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The Modern Witch Hunt1by Alexandre Padilla
Today, we are again assisting to a new witch hunt not much different from the one in Salem. These new witches are not witches per se but they are treated in the same way. These new witches are what witch hunters call insiders; they are businessmen, entrepreneurs, speculators, arbitrageurs, money makers. Their names are Ivan Boesky, Dennis Levine, Martin Siegal or, more recently, Martha Stewart. We certainly do not hang them anymore but we still put them in jail, humiliate them in public or expropriate them by taking away the fruits of their labor. Another difference is that it is not the "people" that are the witch hunters but people supposedly more knowledgeable, omniscient and wise, namely, public officials, government members; in short, the government, the State. People know today that the witch hunt was wrong, illegitimate, and criminal. People have been wrongly imprisoned and killed. While we are told by the government and its dedicated servants that this new hunt is a "just" hunt, there is no word strong enough to describe the wrongness of this new witch hunt. The insider hunt is as wrong and illegitimate as was the witch hunt in Salem. Let's examine the issue. IS INSIDER TRADING IMMORAL? To begin, we are told that insider trading is immoral and unfair because the insiders are operating on the basis of confidential information not available to the public and therefore the investors trading with the insider necessarily lose from the trade. First, this is not true, the information on which insiders base their securities transactions are available to the public but to have access to this information the public, the investors must pay while the insider does not have to pay because his access to such information goes with his position within the corporation. The simple fact that we do not have to bear or pay the same thing to access to the same information is not immoral per se. We do not say that a professor is immoral when he gets paid to teach economics while the students could have the same access to the professor's knowledge without having to pay him by simply buying books or reading papers. In the same way, we do not say that it is immoral when we go to see the repairman to get our car fixed for a very expensive price when we could have done the same thing for a cheaper price by reading the books he has read. Second, even if it was true that investors do not have access to the information that insiders have, it is still not immoral to trade with somebody who has less knowledge than you. If it was why do not we prohibit every arbitrage transaction? What is the difference? We did not say when an art merchant bought the Van Gogh's Sun Flowers for few dollars to a couple of farmers that were using it to shut up a hole in the henhouse and sold it to a gallery for 50 millions of dollars that was immoral. Was it? They probably received more money than they would have if they have sold their "stopgap" to somebody who did not know the artistic "value" of a Van Gogh's painting and thought he was buying a stopgap. Third, to say that the shareholder who trades with an insider loses from the trade is also wrong because actually by selling to an insider his shares, the shareholder will receive a better price for his shares than he would have if he had traded with another anonymous investor. Ultimately, how can we know that he lost from the trade since anyway he would have sold his shares? In the same way, it is true that the investor who buys shares from an insider-seller who knows or to be more accurate expects according the private information he has obtained that the share price will drop buy these shares at a higher price than he would have if he bought these shares when the share price has dropped, this investor still bought the shares at a lower price than if he would have bought the shares from another ignorant investor. Which matters here is not that the shareholder or the investor made a transaction with an insider, which matters is that anyway he would have made this transaction whether or not the other party of the transaction was an insider or another simple anonymous ignorant investor. We are also told that insider trading is equivalent to theft (see for example the Supreme Court's decision, O'Hagan vs. United States, – U.S. – No. 96832 (1997) and the recent Rules 10b5-1 and 10b5-2 adopted in August 15, 2002 which relies upon the misappropriation doctrine, 17 CFR 240.10b5-1 and 17 CFR 240.10b5-2). Shareholders are the legitimate owners of the corporate information whether or not it is confidential. By using confidential corporate information, insiders stole the property of shareholders. This may be true if we believe that there is such a thing as property in information but this can only be true if the insiders are not themselves shareholders which is not the case today in most of the corporations. Today, in most of corporations, insiders are themselves owners of stocks or stock options and, as a consequence, owners of the corporate information as well. Therefore, when we analyze the most recent case of Martha Stewart we cannot deny that when she traded, bought or sold her shares she was legitimately using the private information of which she is a legitimate owner. It is hard to argue against this when we say that the Supreme Court defended such the proprietary information doctrine which argues that to trade on inside information you must ask the authorization of the legitimate owners of the corporate information, i.e., the shareholders. Being a shareholder herself, therefore, Martha Stewart had no need to ask anybody the authorization to sell her shares. It could have been the case if she was not a shareholder and wanted to buy shares on the basis of inside information that a director of the corporation gave her in confidence. And, even if this case, an authorization would have been needed only if the director was not himself a shareholder since one important aspect of property rights is the right of the legitimate owner to give or transfer part or totality of his property rights to another party (Roman Law calls this third right: abusus). IS INSIDER TRADING A THREAT TO THE ECONOMY? The insider hunters also tell us that insider trading is economically dangerous; it is a threat to the economy. They rely upon "sound" economic theory and models to justify their hunt. Here, again, their arguments stumble down and are as fallacious as the models on which they ground their arguments. Let's examine the some of them. First,
we are told that insider trading undermines investor confidence
in the integrity and fairness of the stock market. As a consequence,
insider trading is a threat to the liquidity of the stock market
and hampers capital formation. The argument is the following, if
