Yesterday SAC was indicted for insider trading, more or less, so today people are fighting on the internet about whether insider trading should really be illegal. You know what I think, more or less, but really I just think that’s sort of an unhelpful way to put it. Here is a rough stylized chart of the benefits of informed trading:


That is:

  • If you have no information, just index. That is the baseline.
  • If you have some information, enjoy making foolish trades!
  • If you have better information, that’s nice for you.
  • If you have really good information, and are deeply sourced in the industry that you cover, then that’s super great and you can make a lot of money.
  • If you have really really good information, and are spending too much time at your Hamptons share house with CFOs, you’re probably going to jail.

Now there is a question about which side of that inflection point SAC was on but kind of not really since it was chock full of people who’ve been convicted of insider trading. So everyone who’ll talk about the case, except Ed Butowsky, is using words like “slam dunk” and “death knell”: eight charged or convicted insider traders is probably enough to sink SAC. Steve Cohen won’t go to jail, because there’s basically no evidence that he personally insider traded, but a lot of his employees have or will, and the firm is pretty hosed. It’s worth reading that Bloomberg article, and the forfeiture complaint, to see how hosed: SAC’s insider trading is enough to infect every dollar that it managed with money laundering charges.1 SAC ended up just over the line from “awesome amount of information” to “too much information.”

But the interesting what-should-the-law-be question is, where should that inflection point be? Bethany McLean has the best description of where it is right now:

But the line between what’s insider trading and what isn’t is most definitely not the line between what information an average investor can access, and what information a hardworking hedge fund manager who can spend thousands of dollars and hundreds of hours on expert research can access. “I shudder to think how much of my alpha comes from failed individual investors,” one hedge fund manager tells me. The group of analysts could have done almost everything short of getting a source inside Dell. They could have worked Dell’s investor relations department, used sources at other companies, called customers to do so-called “channel checks” — research on what’s selling — set up meetings with management and industry analysts and pooled all their information. That’s all legal. “Edge,” as they call it in the hedge fund community, can refer to inside information, but it can also be that little bit of knowledge gleaned from incredibly hard work. And within those circles, “edge” gets shared — but not with you.

Emphasis added but that emphasized sentence is not quite right – as she says in the next sentence, they could talk to Dell IR, which apparently disclosed material nonpublic information with some frequency. They could talk to the Dell CFO at his beach house for that matter, as long he wasn’t disclosing (1) material nonpublic information (2) in breach of a duty of confidentiality (3) in exchange for some benefit to himself. All of those concepts can blur. SAC could talk to one doctor involved with Elan’s drug trials, but not a different doctor involved with them.

That’s an arbitrary inflection point, of course: digging up lots of information from well informed insiderish sources not generally available to the investing public is fine, sometimes, and sometimes not. It’s also an inflection point that has moved over the years: in 2000, the SEC adopted Reg FD, which made it much harder to legally get selectively disclosed information from executives and IR people. Before Reg FD, “call up the company, ask them if they’ll beat earnings, and write down the answer” was plainly on the no-problem side of the inflection point; now, it’s on the jail side.2

Of course any inflection point is arbitrary. A worthwhile exercise in thinking about insider trading is just to ask yourself where the inflection point should be.3 Even most insider trading legalizers probably would object to the most egregiously unfair insider trading, like a CEO shorting his own stock and then burning down his factory.4 But they would move the inflection point significantly to the right, making things that are currently gray-area-to-illegal plainly legal. And even most level-playing-field hard-liners wouldn’t want to ban all fundamental stock research, though many of them have ideas for moving the inflection point to the left – cracking down on one-on-one management meetings, for instance, or on talking one’s book. So if you’re all “let’s legalize insider trading,” how would you deal with the CEO who destroys his company to make a buck?5 And if you’re all “Steve Cohen is the greatest monster in history”: is it just for the illegal trades? Or also the currently-legal-but-sure-sketchy-seeming work with expert networks? Or also, like, reading expensive private research reports? Paying Reuters for early data? Or what?

The arguments for moving the inflection point to the left (illegalizing more information), like those for keeping it where it is, are mostly about fairness: let the little guy compete on a level playing field with the SAC Capitals of the world. As McLean points out, actually achieving a level playing field would require moving the line very very far to the left, and banning all sorts of professional-investor tools that are currently taken for granted and that are important to capital formation and price discovery. Also this seems a little nuts because nobody goes around saying “let the little guy compete with trained neurosurgeons in neurosurgery” but of course encouraging everyone to day-trade stocks is the American way and I guess encouraging everyone to cut brains open isn’t.

