What’s Wrong With Insider Trading?

Written by Author

On May 29, 2020
insider trading

What’s wrong with insider trading?

I know the usual responses having to do with fairness and equity, and even fiduciary duty. But is the simple act of trading on information that isn’t widely known morally wrong? Today, the Securities and Exchange Commission (SEC) publishes a running total of the insider trading cases it pursues. If the SEC is going after these people, they must have done something wrong, right? Not so fast.

Today, insider trading cases often hinge on the accusation of either a breach of contract or a breach of fiduciary duty. Practically every case that comes across a prosecutor’s desk involves some type of immorality. But, it goes beyond that. The “moral crime” of insider trading allows even honest people like Martha Stewart to be smeared. The very phrase has become so dirty that the general public believes that there’s no way it could possibly be moral.

Historically, it was not considered an immoral activity

When the market was more free than controlled… It was somewhat common for corporate insiders (i.e. CEOs of companies) to profit from information that was not made public. For example, the famous railroad builder James J. Hill took no salary for himself for decades while he built his empire. Instead, he profited from the gains in the stock of the Great Northern railroad he owned.

What Hill was doing then would, today, be “insider trading.” During Hill’s time, there was no SEC. Companies were free to write corporate by-laws and employer-employee contracts any way they wanted. If a corporation wanted to allow its employees to engage in insider trading, they could.

If a company thought employees were abusing the practice, it could prohibit it or fire the employee. But it was actually uncommon for companies to prohibit trading on inside information. The government respected the contract rights of companies and employees.

Moreover, companies at that time realized that insider trading wasn’t harmful to anyone. Why? Because trading on insider information doesn’t impact the price of a stock, the information does. It’s the nature of the information itself that handles a stock’s price. As far as financial markets are concerned, it doesn’t matter how information makes it to the marketplace. All that matters is that it gets there – and the more information and news traders have, the better.

When there’s no breach of fiduciary responsibility, and no fraud involved, there’s no crime.

At this point, you’ll probably hear people cry, “but it’s unfair.” But is it?

It’s only in the financial world where earned profits and unequal outcomes are seen as unfair. For example, suppose a journalist is about to break a story about some political scandal. This is the scandal of the century. It implicates the President and several cabinet members. Could radically change politics forever. To get his story, the journalist had to rely on secret contacts. He also had to keep the story “hush, hush” for several months while gathering and verifying all the details. He scooped all his peers.

Is he sent to jail? Hell no. He wins the Pulitzer Prize. Yet, if this were the financial world, and he had used non-public information to scoop other investors, he’d be guilty of the crime of “insider trading.”

insider tradingOr what about a man who pursues a woman he’s interested in? He comes up with a great first-date idea based on information provided by mutual friends of theirs. Information that’s not widely known (i.e. it’s non-public)? Is the man morally corrupt? Should he be sent to jail? No, of course not.

What about a scientist who does original research? Uncovers the cure for all cancers. Yet sells his non-public information (and invention) to drug companies for billions ahead of everyone else? Is he a criminal? Hardly. He’s a hero. He just cured cancer.

One man’s gain in romance doesn’t prevent others from finding love elsewhere. Likewise, the journalist’s story doesn’t prevent other journalists from being successful in their own endeavors. There are so many scientific discoveries to be made, the cure for cancer doesn’t prevent other scientists from being heroes in their own right. It’s the same in the financial markets – someone’s gain is not someone else’s loss.

When you trade value for value, everyone involved in the trade wins.

A journalist only has a secret source because the informant finds the journalist’s proposal to work together appealing in some way. A man only gets a date with a woman because she finds his offer attractive. A scientist that sells the cure for cancer clearly benefits monetarily, but so does the drug company.

But what about the people not involved in the trade? What happens to them? Well, if they are rational, they might benefit as well. Take the case of the scientist or the journalist. If you suffer from cancer, would you enjoy the scientist’s hard work? What about the journalist? If you knew about the scandal, do you think that would allow you to make a more informed choice during the next election?

What about insider trading?

Suppose that you learn about a company’s new product line ahead of everyone else. You have access to private documents that detail what the product is. Let’s assume that it’s also not against company policy to trade on this information. You gained that information through your own efforts. You know this will be a revolutionary discovery, so you decide to invest.

insider trading

When the press release hits, the company’s stock soars. You’re a multimillionaire. You spend some of that money and you reinvest the rest for potentially more profit. You benefit and so do others as a natural consequence of you acting morally. But who loses? No one.

In fact, this kind of scenario was somewhat common in the 1920s. During that time, stock pools were large “pools” of money that were invested in the stock market. Normally, a stock pool collected money from many investors. The fund manager appointed to invest that money into a particular stock or group of stocks.

It’s hypothesized that the sheer volume of money in these pools used to influence stock prices. To the detriment of other investors not involved in the stock pool. Some interesting research done at the University of Virginia School of Law shows that:

It is likely that some pools were formed to trade on the basis of non-public information. This explains why contemporary observers claimed that the price of the target stock frequently rose just after the formation of a pool. Company insiders participated in some pools. Moreover, because bankers and brokers commonly sat on the boards of industrial companies, a brokerage firm that operated a pool would sometimes have a partner who was also an insider of the subject company.

This squares with other research done on the stock pools of the 1920s:

…when available, against the list of directors and officers contained in Moody’s Manuals, we can determine that at least 12 of the 55 pools in our sample included a corporate officer or director.

This same research suggests that:

We find abnormal trading volume during pools, consistent with market manipulation, but this trading led to only modest increases in price in the short run and no abnormal performance in the long run. Thus, there is no evidence that the stock pools harmed small investors.

The fact that there were insiders sitting on some of these stock pools. Yet there was no evidence that any outside investors were harmed. Demonstrates something very important – stock pools did not harm investors and, by extension, insiders sitting on these pools did not cause harm to other investors in the financial markets. Why do we have insider trading laws then?

Well, the answer is actually very simple. Some people believe that making money is morally suspect – that the profit motive is morally suspect.

Good luck with your trading!

 

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