Inside Insider Trading

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A scientist working for a pharmaceutical company learns that after decades of research and development, she has succeeded in creating a drug that fights cancer. She wants to buy as much stock in her company as she can afford, knowing that her efforts will cause the stock price to sky-rocket. She wants to take full advantage of her success—to invest in herself. Yet if she buys stock in the company before the news of the cancer drug is made public, she will be liable for insider trading.

The CEO of a real estate development company learns that the local government has denied him regulatory approval for a huge new development project he has been pursuing for his company. Knowing his daughter has hundreds of thousands of dollars invested in his company, he wants to tell her to get it out before the stock price falls. But were he to do so, under insider trading laws, both he and his daughter would face huge fines and jail sentences.

Up until the late 1960s, there was no such crime as “insider trading”. Today, the Securities and Exchange Commission (SEC) spends a large portion of its resources pursuing insider traders. SEC regulations mandate that anyone using non-public, material information about a company to buy or sell stock, before that information has been made publicly available, may be criminally charged. The crime also applies to any type of “tip” given to others (family, friends, clients) concerning such information.

Insider trading laws force company employees, officers, board members, and those they care about to knowingly act against their own interests. Despite the fact that our scientist has spent years developing a life-saving drug, the SEC tells her that she must not make a move to profit from it. Despite the fact that our CEO knows his daughter will lose the money she had hoped to use to send her kids to college, the SEC tells him he must not lift a finger to save her investment. Insider trading laws legally prohibit investors from transforming lawfully obtained knowledge into action.

Contrary to common misconceptions, insider trading laws do not exist to prevent fraud. They do not punish the engineer who steals a file from his supervisor’s office, the lawyer who violates a contractual agreement to keep information confidential, or the CEO who disregards his legal obligation to his stockholders to act in their interests (called a fiduciary duty). Such actions are obviously illegal, but they were illegal long before insider trading entered the picture, and are prosecuted on the basis of different laws. Insider trading laws, by contrast, were created precisely to penalize trading in which such criminal activity is not involved.

If insider trading laws do not exist to prevent theft or fraud, what is their justification? Those opposed to insider trading imply that insider traders profit at someone else’s expense. To quote a speech from an SEC officer, highlighted on the SEC’s website: “[Illegal insider trading] is the trading that takes place when those privileged with confidential information … reap profits or avoid losses on the stock market, to the detriment of … typical investors.” In other words, insider trading is unfair to some  investors.

Even if this were true, it’s not an argument that the practice should be criminalized. It may be unfair for a teacher to play favorites in his classroom, or a secretary to play favorites among her co-workers, but we do not therefore establish a discrete body of law called “favorite-players law,” and make it one of the primary functions of a government agency to stamp out that societal unfairness.

But in fact, the claim that insider traders profit at someone’s expense simply isn’t true. To profit at someone’s expense is to take money that is rightfully theirs, without their consent. When our scientist bought stock in her drug company, she made an enormous profit—but she didn’t steal that money from someone else who didn’t want to part with it. Anyone who invested in the company made money with her when the company’s stock rose. Anyone who didn’t was no worse off than he had been before. And anyone who sold because he didn’t know what she knew missed an opportunity because he lacked the knowledge she had—but still acted voluntarily.

When an insider sells, he sells to people who have already made the decision to buy. He is not duping any new buyer who would otherwise not have bought. When an insider buys, he buys from people who have already made the decision to sell. Again, he is not cajoling anyone who doesn’t want to sell into selling.

The SEC itself is aware of this. When pressed, it effectively admits that individual investors are not defrauded by insider trading, and then switches focus: “[T]here are those who argue that insider trading is a victimless offense…this penny-wise, pound-foolish argument neglects…external costs.” “External costs,” then, and not harm to individual investors, are the SEC’s target in prosecuting insider trading laws. What external costs? Again according to the SEC: “[I]nsider trading undermines investor confidence in the fairness and integrity of the securities markets.” (Both quotes from the portion of the SEC website devoted to insider trading.)

Economists critical of insider-trading laws see that this argument, too, is arbitrary and unsupported. Writes Daniel Fischel, a professor of law and business at the University of Chicago Law School, “There is no evidence that investors had less ‘confidence’ in our securities markets before 1968 than after … No matter how many times the government talked about the need to restore ‘public confidence’… no one was ever able to say what this meant. And how could this meaningless test be applied? How could anyone know when investors did or did not have ‘confidence’?”

