If You Hate Insider Trading, You Also Despise Dating
Martha Stewart. Raj Rajaratnam. Albert H Wiggin. Dennis Levine. Jeff Skilling. Do any of these names ring a bell? They're all people who've been accused of insider trading. Some of them have been convicted, while others have not (there were no laws against insider trading when Wiggin made his money). Today, the Securities and Exchange Commission (SEC) publishes a running total of the insider trading cases it pursues. But should insider trading even be a crime? In a word: no.
In some cases, the SEC takes action based on a combination of breach of contract and insider trading. In these cases, it's important to tease apart the issues because there is more than one thing going on.
Take the case of Stephen B. Gray, former CEO of a Houston-based investor relations firm. Gray violated a contract with his company. Per the terms of his employment, he was prohibited from using sensitive client information for anything other than business purposes. In other words, his firm's internal policy explicitly prohibited insider trading. He is also accused of the somewhat more "classical" notion of insider trading - namely that he used non-public, material, information to invest in companies ahead of other people.
In other cases, there's no breach of contract. For example, a former systems administrator at Green Mountain Coffee Roasters was recently charged with insider trading. The accused, Chad McGinnis and Sergey Pugach, used quarterly earnings reports (before they were released to the public) to buy stock options in the coffee company - making $7 million in the process.
These two cases seem quite similar but are, in fact, very different from one another. Gray is guilty of breaching a contract with his employer. Breach of contract is the same as breaking a promise because a contract is a particular kind of promise - the employee promises to abide by the terms set forth by the employer, and the employer makes other promises about salary and job responsibilities.
In Gray's case, shareholders, and possibly even the firm itself, should be able to sue Gray for damages associated with his breach of contract.
Now consider Chad McGinnis and Sergey Pugach. McGinnis, Pugach, and Gray all used non-public information as the basis for making investments but, unlike Gray, McGinnis and Pugach didn't violate a contract with anyone. The essence of their wrongdoing is that they used non-public information to make make money ahead of anyone else. This "unfairness" is deemed illegal.
However, it's only in the financial markets where an "unfair advantage" is criminalized. For example, suppose a journalist is about to break a story about some political scandal. This is the scandal of the century. It implicates the President, and several cabinet members, and could radically change politics forever. To get his story, the journalist had to rely on secret contacts. He also had to keep the story "hush, hush" for several months while gathering and verifying all of the details. He scooped all of his peers.
Is he sent to jail? Hell no. He wins the Pulizter Prize. Yet, if this were the financial world, and he had used non-public information to scoop other investors, he'd be guilty of the crime of "insider trading."
Or what about a man who pursues a woman he's interested in, and comes up with a great first-date idea based on non-public information provided by mutual friends of theirs? Is the man morally corrupt? Should he be sent to jail? No, of course not.
What about a scientist who does original research, uncovers the cure for all cancers, yet sells his non-public information (and invention) to drug companies for billions ahead of everyone else? Is he a criminal? Hardly. He's a hero. He just cured cancer.
What's so different about a man pursuing a romantic interest, or a journalist scooping a story, or a scientist making the discovery of the century, and someone investing on non-public information for profit? Answer: nothing.
One man's gain in romance doesn't prevent others from finding love elsewhere. Likewise, the journalist's story doesn't prevent other journalists from being successful in their own endeavors. There are so many scientific discoveries to be made, the cure for cancer doesn't prevent other scientists from being heroes in their own right. It's the same in the financial markets - someone's gain is not someone else's loss.
In fact, when you trade value for value, everyone involved in the trade wins. A journalist only has a secret source because the informant finds the journalist's proposal to work together appealing in some way. A man only gets a date with a woman because she finds his offer attractive. A scientist that sells the cure for cancer clearly benefits monetarily, but so does the drug company.
But what about the people not involved in the trade? What happens to them? Well, if they are rational, they might benefit as well. Take the case of the scientist or the journalist. If you suffer from cancer, would you benefit from the scientist's hard work? What about the journalist? If you knew about the scandal, do you think that would allow you to make a more informed choice during the next election?
Now, what about insider trading? Suppose that you learn about a company's new product line ahead of everyone else - you have access to private documents that detail what the product is. Let's assume that it's also not against company policy to trade on this information, and you gained that information honestly through your own efforts. You know this will be a revolutionary discovery, so you decide to invest.
When the press release hits, the company's stock soars. You're a multimillionaire. You spend some of that money and you reinvest the rest for potentially more profit - you benefit and so do others as a natural consequence of you acting morally. But who loses? No one.
In fact, this kind of scenario was somewhat common in the 1920s. During that time, stock pools were large "pools" of money that were invested in the stock market. Normally, a stock pool collected money from numerous investors, and a fund manager was appointed to invest that money into a particular stock or group of stocks.
It's been hypothesized that the sheer volume of money in these pools was used to influence stock prices to the detriment of other investors not involved in the stock pool. Some interesting research done at the University of Virginia School of Law shows that:
It is likely that some pools were formed to trade on the basis of non-public information, which explains why contemporary observers claimed that the price of the target stock frequently rose just after formation of a pool. Company insiders participated in some pools. Moreover, because bankers and brokers commonly sat on the boards of industrial companies, a brokerage firm that operated a pool would sometimes have a partner who was also an insider of the subject company.
This squares with other research done on the stock pools of the 1920s:
...when available, against the list of directors and officers contained in Moody's Manuals, we can determine that at least 12 of the 55 pools in our sample included a corporate officer or director.
This same research suggests that:
We find abnormal trading volume during pools, consistent with market manipulation, but this trading led to only modest increases in price in the short run and no abnormal performance in the long run. Thus, there is no evidence that the stock pools harmed small investors.
The fact that there were insiders sitting on some of these stock pools, yet there was no evidence that any outside investors were harmed, demonstrates something very important - stock pools did not harm investors and, by extension, insiders sitting on these pools did not cause harm to other investors in the financial markets. Why do we have insider trading laws then?
Well, the answer is actually very simple. Some people believe that making money is morally suspect - that the profit motive is morally suspect. They refuse to accept that one person can gain an advantage over another and still be a moral human being. This is exactly how our securities laws were drafted - in the absence of any evidence of wrongdoing on the part of insiders or harm to investors.
Rather than protecting investors, the SEC only gets in the way and makes it harder for individuals to make money. Not only that, the agency violates an individual's right to contract, to property, and to the pursuit of one's own happiness. Instead of punishing insiders for their accomplishments in the financial markets, we should repeal insider trading laws, and let people trade on information they've rightfully earned.