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Free Minds & Free Markets

Legalize Insider Trading

Prohibiting people from profiting from their access to information makes the economy less fair and less free.

Insider trading leads the news again, casting a cloud over Steven Cohen’s SAC Capital Advisors $14 billion hedge fund.

The SEC charged Mathew Martoma, who used to manage a SAC Capital division, with using inside information about tests on an Alzheimer's drug to trade stock of the company working on it.

The media love this stuff. I imagine reporters sitting around saying: “The SEC finally will punish greedy Wall Street! These tycoons rig the game—cheating is how they acquire $14 billion—and now noble government prosecutors will bring justice.”

But this is nonsense. Government prosecutors are as ruthless and greedy as anyone.

It’s easy to hate the rich—and in our bailout economy there are reasons for suspicion. But capital doesn’t find the best outlets by itself. Hedge funds spot promising opportunities and quickly direct capital that way. Their reward is profit. When government interferes with that, we all suffer.

Under current law, insider trading still happens. Stock prices routinely rise before takeovers.

The line between research and felony is very fine. One famous investor asked visitors, “What do you know that others don’t?” Active funds like Cohen’s may get information first because they trade frequently, so brokers want their business. One stock picker even calls CEOs and then buys stock based on the tone of the answer. What’s legal? Even the lawyers can’t agree. The SEC says it is illegal to trade “securities after learning of significant, confidential corporate developments.” Aha! The “insider” has more information than the rest of us!

But people in a stock trade never have the same information. One does exhaustive research about a company, another does less, and a third trades based on some market theory. In no way are these three “equal” in what they know.

Yes, you say, but the prosecutors allege inside information. One trader may be an employee of the firm. Why should he be free to use that information to buy or sell a stock?

Because America should be a free country.

Investors say the law persuades more people to invest. “It makes markets more robust. That gave us biotech, Wal-Mart, Microsoft,” says hedge fund manager David Berman. “Companies raise capital in U.S. markets because of that confidence.”

Sure. But in America, a free market would take care of that. If a stock exchange or company wants to have a rule against insider trading, fine. Some of us will invest only in those companies or that exchange. But imprisoning select people who catch a prosecutor’s attention stifles the flow of information.

Think about the role of prices in a market economy. They aren’t arbitrary numbers. They are bearers of information that guide people in buying and selling. Prices are never perfect, but whenever government regulation stifles this information function, it leads market participants astray.

In an actual free market, a company’s stock prices embody traders’ expectations about its future. Information confirms or upsets expectations, and that is reflected in prices. The sooner relevant information gets built into the stock price, the better for everyone.

As economist Warren C. Gibson writes: “When the dissemination of significant news about a company is blocked by insider-trading restrictions, that company’s shares are mispriced relative to where the price would be if the news were out. If the news is bad, investors will buy at prices they would not have paid had they heard the news. Movement of capital toward more productive uses is inhibited. If it is good, some sellers will let go of their shares at prices they would not have accepted. ... In either case, there is a net loss to the economy.”

Vague anti-insider trading laws distort prices. Prohibiting people from profiting from their access to information makes the economy less fair and less free.

Also, these laws, like all regulation, create a false sense of security. They lead people to think stock traders play on the same level field. Far better to encourage investors to be wary—not complacent—when they buy stocks. For every buyer, there’s a seller. What does the other party know that you may not know?

If you object to insider trading, avoid companies that permit it.

But government should butt out.

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  • anon||

    But, but, those evil people that run the company that you (theoretically) trust enough to invest in might ... make a profit?

    Yeah, I really don't get the "insider trading!" bullshit at all.

  • sarcasmic||

    Yeah, but those people are already rich. It's not fair that they get richer off information that you don't have. Not fair not fair not fair! That and they're rich. And it's not fair.

  • ||

    It's not a meritocracy, it's a fairitocracy. It's all about whether or not people deserve their money. As dictated by politicians and bureaucrats.

