Free the Inside Traders

Manhattan U.S. attorney Preet Bharara claimed another victory in his crusade against “insider trading,” a practice he once called “pervasive.”  Last week he won a conviction against Mathew Martoma, formerly at SAC Capital. 

Another big scalp was hedge fund billionaire Raj Rajaratnam, convicted in 2011 and sentenced to 11 years in prison.  A decade ago Martha Stewart was convicted of obstruction of justice in an insider trading case.

Objectively, the insider trading ban makes no sense.  It creates an arcane distinction between “non-public” and “public” information.  It presumes that investors should possess equal information and never know more than anyone else. 

It punishes traders for seeking to gain information known to some people but not to everyone.  It inhibits people from acting on and markets from reacting to the latest information. 

Martoma was alleged to have gotten advance notice of the test results for an experimental drug.  Martoma then was accused of recommending that SAC dump its stock in the firms that were developing the pharmaceutical.

If true, SAC gained an advantage over other shareholders.  But why should that be illegal?  The doctor who talked deserved to be punished for his disclosure.  However, Martoma’s actions hurt no one.

SAC avoided losses suffered by other shareholders, but they would have lost nonetheless.  Even the buyers of SAC’s shares had no complaint:  They wanted to purchase based on the information available to them and would have bought the shares from someone else had SAC not sold.

Of course, some forms of insider trading are properly criminalized—typically when accompanied by other illegal actions.  For instance, fraudulently misrepresenting information to buyers/sellers.  However, because of the usual anonymity of stock market participants in most cases it would be impossible to offer fraudulent assurances even if one wanted to.

The government has regularly expanded the legal definition of insider trading.  For instance, in 1985 the government indicted a Wall Street Journal reporter for leaking his “Heard on the Street” columns to a stockbroker before publication. 

As I pointed out in my latest Forbes online column

Doing so might have violated newspaper policy, but that was a problem for the Journal, not the U.S. attorney.  The information was gathered legally; the journalist had no fiduciary responsibility concerning the material; there was nothing proprietary about the scheduled columns.

Other cases also have expanded Uncle Sam’s reach.  Information is currency on Wall Street and is widely and constantly traded.  Punishing previously legitimate behavior after the fact unfairly penalizes individual defendants and disrupts national markets.

As applied, the insider trading laws push in only one direction:  they punish action.  It is virtually impossible to penalize someone for not acting, even if he or she did so in reliance on inside information.  This government bias against action, whether buying or selling, is unlikely to improve investment decisions or market efficiency.

Indeed, it is impossible to equalize information.  Does anyone believe that such markets ever will be a level playing field? 

Wall Street professionals are immersed in the business and financial worlds.  A part-time day trader knows more than the average person who invests haphazardly.  Even equal information is not enough.  It must be interpreted.  And people vary widely in their experiences and abilities as well as access to those better able to do so. 

A better objective for regulators would be to encourage markets to adjust swiftly to all the available information.  Speeding the process most helps those with the least information, since they typically have the least ability to play the system. 

Regulators speak of the need to protect investor confidence.  But is there really any small investor who believes that imprisoning Martoma makes him or her equal on Wall Street?  How many people put more money in their mutual fund because of the war on insider trading?

Enforcing insider trading laws does more to advance prosecutors’ careers than protect investors’ portfolios.  Information will never be perfect or equal.  However, adjustments to information can be more or less smooth and speedy.  Washington should stop criminalizing actions which ultimately yield more benefits than costs to the rest of us.