditional property interest”? Is information about a pending merger a traditional property interest? If insider trading is about theft, not fairness, do you have to prove that the insider stole something that the company was using? How do you prove that? Or is insider trading a little bit more legal now?

Since we're talking about NFTs here, it is difficult not to, somewhere in the back of your mind, think of the line from The Magnificent Seven: “If God did not want them shorn, he would not have made them sheep.” But there are larger issues at play here.

With the penalties for financial fraud being probably the lowest they have been in almost a hundred years, and the incentives continuing to grow, it’s reasonable to expect it to take up a greater and greater share of our economic activity. This would seem like a good time to ask if there’s a cost to fraud beyond its immediate, narrowly and somewhat artificially defined victims. 

 Fairness is a social good in and of itself. Insider trading—the very concept of insider knowledge—inevitably tends to favor the rich, powerful, and connected. Though you'll find the odd exception now and then, the kind of information we're talking about is overwhelmingly held by the people who already have too much of everything else.

Beyond fairness, there's also the matter of well-functioning markets. The bigger the role played by cheating, manipulation, and fraud, the less the markets are able to perform efficiently, to best allocate resources where they need to go. Instead of being institutions that ideally drive innovation and progress, they increasingly become zero-sum games where the scam and the bubble outperform worthwhile investments.