An Insider's Thoughts On Insider Trading

When I read a news story on insider trading I always react with a puzzled frown. The frown is not just because insider trading laws are some of the most vague and arbitrary regulations affecting business. It is also because of the broadly held assumption that having non-public data about a company allows one to profit in the market, and that one can always predict the market reaction to news.

I reflect back to my experiences in London in the mid-1990's. Every quarter the accountants in Shell's Controller's group worked late into the night and on the weekends compiling and validating the financial results from the 126 countries around the world in which Shell did business. These accountants were the best and brightest from the accounting departments of the operating companies and included Dutch, British, American, South African, Nigerian, French, Norwegian, Malaysian, and Singaporean staff.

Based on the final numbers, the press release was written, reviewed and edited by auditors, management and legal, and finally released. The press release represented the end result of all the accountants' work and was an exciting moment. To add more excitement and to reinforce the importance of the work done, I set up a "betting pool".

Similar to the football pools in many offices, this worked by participants putting up a small amount of money and attempting to chose a winning number. But the number here was not a football score, rather it was a prediction of how the market would react when the financial results were announced.

Would the share price go up or down and by how much? Was the market already expecting that production in Nigeria would be down? Has it already considered the impact of oil price changes? Will it be pleasantly surprised by the savings achieved in our latest company acquisition? Will the consistent dividend payment have any impact?

Sometimes the range of predictions was narrow, but they could often be rather extreme. And these were predictions being made by people who were clearly "insiders".

But before further addressing the betting pool, let's examine the insider trading laws.

While the government clearly has a role in prosecuting actual fraud and in enforcing confidentiality contracts that companies may have with their employees and agents, this is not what insider trading laws do. Instead they punish one for making money based on knowledge and judgement.

There are economic arguments against these laws. They are victimless crimes, with a willing buyer and seller. Some argue that they are a violation of the rights of free speech. And it is also pointed out that the market benefits when those with the most knowledge trade because this information is then quickly reflected in the market price. This latter point is particularly true in the cases of "negative" information, with Enron as the most notorious example. Had insiders been allowed to trade on negative knowledge, it is possible the share price never would have reached its undue heights.

But a more fundamental argument is one of a practical and philosophical nature. The laws attempt to achieve an equality of knowledge, as if that were just or even possible. As economist Richard Salsman has noted:

"As with all share-the-wealth policies, this share-the-knowledge scheme ignores entirely the method by which the item to be shared is first brought into existence. It evades the fact that knowledge is the product of the thinking of an individual human mind - that it is not the work or the property of some collective brain-that it is not the state's to "redistribute." Forcing innovators to share the products of their thinking does not provide the recipients with the capacity to think. It simply deludes the public into believing that no independent thinking is necessary in judging investments."

In the example with Shell's accountants, all had access to the same detailed inside facts, but it was their independent judgement in not only analyzing that data but in integrating it with regard to other relevant markets that determined the winner in the betting pool. And similar to trades in stock, some with "inside information" actually lost money.

Law can and often does protect freedom of thought and action, but it cannot and should not attempt to deny the fact that knowledge and its applications is earned.