investors or potential investors perceive that the market is unfair
and that insiders trading in possession of confidential information
can take advantage of investor ignorance, investors are going to
be reluctant to invest in the stock market. To say it in other way,
if investors perceive that they are not on the equal footing with
any other investor (whether they are insiders or not) they are not
going to invest in the stock market and, hence, corporations won't
be able to finance their new investment projects by raising new
capital. Ultimately, the hunters tell use, we can observe a stock-market-run
where everybody will withdraw his investment money from the stock
market and at the end the stock market will collapse. To support
their arguments, they tell us stories about how it is business malpractices
such as insider trading, stock price manipulation, or false accounting
and financial reports that were at the origin of the stock-market
crash in 1929 and lead us to the Great Depression. John Shad, for
example, great leader for a while of the witch hunters tells us
that it is because they have enacted strong securities regulations
to protect the small investors from the immoral, unfair, predatory,
greedy businessmen that today the United States securities markets
are "by far the best capital markets the world has ever known –
the broadest, the most active and efficient, and the fairest" (Securities
and Exchange Commission " … good people, important problems and
workable laws," 1984, p. 1). Unfortunately, these stories used to
support their theory are nothing more than legends. Emory University
Professor George Benston has investigated this issue particularly
regarding accounting practices and found no real evidence that,
at the time, the stock market was nothing more than a "den of thieves";
there may have been certain malpractices in the stock market but
certainly not of the gigantic magnitude that the hunters would like
to make us believe in. We are told also that, if investor confidence is undermined, the stock market liquidity will be impaired and corporations will have difficulties to raise capital. Insider trading being perceived unfair it hampers the stock market liquidity. Therefore, we need to prevent insider trading and hence putting market participants on the same level playing field. If everybody is on the same level and is equally informed on the stock market, people won't be afraid to invest their money in the stock market and the corporations will be able to raise new capital. In other words, the underlying rationale behind the prohibitions against insider trading is that people, and particularly, individual investors would stop investing their money in the stock market if they perceive that, as a "little guy," they are trading "against" individuals who have more information, if they do not have the same fair chance as the "big guys." Well, that may be true but, if it is the case that people invest in the stock market because they think that they are all on the same equal footing, we are here confronted with a more serious problem which is that the implementers of the securities regulations are lying to the investors because this level playing field in impossible to reach and will never be reached. Theory is not necessary to understand that the division of labor and knowledge are a pervasive fact of the life and, even if, people would all have access to the same information, it does not mean that they are on an equal footing when it comes to making investment decisions or any decision in general. The government wants to make us believe that by compelling corporations to disclose more and more information, to comply with some accounting standards, and by prohibiting insider trading, people would be on an equal footing but this is impossible because not only information is a subjective thing that is subject to the interpretation of people regarding their knowledge and education but also because people have different abilities to process and understand information. Another important problem is that not everybody can access information at the time, information must start from somewhere and, as it would be when you inject money in the economy; people who get it first will use it first. And, if we accept the idea that information has some kind of objective content, when the first acquirers of the information will use to make their investment decisions, the impact of their decisions will render obsolete the information in the sense that the information transmitted through their decisions will be incorporated in the price of the stock concerned by the information. In other words, the idea of level playing field and equality between investors is a myth and the victims of this myth are the investors. This lie could lead to a phenomenon similar to the one we observe in the banking system that we called bank-run which is when people realize that their money is not 100% backed-up in gold and that there are more money certificates issued than gold available in the bank vault. The analogy is a little bit far-fetched but we understand what could happen if people become aware that they have been deceived. As in the context of the banking system when it comes to gold reserve, when investors come to realize that they are not really in the same level playing field, the general reaction will be that they are going to take back their money and the dramatic scenario imagined by the witch hunters will come true. Fortunately, it is more doubtful that the explanation of why people invest more today than they did in the past lies in the fact people believe that they are more on an equal footing than they used to be. It is true that people have more access to information but it is not because the government imposed corporations to do so but because corporations understand that it was necessary to stimulate investment and capital rising. Moreover, it seems that people are not as ignorant as the government officials would like to make us think, a look at the data shows that if it is true that more and more people invest in the stock market is more due to the development of financial institutions such as pension funds, insurance companies, or mutual funds through which they invest their capital. It is true that more and more people invest in individual stocks outside these financial institutions but mostly these individuals have one or more brokers and have recourse to financial advisers. Moreover, in average, these investors have been active investors in the stock market for over 15 years and are mostly college educated.2 As these data can show investors are not really the little average guy that we can meet on the street everyday. People who invest their money are usually knowledgeable when it comes to investing their money in the stock market. It is therefore doubtful that the prohibitions