Erie v. Tompkins (1938) has attained some pop-cultural notoriety as the civil procedure decision out of which Harvard Law professor Arthur Miller built the tradition of “Erie day,” his annual neo-vaudevillian exposition on federal/state law boundaries.
Erie began simply enough: a freight train owned by a company incorporated in New York injured a Pennsylvania man walking on a footpath adjacent to its tracks, who brought his lawsuit in the federal district court in New York. The dispute eventually reached the U.S. Supreme Court, which held that the federal court should have applied Pennsylvania tort law, not something called “federal common law.”
What does that have to do with alpha? Therein hangs a tale.
On June 20, 2011 the 2d Circuit Court of Appeals invoked Erie v. Tompkins in ruling against a bit of tactical opacity that might otherwise have been of assistance both to the research departments of investment banks and to their clients. This was the Fly on the Wall case.
One of the long-term trends that the hedge fund industry, and many others, face is the fact that the new media have unpredictable and sometimes unsettling consequences for many ways of doing business, including ways of finding alpha. The case of Barclays v. Fly on the Wall illustrates some of those consequences.
This dispute arose because the news-feed website defendant offers content it describes as “breaking analyst comments as they are being disseminated by Wall Street trading desks, consistently beating the news wires.” Its findings go to its subscribers for monthly rates ranging from $25 to $50.
The plaintiffs in the underlying lawsuit are: Barclays (which inherited the case from Lehman Brothers), Merrill Lynch (now of course part of Bank of America), and Morgan Stanley. The claims contested on appeal involve Fly on the Wall’s alleged misappropriation by virtue of single-line references to the conclusion or recommendation of a report by the research departments of the plaintiffs, generally on the order of, “EQIX: Equinox initiated with a Buy at BofA/Merrill. Target $110.”
Sixteen months ago the federal district court agreed with the plaintiffs that such a headline, although not a copyright infringement, is an example of the misappropriation of “hot news.” The tort of hot-news misappropriation was invented to limit the free-riding of one news organization upon another: it protected the Associated Press from misappropriation by the International News Service of its reports from the war in Europe in a famous 1918 case.
The district court entered a permanent injunction that prohibited Fly on the Wall from reporting any such recommendation until at least 10 AM. Since trading begins at 9:30, this gave the Firms’ clients a half-hour head start in contrast to any member of the general public who relies upon Fly on the Wall for his data.
The Second Circuit’s decision reversing that ruling is surprisingly void of arguments about securities law, copyright law, or appeals to the first amendment. Judge Robert Sack (writing for himself and one other member of a three judge panel, Judge Rosemary Pooler – Judge Reena Raggi concurred in a separate opinion) alluded to such contentions at the very start of his decision, writing that the parties “have raised a wide variety of interesting legal and policy issues” but immediately added, “we need not address most of them.”
A Ghostly Presence
What is crucial for Sack is that the 1918 Supreme Court decision on misappropriation of hot news “itself is no longer good law.” That decision was purportedly based on federal common law. The Supreme Court abandoned the whole notion of federal common-law torts 20 years later, in Erie v. Tompkins.
The Second Circuit, accordingly, now maintains that the INS decision is “a ghostly presence as a description of a tort theory, not … precedential establishment of a tort cause of action.”
Under Erie, federal courts often employ state law. In this case, though, the panel said it could not simply apply New York’s law on misappropriation, because that law had been pre-empted in large part by the federal copyright statute on Congress’ determination that it is important the United States maintain a “uniform nationwide scheme” in intellectual property law.
Sack doesn’t quite exorcise the ghost of hot-news appropriation completely, though. He says that such misappropriation remains a tort, under New York law and safe from federal pre-emption, given this panel’s reading of the federal copyright statute, if and only if it truly is a case of “free-riding” – if the defendants were receiving the information at issue for free, or very cheaply.
On the facts as demonstrated at the trial before the district court, through, approximately half of the defendant’s twenty-eight employees “are involved in the collection of the Firms’ Recommendations and production of the newsfeed on which summaries of the Recommendations are posted.” This is a “substantial organizational effort,” and thus is not free riding.
Looking at the issue in another way, though, Sack also observes that the Wall Street firms are not in the news business. Their recommendations aren’t a report on news, but a fact that must itself be subject to news coverage – like a Tony Award or a basketball score.
What is the lesson for asset managers in a position to buy services such as those these plaintiffs are selling? One possible conclusion is precisely the one that the plaintiffs feared. Those reports are no longer as valuable as they were before this decision issued. As to the “bottom line” of the reports, the recommendations, at least, paying clients will no longer receive a half-hour jump on non-recipients. That 9:30 to 10:00 AM interval in which, under the reversed injunction, they could trade on an upgrade or downgrade of which much of the rest of the market was still ignorant, is gone.