  • rts||

    I prefer the cheerocracy.

  • sarcasmic||

    Fairitocracy? Is that anything like a ferretocracy?

  • Almanian.||

    I, for one, welcome our new ferret overlords.

  • Almanian.||

    In fact, new feral ferret overlords.

  • ||

    No, it's more like a fairietocracy. And it isn't pretty (unless you're into that stuff).

  • The Derider||

    Buying or selling stock in a company you run or work for is legal, no matter how many secrets about it you know.

  • Brutus||

    The injunction against insider trading should only be applied to officers of the company in question, who are employed by the shareholders to act in their interest. If one of these execs tells a hedge fund of pertinent information, the hedge fund shouldn't get its hand slapped, but the exec should.

  • ||

    The injunction against insider trading should be a contract issue between the company and the exchange it is traded on. It should not be a government concern at all.

    Some exchanges may have such rules. Some may not. Guess which exchanges will more accurately portray the valuations of their companies?

    Insider trading laws do nothing but protect the privilege of outside traders closest to the exchange.

  • Robert||

    As if gov't doesn't operate courts where contract issues are sued over? As if you couldn't be prosecuted criminally for deliberately breaking a contract provision to steal a trade secret?

  • ||

    Yes, the government runs courts that adjudicate civil matters -- though the contract could of course specify some other means of arbitration.

    Yes, theft is a crime.

    What does this have to do with insider trading?

  • Bill Dalasio||

    Like I say, in theory, insider trading of information provided managers for business use for their personal gain CAN be considered theft.

  • Sevo||

    Bill Dalasio| 11.28.12 @ 8:49PM |#
    "Like I say, in theory, insider trading of information provided managers for business use for their personal gain CAN be considered theft."

    And the penalty for not getting med insurance CAN be considered a tax.
    So what? Both arguments should be considered stupid.

  • ||

    That is a civil issue between a company and its directors, officers, and employees. If a company doesn't want insider trading to happen, it can write its employment contracts that way. A company can even trade itself on an exchange that doesn't allow insider trading. There needn't be a law.

    Seriously, what is it about securities trading that makes people think that fascism is the solution?

  • Bill Dalasio||

    The information is properly considered the property of the shareholder. If managers are stealing it for their own use to the detriment of the owners of that information (shareholders) a case can be made for criminal proceedings.

    Of course, that stand would open up the entire matter of the market for corporate governance that government intervention (including the courts) have made a farce.

  • Sevo||

    Bill Dalasio| 11.28.12 @ 8:29PM |#
    "The information is properly considered the property of the shareholder."

    That's a conclusion, not a premise. Prove it.

  • PM||

    Rights are natural. Prove it.

    You can't "prove" a fundamental premise that underpins a philosophical argument. You can debate its merit, but you can't "prove" it. Demanding such is retarded.

  • OldMexican||

    Prices are never perfect, but whenever government regulation stifles this information function, it leads market participants astray.


    There's no difference between anti-"insider" trade laws and price gouging laws: Both are based on the notion that there is a "fair price" for goods or services from which only the wicked stray.

    The reality is that these so-called "insider traders" perform a very important and BENEFICIAL role in conveying information QUICKLY into the market by their activities, just like the higher prices charged by the so-called "gougers" send signals throughout the market (not unlike smoke signals or flares) that an unmet demand exists. Resources are driven towards where they're needed in BOTH cases. Impeding this process is what governments do, either because of sheer ignorance, callousness or just plain old corruption.

  • sarcasmic||

    Impeding this process is what governments do, either because of sheer ignorance, callousness or just plain old corruption.

    They're pandering to the "It's not fair!" crowd who will forever remain ignorant due to the fact that they emote rather than think.

  • rts||

    either because of sheer ignorance, callousness or just plain old corruption.

    D) All of the above.

  • Ryan60657||

    Would be curious to know what Stossel and Reason readers think of insider trading by Congress-people and their staff? Should elected officials and their taxpayer-paid staff be allowed to trade indiscriminately based upon confidential inside information?