of insider trading are at the origin of the growth of equity ownership. Actually, if the regulation of insider trading did not contribute to the growth of equity ownership and the liquidity of the stock market, it is more likely that the regulations of insider trading but not only has largely contributed to impairing the system of corporate governance and enhancing the ability of managers to expropriate shareholders contrary to what the government officials and other economists have argued. Economists and the witch hunters have argued that by allowing insiders to trade on confidential information, insiders will have more ability to manipulate stock prices, expropriate the shareholders, or work against the interests of shareholders since they can make profits on the fact that the corporation is performing well or bad. As I have shown in a paper (Padilla, "Can Agency Theory Justify the Regulation of Insider Trading?" The Quarterly Journal of Austrian Economics, Vol. 5, No. 1 (Spring 2002), pp. 3–38), shareholders have a large variety of market mechanisms to discipline insiders and, actually, it is the various government regulations which have impaired these mechanisms that have given more latitude for managers to expropriate the shareholders. On the other hand, we can show that the regulation of insider trading, by defining large shareholders as insiders as is the case in the United States or by narrowly defining inside information, requiring it to be precise as it is in the European Union, have discouraged large and active shareholding. These regulations have increased the costs of holding large blocks of stocks and performing active monitoring of managers' activity, thus, giving to the latter more opportunity and latitude to engage in self-interested decisions which can negatively affect the performance of the corporation and ultimately harm the shareholders. We are told that the liquidity of the stock market is beneficial to the investors by reducing the costs of transactions and the costs of raising capital but the issue is that the regulation of insider trading had no role in this process; actually, the regulation of insider trading as well as capital gains tax prevent large shareholders to benefit from the liquidity of the stock market and discourage large ownership because they cannot protect themselves against random exogenous effects that could affect the corporation performance and make them incur great losses by selling their stocks because they are likely to incur greater losses if they face prosecutions for insider trading. They cannot use their expertise and access to confidential information when necessary. It is why most institutional investors such as corporate and pension funds are reluctant to own large blocks of stocks or receive confidential information. They want to protect the liquidity of their holdings; but by protecting the liquidity of their holdings they reject any possibility to play an active role in the management of the corporation and instead stay passive. Finally, the prohibitions of insider trading have serious consequences on the informational efficiency of the stock market and lead sometimes to dramatic outcomes such as the most recent Enron scandal. Henry Manne has for years argued in favor of the deregulation of insider trading.3 As Henry Manne explained, insiders are entrepreneurs who, through their transactions, communicate investment-decision relevant information to the stock market participants without disclosing the actual content of the confidential information. Insider's transactions affecting the stock price send a signal to the market participants about the state of affairs of the corporation. Insider's transactions are important because insiders do have an access to confidential information and are likely to know what is going on inside the corporation. It is true, as some economists argue that it is a noisy signal and it can be subject to many interpretations but it still is a signal. By prohibiting insiders from trading on the basis of inside information, the regulation deprives shareholders and other potential investors from having indirectly access at a low cost to information. This type of barrier can lead to dramatic situations such as in the now very (in) famous case of Enron. As Fred Smith Jr, the founder and president of the Competitive Enterprise Institute, argued in an op-ed in the Liberty Unbound Magazine, if insiders had been allowed to trade, investors would have ultimately incurred less losses than they actually did because insiders by trading would have sent a signal to the investors about the illusory soundness of Enron.4 Investors would have been more aware with the drop of stock price that Enron was in trouble. The price would never have gone so high and probably employees would have been more reluctant to invest all their savings in Enron. Ultimately, Enron would have been just a banal story of a corporation which has to close its doors and announce bankruptcy as it happens every day when a corporation becomes obsolete and unable to satisfy the consumers. Unfortunately, the people who were most in position to learn critical information about the real situation of Enron were prohibited to trade and we know what happened after many people employees and non-employees who invest a lot of their money lost a lot of money. The Enron's case was certainly not an evidence of market or capitalism's failure but another evidence of government failure in many aspects. This witch hunt of which insiders are the modern victims is totally unjustified. The witch hunters; that is to say, the government officials may try any argument to justify their hunt and this new "war" on the free market but the fact is that these arguments are unsound in many respects. There is no case against insider trading; the only thing that can be said is that the insider trading issue must be left between private hands; it is not up to the government to decide whether insider trading must be prohibited but the corporations and the shareholders who are the ones concerned to decide whether or not insider trading should be prohibited or not through contracts. The market is the ultimate judge because if insider trading is really harmful to shareholders, the corporations will prohibit it; because if not, shareholders will not invest their money and corporations will not be able to raise capital or finance their projects. We should consequently leave the market and the competition between corporations to decide of the fate of insider trading and not the government.
Alexandre Padilla [send him mail] is a PhD candidate at the University of Law, Economics, and Science of Aix-Marseille (France) and a visiting instructor at the Metropolitan State College of Denver. He also has a web page.
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October
22, 2002