The argument for moving the inflection point to the right is in part that that American way is dumb. Dylan Matthews:

Felix Salmon, arguing for bans on insider trading, wrote, “If you want a nation of shareholders, you need to give individuals some faith that they won’t get picked off like so many fish at a poker table.” But we don’t want a nation of shareholders — or we shouldn’t, in any case. We want a nation of index fund holders, and banning insider trading makes that harder.

In my terms, moving the inflection point to the right increases the (available) profitability of informed trading, and thus, through the zero-sum-ness of alpha, increases the unprofitability of stupid trading. (McLean’s hedge fund manager says “I shudder to think how much of my alpha comes from failed individual investors,” but I bet he doesn’t really. In some loose sense the answer is “all of it.”) In some approximately informationally efficient world, doing that would discourage people from trading stupidly, and encourage them to index, which would be nice, though if you’re assuming an informationally efficient world why are we having this conversation?

There are also pro-insider-trading arguments from price discovery, which is important, but it’s hard to actually get excited about price discovery, which I guess is how you know it’s important. Also there are capital-formation arguments for banning it, which I find slightly obscure; just index and/or insider trade, depending on your situation, y’know?

As for my personal view, I have a tendency to think that prison is bad, but mostly I just think that inflection points are bad. Or, really: that using fuzzy concepts (“material,” “benefit to the tipper,” etc.) to fix very sharp inflection points is bad. Everyone has some gut feeling that some stuff is okay and some stuff is not okay, everyone’s gut feeling differs on exactly which is which, and some arbitrary compromise is reached full of blurry words like “material.” And then if you’re just on the right6 side of that blurry line, you get very rich, while if you’re just on the wrong side you get very sent to jail. The fact that SAC more or less ended up doing both is a sign that the line is too blurry.

The folly of trying to level the investment playing field [Reuters / Bethany McLean]
Insider trading enriches and informs us, and could prevent scandals. Legalize it. [WonkBlog]

1. Not your lawyer but as I read it the theory is that, if you insider trade, and then don’t put the money in a special account labeled “insider trading profits” but just co-mingle it with the rest of your money, then that is money laundering, and all of your money has now been used in money laundering, so it’s subject to forfeiture. Your money, and your investors’ money. Also maybe your prime brokers are co-conspirators. It is pretty pretty pretty broad is what I’m saying.

2. Not necessarily quite right but close. In any case the company isn’t supposed to disclose it.

3. A question that is perhaps of secondary interest intellectually, though also quite important as a human matter, is how steep the prison cliff should be. A decade in prison for trading on almost-legal information seems harsh.

4. Also breach of an explicit negotiated contract not to use information given you in confidence should be regulated somehow, though perhaps only by contract remedies. Anyway this guy seems like a tool.

5. I mean, there are ways. Disclosure, fiduciary duties, etc.

6. Left, in my chart, sorry.

Comments (17)

  1. Posted by 1 hour left! | July 26, 2013 at 2:54 PM

    Haters gonna hate but I'm going to say it anyway… I am sick of reading about SAC, please diversify!

  2. Posted by Matt's Agent | July 26, 2013 at 3:13 PM

    Welp, now that SAC is gone, I guess it's time for ML Capital* Advisers**

    *Please provide forthwith

    **Meh, we'll do something fun with it

  3. Posted by Guest | July 26, 2013 at 3:16 PM

    Yep, comparing monkeys who buy/sell stocks on half-baked rumors and supposed "edges" with neurosurgeons is totally fair.

  4. Posted by @insidertrading_ | July 26, 2013 at 3:22 PM

    It came about a three year and three month Federal sentence late for me too.

    Shame you did not put together that bitchin' chart for me earlier — would have saved me the sight of seeing a man buy vomit from another and then consume it out of his hands for its methadone content. Live and learn.

  5. Posted by Guest | July 26, 2013 at 3:30 PM

    White Shoe Law Firms: . . . So it's been a bit light around here, what with the aftermath of the financial crisis winding down.

    Robert Khuzami: What are you asking?

    Law Firms: Anything you can do to make some business, we'd really make it worth your while.

    Khuzami: Like what?

    Law Firms: I don't know – isn't this your thing? Insider trading, whatever, just make sure it's someone who can pay the bills.

    Khuzami: And you'll make it worth my while?

    Law Firms: We sure will.

  6. Posted by TT. | July 26, 2013 at 3:32 PM

    I don't think you can come to a principled, clean, viewpoint on this. You would have to land in a compromise where you try to minimize the risk of corrupting incentives for inside information holders (e.g. I will make more money burning down my factory and shorting my stock), whilst not discouraging price discovery. Somewhere, society's trust in the financial markets (whatever we have left) should also figure I guess.