  • The Derider||

    All the same economic efficiency and information flow arguments apply.

  • Sevo||

    The Derider| 11.28.12 @ 2:27PM |#
    "All the same economic efficiency and information flow arguments apply."

    Yes, deidiot, but you left out a very important caveat:
    If the government critters had no power to affect markets through coercion, there would be no threat of distortion.

  • The Derider||

    As long as there is a government, there will be government officials who have access to information not available to a great portion of the market.

    I'd be in favor of complete bans on stock trading by government officials with potential insider knowledge, even though such a ban would slow the market adjustment to that knowledge.

  • ||

    I think the main issue against government insider trading is the blatant hypocrisy of participating in the very same actions that they insist should be illegal.

  • RandomJackass||

    A lot of these arguments against insider trading laws are good, but one point not being address - the first mover advantage. Yes, the price is misjudged by the market due to a lack of information. But the ability for an insider to take profits before others have the opportunity to is a real issue.

    For example, let's say I am an executive officer of a public company, and I myself caused a problem which I know will cost my company a lot of money and lower the stock price. Without insider trading laws, I legally go and tell my friends and my stockbroker about it, so that I and they can start selling before other people can.

    So you see my stock price drop from $20 to $18 in the early morning - perhaps it's warning sign, maybe you start to sell as well, but maybe not. By mid-day, the stock is at $15 and I issue a press release notifying the public of this company's problem and the resulting impact to the bottom line. Now everyone else starts selling, eventually the stock drops to $10, where the price levels out based on the new evaluation of the asset with this additional info.

    Now, people who were not on the inside got hit with a loss of anywhere between $8 and $10 per share. The people who were on the inside got hit with a loss of only $2-$5 per share.

    Theories about insider trading are flawed, but so is the real world. In the real world we do not all have equal access to information, and not just because we are lazy or not paying attention.

  • ||

    But the ability for an insider a Wall Street trader to take profits before others have the opportunity to is a real issue.

    Fixed that for you.

    The rest of your example stands pretty much as is -- except that the trader got the legislature to pass a law prohibiting that executive or his friends trading on his inside knowledge.

    As a result the Wall Street trader loses between $0 and $2 since he is first to see the press release, and everyone else loses between $8 and $10.

    Theories about insider trading are flawed, but so is the real world. In the real world we do not all have equal access to information, and not just because we are lazy or not paying attention.

    Indeed. And who has the most unequal access to public trading information today? Exactly the people who benefit from laws against other people using inside information earlier.

  • The Derider||

    That is no guarantee that removing these laws will not result in an equilibrium where an even smaller elite has an even larger information monopoly.

    I'd rather have legions of cokehead stockbrokers taking arbitrage profits than a cabal of billionaires.

  • ||

    Would you trade on such an exchange?

    You wouldn't? Neither would I -- or millions of other people.

    Indeed, if that is the result of allowing insider trading, the exchange wouldn't permit it. There needn't be a law.

  • OldMexican||

    Would you trade on such an exchange?


    He's not going to answer that precisely because his logic is totally flawed: who the fuck invests in something they cannot know?

    He's an idiot.

  • The Derider||

    There are many reasons that you can't assume this market equilibrium is necessarily more efficient than a government-imposed one in this instance.

  • ||

    Since you can make the same argument about assuming superior efficiency in a government-imposed one, who cares?

    And since no one is assuming anything like this, why are we bring up red herrings?

  • KPres||

    "Now, people who were not on the inside got hit with a loss of anywhere between $8 and $10 per share. The people who were on the inside got hit with a loss of only $2-$5 per share."

    So why does that require a law? Seems to me there's a perfectly functioning feedback loop taking care of the problem already. If investors think that scenario is a real threat, they'll favor firms where the executives are not heavily invested personally. Firms will react by compensating executive with more salary/fewer stock options. Problem solved.

