By Jeff Robinson
In May 2012, The Economist held an online debate on the motion “This house believes that the crackdown on insider trading has gone too far” link here. After hearing both sides’ arguments, readers were asked to vote. 78% voted against the motion and 22% for it. Even the newspaper’s own debate moderator expressed surprise at the strong “No” vote, citing the fact that many of the newspaper’s readers “are moneymen and business executives.”
There are two interpretations of the readers’ verdict: If you’re against decriminalizing insider trading you could claim that “moneymen,” being close to the action, know better than anyone what shady practices go on behind the scenes. If, however, you’re in favor of decriminalization, you could claim that the result reflected not so much the proportion of The Economist readers who are “moneymen,” but the large number who are senior public servants – a category hardly likely to support decriminalization.
The fact is that the jury is out on insider trading even though some of the finest financial and legal brains around the world have frequently presented the arguments for and against. Only politicians can change the law. Many of those, however, have vested interests in maintaining the status quo since it criminalizes the use of material non-public information by most other people, but not by most senior legislators, who have access to quite a lot of it. So, if you’re hoping for change, don’t hold your breath.
Recent US court cases such as the indictment of Mathew Martoma of SAC Capital Advisers have focused attention once again on insider trading. (Questions remain after SAC Capital’s Mathew Martoma is found guilty – link here). The debate about whether the authorities are going too far or not far enough, or indeed whether insider trading should be decriminalized, has heated up. It would take an excessively long post to rehash all the arguments, but here are the main ones as I see them.
Reasons not to decriminalize
Helping Market Confidence
In the past six years or so, headline-making scandals have led many people to become extra cautious about investing in the stock markets. Without sufficient market confidence many potential investors, especially smaller ones, put their money in safer, relatively non-productive places like savings accounts. Businesses, thus, have more difficulty raising capital for new ventures and expansion, and the knock-on effect is less wealth generation, lower economic growth, and weak job creation.
Prosecuting high profile names for insider trading helps restore some of that investor confidence and demonstrates that the Law is intent on insuring that a level playing field exists for all players.
Curtailing Unfair Advantage
Increasing amounts of information are needed to make informed decisions on future share price movement. Hedge funds and other investors with deep pockets get this information usually by paying “expert networks” to dig it out. Individual smaller investors can’t afford such methods, but at least have the assurance that those engaging expert networks are unlikely to use illegal insider information because they fear vigorous legal enforcement by zealous authorities.
Reducing the Number of “Victims”
Illegal insider trading always creates victims despite claims to the contrary. When an insider with material non-public information sells shares knowing that tomorrow the price is certain to drop when that information becomes public, he robs the person who buys those shares. That buyer may not realize he was robbed, thinking that he was just unlucky, but he was robbed nonetheless. It’s not much different from a barman diluting the whiskey he sells with a little water. Most customers won’t notice any difference, but they’re still being robbed.
Reasons to decriminalize
If insiders were legally allowed to trade on their knowledge, their trading would alert the market and cause prices to find their true value quicker. A few people would benefit more than others, but the widespread availability of material information to all investors would lead to a more transparent and fairer marketplace. The argument that this would create victims is over-exaggerated. The relatively small number of insiders who might benefit from decriminalizing would have a negligible effect on the large number of other shareholders.
Laws are Unfair and Vague
Over the last decade or so, the authorities have gradually expanded the definition of insider trading through what some people cynically call “legislative creep.” Apart from the obvious targets, it now also encompasses trading or tipping by anyone who has the most tenuous “relationship of trust.” Many people have difficulty knowing who’s excluded by the law and who’s not. The result is that individuals are often charged and convicted through what is sometimes termed “regulation by enforcement” – they only know they may have broken the law when they get a summons. Then, they may be offered a deal: pay the amount earned in the alleged illegal activity, or go to trial and risk paying a multiple of that figure as well as serving prison time. Many people, confused by the complexities and vagueness of the laws and terrified of losing in court, pay up and try to get on with their lives. Who knows how many of them are innocent? This situation not only causes devastation to individuals, their businesses and their families, but also hinders the whole area of legitimate information research causing inefficiencies that undermine normal market activity.
The laws don’t work
The number of people privy to material non-public information that might affect the value of even one stock /security is enormous. Multiply that by all the stocks and securities in play, then factor in the imprecise nature of the insider trading laws and you have a legislative behemoth that by virtue of its very size could not work efficiently. The relatively small number of people arbitrarily prosecuted each year attests to this. These prosecutions amount to little more than ridiculously expensive gestures. Rather than trying to achieve the impossible, the authorities should divert their resources to areas of real financial criminality where they could make a profound difference.
Cost of Enforcement
Because most cases involve many grey areas, the very high costs of regulating and prosecuting cannot be justified. In the US, the SEC prosecuted an average of 20 cases of insider trading each year since 2009. As hundreds of thousands of people work in the industry, only a naïve person would suggest that this represents any more than a tiny percentage of transgressions.
Politicians ultimately decide if the laws should be changed. Like everyone interested in insider trading, they are well aware of the most obvious three options.
The first is that insider trading legislation should be tightened and extended to all activities that enable any category of insider to benefit from or pass on material non-public information. Tightening existing regulation would ensnare, for example, congressmen and their staff who benefit directly or indirectly from the use of confidential information about the kind of planned legislation that would be likely to move the markets when published.
Such regulation tightening would probably also prohibit the currently widespread practice of selling market sensitive statistical data (like reports from trade groups, universities and other organizations) to a restricted number of select companies or individuals before releasing the data to the general public. (High frequency insider trading and its completely legal - link here). The sale of such data generates valuable income for the selling organizations as well as enabling investment analysts and other professionals to accurately predict the markets’ movements before everyone else.
The second option is to decriminalize insider trading by repealing most or all relevant existing legislation.
The third option is to freeze the legislation in its current state allowing for occasional minor adjustments, but not new fundamental changes.
If you favor decriminalizing insider trading, you’re not likely to see your wish come true any time soon. It won’t happen till politicians feel under sufficient pressure. And they won’t feel that pressure until many more reports appear in the Media showing how the current legislative environment is counterproductive and unfair, and how it would be greatly improved by decriminalizing. Evidence suggests that this may be starting to happen. But media coverage alone won’t alter politicians’ minds. In the end, they follow public opinion and rarely do anything that might cost votes.
Since the 2008 global financial crisis, more voters than ever distrust the financial / banking industries and believe those industries should be regulated more tightly because of their key roles in causing the crisis. Much of the opposition to decriminalizing insider trading derives from this general distrust. This is regrettable since insider traders were mostly not implicated in precipitating the crisis, yet are tarred with the same brush as those who were.