The Non-Crime of Insider Trading

For some reason that completely escapes me, most people cheer from the sidelines when the SEC has upstanding businessmen handcuffed and hauled away for the so-called crime of insider trading. Why is this? Given that there is nobody who can claim to be the victim of insider trading, all I can figure is that they cheer out of jealousy and resentment.

According to the SEC, insider trading is the act of buying or selling a security while in possession of relevant, "nonpublic" information about that security. A person is also in violation if they "tip" this nonpublic information, whatever that means.

First of all, the law is ambiguous and necessarily arbitrary. What is "nonpublic" information and what is "tipping"? If I have a web site with 100 members and I provide some information, is that "tipping," or is the information now public? How about 1000 members? 10,000? What if the site is CNN.com?

Certainly, nobody has all the information, and each person has different sources of information than the others. The SEC wouldn't have us trade stocks based on no information at all, would they? That would just be gambling. And even if everyone had all the same information, on what basis would some of us want to buy and others want to sell? The only reason you trade at all is because you think you have better or more information than others in the market. Otherwise, you're just guessing.

Despite all this, the idea of criminalizing insider trading seems to have broad support. I think this comes from the mistaken notion that these "insiders" are profiting at the expense of the average Joe stockholder. Is this really true? Who is the victim?

Let's use the fictional case of a drug company executive who is waiting on FDA approval of his company's new wonder drug. Prior to official public release of the information, he becomes aware that the FDA has denied approval of the drug. He has two choices: (A) sell his shares in the company and get out before the stock price plummets, or (B) sit on his shares like a fool and lose half his money.

On the other side of the country someplace, we have two classes of investors, those who already own stock prior to the insider information becoming available, and those who are considering a purchase in the period of time between when the insider information became available and when it becomes public. Anything that happens after the information goes public is irrelevant; all the information is out and the stock will settle at its new price, say 50% of where it was prior to the FDA decision.

Who's the victim again? Let's look at the investor who already owns the stock prior to the insider information becoming available. If the executive chooses (B) and does nothing, the investor will suffer the same fate as the executive. He will wake up one morning and find that he lost 50% of his investment. Unlike the executive, he at least is allowed by law to get lucky and sell his shares in the time period after the insider information is available. If the executive chooses the evil course (A), the investor may or may not suffer the same fate. He could get lucky, or he could notice that a large number of shares are being unloaded onto the market and sell early, possibly saving himself some money. Regardless, he's no worse off as a result of the insider trading.

What about the investor who is considering a purchase during the "insider information" time period? This is probably the one most people would point to as the victim in all this. After all, he could, conceivably, be buying the exact same shares that the insider is unloading! Of course, this is not a face-to-face transaction, and the insider has made no claims to anyone about what the stock price will do in the future. If any false claims were made, this would be fraud, requiring no insider trading laws to prosecute.

Is the investor who buys, while the insider is selling, a victim? Suppose the insider chooses option (B) and rides his shares into the ground. Obviously, if the investor had made up his mind to buy, the fact that the insider is doing nothing will not cause him to change his mind. Thus, he will buy the shares and will lose 50% of his money when the FDA decision becomes public. What if the insider chooses course (A) and dumps his stock on the market? A few things can happen. If the investor is astute, he may notice that the price is dropping as the insider's shares are dumped onto the market. He may not buy, and may save himself a bundle of money. If he doesn't notice, he will still buy, but will get the stock at a lower price as a result of the insider's selling. He will still lose a lot of money, but not as much as he would have if the insider had done nothing.

So, in all cases, nobody loses any more money than they would have if the insider had "gone down with the ship." By using his inside information, the executive simply brings the stock price more quickly to its appropriate market value. Why then, force the insider to either lose a bunch of money for no reason, or risk going to jail? As I said at the beginning, the only reason I can imagine is that people are bitter and resentful that the insider had the opportunity to escape the sinking ship where they did not. But this is not a case where he escaped at anyone else's expense.

Making someone else lose their shirt because "misery likes company" is ridiculous. Hauling innocent businessmen off to jail is a disgusting perversion of justice that should end now.

June 11, 2003

Charles McDowell [send him mail] is an electrical engineer in Cedar Rapids, Iowa.

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