  • Robert||

    That's like saying no law is required against stealing a publicly traded company's goods, because investors will favor companies with better security against theft.

    What part of "confidential" do you not get? The employee has a duty to the business to not let that info out thru channels other than those the business has sanctioned for the release of hitherto confidential info.

  • The Derider||

    Currently, markets are aware when a CEO or other executive buys or sells a large number of shares in the company they work for. This kind of insider trading is not (and should not) be regulated. People are able to use this information to make judgments about the future health of the company.

    Nothing stops these CEOs from owning stock in their company by proxy-- having a trusted friend buy and hold the stock for the CEO. In the absence of insider trading law, a CEO could tell this trusted friend to sell the CEO's stock before bad news hit the market, thereby allowing the CEO to avoid losses without alerting the market that the CEO is selling his stock-- usually an indication that he believes the stock is overvalued. Insider trading laws criminalize this behavior, and encourage insiders to trade stocks in their own name (because that is legal), thereby improving the information available to the market.

  • ||

    The derider said:

    Nothing stops these CEOs from owning stock in their company by proxy-- having a trusted friend buy and hold the stock for the CEO. In the absence of insider trading law, a CEO could tell this trusted friend to sell the CEO's stock.

    And then he said:

    Insider trading laws criminalize this behavior, and encourage insiders to trade stocks in their own name (because that is legal)

    So, which is it? Does nothing stop these CEO's? Or do insider trading laws stop these CEO's?

    Also, how does this aid in information available to the market? It is still illegal for CEO's to trade stock in their own name using nonpublic information. And, if a CEO wants to trade stock by proxy, he can find a way to do so. If Bernie Madoff can run a Ponzi scheme without the SEC noticing, I seriously doubt they are catching a majority of trades by proxy.

  • dinkster||

    Algorithmic micro-fluctuation trading with super computers. That is real insider trading, trading before anyone is even made aware of the current price. Its like a fractional cent rounding scam.

  • The Derider||

    Well... it's not a zero-risk proposition.

    The Knight Capital Group announced on Thursday that it lost $440 million when it sold all the stocks it accidentally bought Wednesday morning because a computer glitch.

    http://dealbook.nytimes.com/20.....0-million/

  • Robert||

    Why should gov't butt in when an employee pilfers goods owned by the employer?

  • GILMORE||

    I havent RTFA yet, but from the gloss on the front... I'm not sure I agree, or that Stossel has spent a whole lot of time working with investment banks or hedge funds.

    in principle maybe he's right. But in the actual cases of *prosecuted* insider trading that have popped up since 2009, most of them were egregious, blatant, unethical, contrary to the interests of clients/shareholders and engaged in purely for personal gain.

    Also -
    "insider" = "officer or director or 10%+ owner of a firm"
    vs
    "Insider = someone with access to privileged, material non-public information"
    - very different things.

    If an officer/director buys/sells shares, it is made public on SEC Form4. It is generally a strong signal to the market. People like me track it daily with companies we're invested in.

    e.g.
    http://finviz.com/insidertrading.ashx

    Say you have a pre-approval biotech firm, where most officers don't own huge stakes in the firm themselves.

    But a dozen Early-Stage 'angel investor' golf-buddies own large stakes. And suddenly they're unloading. All of them. Just coincidentally.

    And it turns out the core product has a side effect of 'mild death'.

    If Stossel is suggesting that isn't illegal advantage of non-public material information ... I think that's bullshit. There's a difference between Martha Stewart and Raj Rajaratnam, obviously, but the law should still apply regardless of scale.

  • The Derider||

    His argument is that insiders + corporate officers will sell more shares than corporate officers alone, therefore causing a quicker correction in the market price.

    He'd have to be against SEC requirements like Form 4, too. Individual stock markets would make their own rules.

