The Sheer Vacuity of Insider Trading Laws

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The recent Sokol-Lubrizol and insider trading stories brought out the usual litany of rabid anti-capitalist commentary seeking to showcase the supposed ethical bankruptcy of capitalists. What was really showcased is the vacuity of insider trading laws.

The concept of insider trading has been inflated over the years to include all sorts of activity. On dissection, it becomes clear that as a legal concept, it is a bad one. Its meaning is that businessmen can go to jail for transacting in the market, regardless of whether they fulfill their fiduciary responsibilities to investors. Insider trading laws are by their very nature non-objective law, and they should be abolished.

A few caveats are in order lest this assertion be misinterpreted. Executives, employees, and anyone working in a formal relationship with a company do have a responsibility to control confidential information to which they may be exposed.

They are obligated to follow certain standards or principles regarding the release of such information, and here the law should have something to say, because the information is company property whose value rightfully belongs to shareholders. That value cannot be protected if the information is subject to uncontrolled dissemination.

Protecting that information is therefore a matter of enforcing property rights. Anyone knowingly involved in the theft of confidential information can and should be held to account under the law.

Companies should also set conditions on executives regarding the trading of its stock to the extent that its interests are at stake. There may be good reasons for a company to set limitations and conditions around stock trading in some circumstances. Executive contracts should mandate compliance with company policy, and they are subject to enforcement by the court system.

As long as these things are done, there is no valid basis for complaint about what businessmen do with their own money. Individuals have a right to invest or disinvest their money however they see fit without interference from the government.

Executives do have a legal fiduciary obligation to work toward the financial health of the company, but that does not include forbearance from buying or selling stock in furtherance of their own interests. Trading stock is not divulging confidential information, and these two things should not be conflated.

The health of a company is determined by more fundamental factors than a seemingly arbitrary trading decision. That is why it is incumbent upon investors to verify fundamental data before investing. If they decide to invest based on the behavior of insiders instead, they are free to do so, but these investors must accept the consequences of that strategy without any whining about it if things go wrong.

It is therefore not against the interests of shareholders for an executive to buy or sell stock, even large quantities. For individuals to buy or sell stock based on their inside information is not harmful to the other shareholders in a meaningful sense.

Individuals simply do not control enough shares of a public stock to create a sustained downward pressure on price. If a company is in poor health, then its falling share price reflects that fact and is not the result of an individual's transactions. The professional and ethical obligation of the executive in such a case is to make the best business decisions he or she can to restore it to health, not make displays of self-abnegation so that people of lesser wealth or status do not get upset-or envious.

David Sokol recommended Lubrizol to other management in his investment company, Berkshire Hathaway, after purchasing shares in it. The details of his recommendation and disclosure to Warren Buffett are unclear, but as yet, there is no indication that he violated either federal law or company policy.

His actions have nevertheless drawn indignation, but not because he harmed his shareholders. No one is claiming that he did, and no one is concerned that he may have made a bad choice for his shareholders. Indeed, if the interests of Berkshire Hathaway shareholders were the real concern, then the sole subject of debate would be whether Lubrizol is a good investment or not.

The real reason for the indignation is that the man took actions that were in his own self-interest-full stop. The howls of outrage are driven by the philosophy of altruism, the essence of which is the absurd notion that the welfare of others is the standard of right and wrong, and individuals are obligated to sacrifice for it. The logical end road of this philosophy is the notion that if you take action which benefits you, you are wrong, and the more beneficial the action to yourself, the more wrong you are.

Insider trading laws amount to the assertion that executives should not be allowed to trade based on their information, because they benefit. In the final analysis, the welfare of the shareholders has nothing to do with it. The essence of anti-insider trading laws is self-sacrifice. Executives are supposed to sacrifice their own personal fiduciary interests, just because.

Observe: The formal argument against Sokol's actions is that executives have a fiduciary responsibility to "put shareholder interests before their own." This seemingly innocuous phrase was originally intended to mean that where priorities and incentives are not aligned in the context of company business, an executive has a professional obligation to choose the course of action which maximizes long-term shareholder wealth over the course of action which would provide the eyed benefits to himself. (Such a policy is not against the executive's rational self-interest-it is in it. Advanced cooperation of this nature is a requirement of a capitalist system, and without it, the benefits of capitalism are not available to anyone).

What the advocates of altruism attempt to do is pull a bait and switch with the word "before." To "put shareholder interests before their own" no longer means merely to prioritize the shareholders in case of a conflict of incentives. It now also means that shareholders must receive benefits earlier in time than the executive. Since Sokol ostensibly benefitted first, he was wrong. (Ironically, they argue this even while decrying the short-term profit mentality of today's investors).

In practice, it would be impossible for the individual to benefit at all under such a policy because he would have to invest after the rest of the market. In reality, movement of insider money well in advance of major company turning points seems to be more the rule than the exception.

Under current law, all executives are assumed to be insiders with access to inside information, so there is simply no standard by which to label some executives criminals, and others not, for their personal portfolio reallocations. Yet, the concept of insider trading survives, ready and able to demonize the next random (or politically out-of-favor) executive.

Some will argue that insider trading laws are needed because executives could pump and dump a stock. This is not a realistic objection. It takes years of solid, trustworthy performance for an individual to be promoted to the executive level.

Despite leftist agitprop to the contrary, as a rule, executives simply do not get there by dealing at the expense of their company. If an executive did knowingly offer false information to pump a stock, that would be the crime, and he would already be liable under anti-fraud laws.

If investors are worried that company standards are inadequate to safeguard against improper or counterproductive behavior, then they should make the effort to get its policies improved, not demand that the government dictate who can or cannot trade what. In the meantime, they should be glad that there are people in existence who are very good at producing profits for themselves, because when all is said and done, their self-interested behavior benefits us all.

Wendy Milling is a contributor to RealClearMarkets
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