  7. Posted by Guest | July 26, 2013 at 3:47 PM

    Everyone is missing the basic point here. The "inflection point" is already in the law. If your material information comes from someone who is not permitted to share it — i.e., if they are breaching a duty to the source of the information — trading on it is illegal. Period full stop. This is not a "grey area" — the notion that the lines are fuzzy is bullsh*&. Nor is it about leveling the playing field so all investors have the same information; the Supreme Court itself has said that neither Congress nor the SEC ever has created or endorsed an information-parity rule. Rather, the issue is that you can't trade on information from sources that you know, or should know, have provided it in violation of a duty they owe to the source.

  8. Posted by Gozer | July 26, 2013 at 4:05 PM

    anyone else getting a sense of deja vu?

  9. Posted by News Update | July 26, 2013 at 4:43 PM

    The gray area here isn't the source – it's the type of information.

    "I think our sales figures this quarter will be strong" isn't material, even if it's coming from a company insider – that's the sort of fluff they spout all the time that nobody takes seriously. "We're going to spin off our computer gaming division so that it sinks under its own weight" is material and actionable.

    But somewhere between those is the gray area – things like internal projections of sales figures, preliminary exploration of M&A deals, progress reports on negotiations over litigation, etc. Whether it is material depends on a whole lot of other stuff – and whether there is a violation of a duty depends on a whole lot of other stuff besides (like whether they've already disclosed it, or if it's already common knowledge, or how well the person disclosing it actually knows it to be a fact, etc.) That's where some additional bright lines would help – e.g., internal projections, advance talk of possible strategic moves, OK; final numbers, regulatory approvals, not OK; etc.

  10. Posted by guest | July 26, 2013 at 5:02 PM

    I disagree. What you call an "inflection point" is what lawyers call a "bright line" rule.

    All such rules are arbitrary (0.1 rat parts per box of cereal is ok, but 0.11 is not?), but they protect individuals from being charged with and convicted of crimes when they had no notice that their conduct was a crime. A fuzzy standard means that a lawyer would likely have to counsel his investor client to never talk to corporate executives at all, as it is not possible to define what it would mean to have traded on "inside information."

    We expect prosecutors, judges and juries to exercise discretion, but the law should try to be as clear as possible. Otherwise, nobody has notice of precisely what conduct is prohibited, and we could just have a single rule that "it is a crime to do wrong in the eyes of the Attorney General."

  11. Posted by Turnip Truck | July 26, 2013 at 5:34 PM

    Individual small-time investors already have no chance trading, but it doesn't seem to have dawned on them. What makes you think that making it even more unprofitable will clue them in that they should have been indexing all along?

  12. Posted by Um, what? | July 26, 2013 at 9:19 PM

    Explain again what this case has to do with "Individual small-time investors"?

  13. Posted by Guest | July 26, 2013 at 9:42 PM

    You are basically arguing materiality, and materiality is a losing argument for a defendant. All prosecutors and regulators will tell you that if you trade after receiving information — even info you would say is 'immaterial' — they will have little difficulty convincing a judge or jury that it *was* material, simply because you traded on it. Circular, I know, but that's the benefit of hindsight. So as a result, market participants have to focus on the source. If you know or have reason to know the info is coming from someone prohibited from sharing it, even if you think it's not material, you shouldn't trade on the info or, at a minimum, you should bring the issue to compliance.

  14. Posted by Turnip Truck | July 26, 2013 at 9:57 PM

    "The arguments for moving the inflection point to the left (illegalizing more information), like those for keeping it where it is, are mostly about fairness: let the little guy compete on a level playing field with the SAC Capitals of the world. As McLean points out, actually achieving a level playing field would require moving the line very very far to the left, and banning all sorts of professional-investor tools that are currently taken for granted and that are important to capital formation and price discovery. Also this seems a little nuts because nobody goes around saying “let the little guy compete with trained neurosurgeons in neurosurgery” but of course encouraging everyone to day-trade stocks is the American way and I guess encouraging everyone to cut brains open isn’t.""

    C'mon, that wasn't even in a footnote.

  15. Posted by Fire Jon Shazar | July 27, 2013 at 11:04 AM

    Nice chart, Levine. All this article lacks is a diagram depicting the average size of an anus before and after prison.

  16. Posted by trader | July 29, 2013 at 10:33 AM

    What's the sharpe of these graphs?

    UBS quant

  17. Posted by Rick | July 29, 2013 at 12:11 PM

    Yesterday, I bought some bananas for 20c because the fruit marketer told me that rains had reduced the quantity of the next shipment and prices may go up to 22c. Am I guilty of insider trading?