    I think both of these de-regulations would have the effect of making market forecasts completely unprofitable. If the only way to find out information about a company is the stock price itself, using other metrics like the earnings of a company loses utility, because by the time you have the information, the stock price has already changed. In other words, it would de-incentivise market research.

  • GILMORE||

    None of the points you summarize in any way seem to argue in Favor of the idea of legitimizing undisclosed insider trading.

    "" In other words, it would de-incentivise market research""

    And it would simply hand over the power to rig prices to the largest connected shareholders. Its basically saying, "lets go back to the 1920s! It was *real* back then."

    God, I'm actually arguing in favor of SEC regulation. (well...at least regulation passed in like...1933-1940)

    The SEC really doesn't annoy me as much as FINRA to be honest. FINRA's got all sorts of useless layers of regulatory & compliance stuff that creates enormous costs but does little to nothing to help clarify the 'rules of the game'

  • Sevo||

    The Derider| 11.28.12 @ 8:00PM |#
    ..."I think both of these de-regulations would have the effect of making market forecasts completely unprofitable."

    Uh, yeah, and then?
    Are you suggesting that the rules should *make* market forecasts profitable?

  • The Derider||

    I'm suggesting that people having a profit motive to investigate and forecast the future performance of publicly traded corporations is better than them waiting for inside traders to move the price, and following suit.

    Predicting the future accurately is valuable. Insider trading poisons the well.

  • ||

    The Derider said:

    I'm suggesting that people having a profit motive to investigate and forecast the future performance of publicly traded corporations is better than them waiting for inside traders to move the price, and following suit.


    This is a fallacy of false choice. Why not do both fundamental and technical analysis? This requires both investigating the company and observing any insider trading effects on price action.

  • ||

    The Derider said:

    I think both of these de-regulations would have the effect of making market forecasts completely unprofitable. If the only way to find out information about a company is the stock price itself, using other metrics like the earnings of a company loses utility, because by the time you have the information, the stock price has already changed. In other words, it would de-incentivise market research.

    So, are you saying that, if we legalized insider trading, this would create a situation in which "the only way to find out information about a company is the stock price itself," i.e., we are now required to do technical analysis only? I really don't see how this follows. How do we jump to the conclusion that legalization of insider trading makes fundamental analysis worthless?

    because by the time you have the information, the stock price has already changed


    Have you ever followed stock prices? Prices are constantly changing already while people do fundamental analysis. In fact, it would be a very strange world if it didn't. People engage in both fundamental and technical analysis all the time, and it would take a lot more than a change in insider trading laws for either forms of analysis to be abandoned.

    You sound like a thoughtful person (i.e., using phrases like "de-incentivise market research" sounds thoughtful and all), but it seems like a bunch of wild assumptions pulled out of nowhere.

  • mtrueman||

    I thought insider trading was the norm. Just like our banks are up to their ears in laundering profits from the narcotics trade. The fact that almost nobody is investigated, let alone charged or put in prison for these activities doesn't mean they're not going on. And those in a position to influence the laws regarding this have almost no incentive to make any changes - things are pretty much fine the way they are.

  • mtrueman||

    It's good at times to recall the words of a certain Trotskyite SF writer:

    "Libertarianism, by contrast, is a theory of those who find it hard to avoid their taxes, who are too small, incompetent or insufficiently connected to win Iraq-reconstruction contracts, or otherwise chow at the state trough. In its maundering about a mythical ideal-type capitalism, libertarianism betrays its fear of actually existing capitalism, at which it cannot quite succeed. It is a philosophy of capitalist inadequacy."

  • NL_||

    Since companies can release positive info themselves, insider trading is a criminalization of employees lowering their own companies' stock. It's a gift to big CEOs from a Congress that perpetually thinks the stock market should only go up.

  • NL_||

    Also the fact that congress refuses to define insider trading should make it unconstitutionally vague.

  • Tablet pc||

    In an actual free market, a company’s stock prices embody traders’ expectations about its future, this may come true.

  • attractions guide||

    If there is no poor, then there is no rich...

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