Insider trading does not exploit the wealth of individual investors. It does not undercut market confidence. Most importantly, even it did do these things, it does not involve theft, fraud or any legitimate crime.

What, then, gives insider-trading laws their plausibility? Why has the SEC, and those who support its actions, met with so little resistance in its attempt to prosecute insider traders?

The general public opposes bad legislation and prosecutorial zeal in cases where the moral innocence of the victim is clear. When municipal governments and real estate firms team up using eminent domain law to forcibly evict gentle old ladies from their homes, the public is (properly) outraged. In the case of insider trading, however, there is no public outcry against making insider traders legally guilty. This is because they are already presumed to be morally guilty. The image of an “insider” is a sycophant banker who has risen in his company through social manipulation at golf games and charity events, and such an investor does not seem to have earned his privileged position.

But this is a prejudiced, inaccurate conception of how an insider trader accesses inside information. In any human activity, there are going to be people who take advantage of the hard work of others. There are professors who rise because they are better at navigating departmental politics, even though they are worse researchers and teachers. Doctors, construction workers, cooks, government officials—whatever the job, there is a marginal minority whose success does not reflect their effort and professional worth. The proper approach is not to look at these exceptions, but to consider the normal case. How does an insider trader come to possess the information that allows him to invest one step ahead of the rest of the public?

He earns it. Through his own efforts he gains skills, knowledge, experience, positions of employment, and the respect of his colleagues in his field. Through these means, he gains access to information that he would not otherwise be able to access. The savvy investor goes to business school, studies balance sheets, learns about corporate practices, determines how to evaluate both financial statements and managerial intangibles. He also networks with colleagues and potential clients—and this is perfectly legitimate. As a result of his efforts, the capable investor acquires access to information that someone who hasn’t done the work can’t access. This is part of the reward for his achievement. Ditto for the CEO who starts out as a rank and file employee, and works his way up over the course of 30 years to a position where he has earned access to information about the company’s behavior—including the right to profit from that information, so long as he does not do so at the expense of the company and the company’s shareholders. He earns the right to help his daughter and the people he cares about to profit or avoid loss—again, so long as this does not conflict with his legal responsibilities as CEO.

To call it unfair for people like this to profit is to say that it is unfair for one person to learn more than another, to work more than another, to be promoted when another is not, to have friendships and relationships with one person, but not another. To say that experienced, hard-working, successful individuals cannot profit from their experience, hard work, and success because not everyone has made the efforts that they have made is to sacrifice knowledge to ignorance, industry to laziness, success to failure. It is to actively penalize virtue.

Yet it is precisely this notion of unfairness that is at the root of the widespread opposition to insider trading. This is the idea, not that everyone should be treated equally under the law (that’s American capitalism), but that everyone should actually be equal, and that all differences between people should be stamped out by the government wherever they appear. On this notion, wealth must be redistributed until everyone has the same amount, and information should be redistributed in the same way.

The argument against insider trading is, at root, the ethical theory of egalitarianism. This theory holds that fairness requires equality of results, and that the government should “correct” inequalities to approximate this ideal. Whether or not one opposes insider trading comes down to one’s basic view of fairness.

In a free society, fairness is taken to mean that people attain the just results of their productive activities, and that the rest of society leaves them alone to enjoy those results. Put simply, it means that people receive what they earn. Of course, this necessitates unequal results. Some people will work harder than others, and will earn more. These individuals will then have the right to share their wealth with those they value.

In the case of insider trading, the focus is not earning more, it is learning more. But the analysis is the same. It is impossible to eliminate differences in information, unless one makes all information sharing of any kind illegal. Thus, one creates a world in which no investor has any basis for his investment, and the stock market becomes a roulette wheel or a slot machine.

Insider trading laws do not punish criminals or even rascals. They prosecute productive achievement on the grounds that individuals must achieve identically, or not at all. Insider trading laws are an injustice. Enacting a perverted, egalitarian notion of fairness, they actively penalize that which should be rewarded.

R.K. received her B.A. in Classics at the University of Chicago in 2006, and will graduate from the UCLA School of Law in 2009.

Posted by on April 4, 2008. Filed under Business & Economics, Spring 2008. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry