Last week’s headlines had a lot of people asking if we're in an insider trading surge. And also: “Why are there so many husband and wife teams getting tagged by the SEC?” On Friday evening we went onto CNBC’s On The Money to try to straighten all this out. The fun part was really when we got to throw down with a Robert Heim, Meyers & Heim senior partner and former SEC enforcement attorney.
Let’s start with the Marriage Question. A lot of insider trading cases involve married couples, old friends, college buddies. If you are going to set out to get rich by breaking the law, it makes sense that you conspire with someone you trust not to turn you in to the authorities. Also, since insider trading cases are often prosecuted by having one of the crooks turn states evidence against the other—they are hard to prove through merely circumstantial evidence, so it helps to have an actual witness testifying that there was a criminal intent--you might hope that your wife or husband won't sell you out. If you are in the classic game of prisoners dilemma—where both crooks get free if neither talks, but both have an incentive to talk to avoid being the only one prosecuted—you want to have someone you trust in the other cell. Your wife or husband probably seems like a good bet. Unfortunately for the crooks, there are a lot of people who prefer to avoid jail sentences to staying faithful to their criminal conspiracy marriage.
[After the jump we explain who really gets hurt by insider trading. Hint: it's not individual investors.]
Is there a surge of insider trading? Or is this just a surge in enforcement? It's actually very hard to tell whether the additional cases and headlines have come about because there is more insider trading happening or more enforcement. The SEC does seem to have stepped up its enforcement of insider trading lately. But the high level of M&A activity is surely creating more opportunities for insider trading. On any given deal there are lots of people who have inside information about it. Company insiders, investment banks on both sides of the deal, banks that are considering financing the acquisition, and lawyers and accountants for everyone. Obviously, the more people in the know, the greater chance there is for inside information to leak out.
Of course, not all trading by people who have non-public information is illegal. If the inside information is obtained innocently by a non-insider, that person can probably trade. There is widespread confusion about what constitutes illegal inside information, in part because the laws against it consist of a few vague regulations and a host of confusing court cases.
Should the SEC be turning its guns against insider trading? It's not clear that insider trading actually imposes serious costs on outside investors, other than the fact that they might be reluctant to invest if they think the game is fixed. It also gives rise to a less than fully efficient market, since some of the people with the best information are kept out.
The main point of making insider trading illegal is to create the impression that there is a level playing field in the stock markets. The government wants to encourage ordinary, mom and pop citizens to invest in the stock market. But should the government be doing that? It might not be a good idea to encourage people to believe there is a level playing field. There is not and has never been. Large institutions and hedge funds will always have an informational advantage. Also, almost no-one can beat the indexes—especially not part time investors who try to pick individual stocks. Most people would be better off in a low fee index fund.
One group that does benefit tremendously from encouraging people to invest in individual stocks are broker-dealers. They make money off fees from their customers, and it is very important to them that their customers believe in the level playing field. This makes it very ironic that so many of the recent cases brought by the SEC have targeted people inside of financial institutions.
The crackdown on insider trading in the eighties came from federal prosecutors who started using a host of laws in creative ways. Activities that no-one previously understood as illegal were labeled criminal, and laws that no-one imagined could be used against "white collar criminals" were suddenly marshaled against them. RICO, which was intended to crack down on organized crime, became a tool for going after executives and Wall Streeters. Rudy Giuliani--then a federal prosecutor, later the mayor of New York City, and now a Republican presidential hopeful--was one of these innovators. He's now considered to be a pro-Wall Street candidate, but back then he was widely reviled and feared.
That crack-down, like this one, is problematic precisely because trading on non-public information is in all likelihood very widespread. That means the SEC can only catch a fraction of insider traders, and hope that the publicity these cases receive discourages others. But the publicity from these cases might actually discourage individual citizens from investing in the stock market by revealing what seems to be widespread corruption. There’s precious little data on whether or not these high-profile arrests undermine the questionable goal of fostering an impression of market integrity.
All these high-profile cases also risk attracting the attention of lawmakers and regulators. Unfortunately, more regulations probably won't help. It might be better, in fact, to scrap our current rules against insider trading and take the whole thing out of the hands of the SEC. Foster Winans, who was the Wall Street Journal reporter who was prosecuted on insider trading charges for leaking information about his own columns, has recommended getting rid of the law. Instead, we should prosecute these "insider trading" cases as something much more clear—theft from employers.
Interestingly enough, that's what a lot of these recent cases are. People working at banks have been stealing information from their banks and their clients and using it to profit on their own. They are thieves and should go to jail, and we should just call it what it is. These cases should probably be brought by the justice department, or even the local prosecutors, rather than the SEC. And then the SEC can concentrate even more of its resources investigating more complex cases of corporate fraud.
But it’s unlikely we’re going to get rid of insider trading rules anytime soon. Many people are offended by insider trading because it strikes them as unfair and immoral. It's a financial sin. And so even comments like these will strike a lot of people as heresy. That reflects a healthy moral attitude on the part of the American people. But in our more reflective moments we can’t help but wonder if our financial markets are really the right place to find religion, and whether our financial regulators are really equipped to prevent sin.