Economics

A Knowledge Problem with Insider Trading Law

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Reihan Salam at The Daily is of course glad hedge fund villain Raj Rajaratnam was convicted for insider trading, blah blah, but spells out one of the perverse results of keeping those who know the most about companies (theoretically) from helping spread that knowledge and help bake it into the price of stock through the buying and selling of stocks in those companies:

The basic idea behind these [insider trading] rules is that officers, directors and stockholders that own at least 10 percent of a company should not be allowed to use inside information to influence their investment decisions. Say a senior executive knows that his company is about to post huge losses in the next quarter. He might use this information to dump the company's stock before outside investors catch wind of the bad news and the stock price plummets. Similarly, investors who own a big stake in a company can bend the ear of directors or executives to gain the material nonpublic information, i.e., information that only insiders have that could affect the movement of the stock price. The SEC demands that insiders file statements that reveal all of the equity securities they own, to guard against just this kind of behavior.

The result of these regulations is that American investors, large and small, keep the executives running the big public companies they invest in at arm's length. They don't forge long-term relationships based in mutual trust. Instead, thousands of anonymous investors pump money in and out of these companies, knowing nothing more than what appears in annual and quarterly reports….

As a result, the executives and directors of big public companies can get away with almost anything, as their investors are widely dispersed and legally barred from profiting from any effort to get under the hood of the company. The corporate scandals that marked the Enron era — the headlong rush into toxic assets, the corruption of corporate boards — all can be traced to the resulting lack of accountability. Ironically enough, insider trading rules work all too well. They've not only restored confidence in the stock market. They've created the illusion that it is safe to invest in a company without doing any due diligence of your own.

Privately held companies understand the benefits of linking ownership with oversight and with the ability to act to profit on that oversight:

Contrast this with venture capitalists, who devote considerable energy to getting to know the entrepreneurs they back. It's not unusual for VCs to offer advice to the startups they invest in, and to devour all of the information they can to keep their partners on track. The best VCs understand that this nitty-gritty engagement in their investments can make all the difference between success and failure.

Insider trading laws have been looked at askance here at Reason by Michael McMenamin and me.