A major piece of financial news last week was billionaire Raj Rajaratnam’s conviction on 14 counts of securities fraud and conspiracy. Rajaratnam, founder of the hedge fund Galleon Group, was worth an estimated $1.8 billion in 2009. His conviction has pleased those who want the feds to crack down on “insider trading” and show the fat cats on Wall Street that they aren’t above the rules.
Although the public generally loves the fall of a ruthless and greedy financial titan — this, of course, is what made Oliver Stone’s original Wall Street such a hit — economists have argued for decades that the practice of “insider trading” can actually be beneficial. In practice, the government can use the amorphous “crime” to go after any successful trader it wants. In a free society, there would be no such thing as laws against so-called insider trading.
The Facts of the Case
To argue that “insider trading” is a bogus offense, and that laws against it only give the government the power to interfere with economically beneficial activity, is not to suggest that Rajaratnam was an innocent babe in the woods. Indeed, some of the episodes being used to shock the general public would probably also be criminal in a genuinely free market.
For example, in 2008, Rajat Gupta, a board member at Goldman Sachs, apparently told Rajaratnam that Warren Buffet was about to invest $5 billion in Goldman. Rajaratnam bought millions of dollars worth of the stock before the market closed, and then he profited handsomely when the news broke and the stock jumped the next day. Later in the year, after a board meeting, Gupta apparently told Rajaratnam that Goldman would report earnings well below expectations. Rajaratnam dumped the stock, getting out before the earnings news became public and pushed down Goldman’s share price.
Now this type of activity — let alone the breaking and entering that Charlie Sheen’s character performed for Gordon Gekko in the movie Wall Street — would probably be criminal even in a purely laissez-faire world. Specifically, when the shareholders of a corporation appointed board members, they would presumably have standard confidentiality clauses in the contracts prohibiting this type of behavior. The same thing would hold for a law firm; it’s not good business if clients know that their lawyers can phone tips to their buddies on Wall Street while working on a sensitive case, and so a major law firm would insist that its employees sign contracts prohibiting such things.
We Want People Trading on Unique Knowledge
To understand the social benefits of insider trading, we have to first realize that stock prices meansomething. They reflect real facts about the world, such as the assets and liabilities of a particular corporation and how effectively its current management is using resources to satisfy customers.
If a computer glitch suddenly swapped the prices randomly on all corporate stocks, the result would be disastrous, and it would affect “Main Street” as much as Wall Street. For an exaggerated example, if the share price of Microsoft fell from its current level of around $25 down to $1, a “corporate raider” might find it very profitable to borrow money, buy a controlling share in the company, and sell off all company assets to the highest bidders. The high price of $25 per share fends off such efforts to break up the successful company. The assets currently owned by the Microsoft Corporation are best deployed by Microsoft, rather than being integrated into different organizations around the world.
In general, speculators perform a useful social service when they are profitable. By buying low and selling high (or by short-selling high and covering low), stock speculators actually speed up price adjustments and make stock prices less volatile than they otherwise would be.
In this context, we can see the absurdity of the general view of “insider trading.” There is a whole literature on the economic analysis of the subject, and economist Alex Padilla’s 2003 dissertation defended the practice from a specifically Austrian angle. In a nutshell, insider trading is beneficial because it moves market prices closer to where they ought to be. Those profiting from “inside knowledge” actually share that knowledge with the rest of the world through their buying and selling.
Insider Trading: Who Is the Victim?
Above, we acknowledged the fact that obtaining information in illegal ways obviously had actual victims. But the mystique behind “insider trading” suggests that somehow if a person financially profits from special knowledge, that he or she is bilking the general public.
In general, this analysis doesn’t hold up, as Murray Rothbard has pointed out. For example, suppose a Wall Street trader is at the bar and overhears an executive on his cell phone discussing some good news for the Acme Corporation. The trader then rushes to buy 1,000 shares of the stock, which is currently selling for $10. When the news becomes public, the stock jumps to $15, and the trader closes out his position for a handsome gain of $5,000. Who is the supposed victim in all of this? From whom was this $5,000 profit taken?
The $5,000 wasn’t taken from the people who sold the shares to the trader. They were trying to sell anyway, and would have sold it to somebody else had the trader not entered the market. In fact, by snatching the 1,000 shares at the current price of $10, the trader’s demand may have held the price higher than it otherwise would have been. In other words, had the trader not entered the market, the people trying to sell 1,000 shares may have had to settle for, say, $9.75 per share rather than the $10.00 they actually received. So we see that the people dumping their stock either were not hurt or actually benefited from the action of the trader.
The people who held the stock beforehand, and retained it throughout the trader’s speculative activities, were not directly affected either. Once the news became public, the stock went to its new level. Their wealth wasn’t influenced by the inside trader.
In fact, the only people who demonstrably lost out were those who were trying to buy shares of the stock just when the trader did so, before the news became public. By entering the market and acquiring 1,000 shares (temporarily), the trader either reduced the number of Acme shares other potential buyers acquired, or he forced them to pay a higher price than they otherwise would have. When the news then hit and the share prices jumped, this meant that this select group (who also acquired new shares of Acme in the short interval in question) made less total profit than they otherwise would have.
Once we cast things in this light, it’s not so obvious that our trader has committed a horrible deed. He didn’t bilk “the public”; he merely used his superior knowledge to wrest some of the potential gains that otherwise would have accrued as dumb luck to a small group of other investors.
To repeat, stock-market speculation is not a zero-sum activity. Even though we can look at any particular transaction and tally up the “winners” and “losers,” the presence of speculators enhances the overall functioning of the stock market. For example, the market for any particular security is more liquid when there are rich speculators who will quickly pounce on a perceived mistake in pricing. If an institutional investor (such as a firm managing pensions) suddenly has a cash crunch and needs to dump its holdings, speculators will swoop in and put a floor under the fire-sale price. This is good for the beleaguered pension fund, and for the stock market in general.
Laws against Insider Trading Give the Government Arbitrary Power
Crackdowns on insider trading are harmful because they chill the cultivation of superior knowledge and speculative correction of market prices. Beyond this loss of general economic efficiency, insider-trading laws are insidious because of the arbitrary power they give to government officials.
In the specific case of Rajaratnam, prosecutors for the first time relied extensively on wiretaps to prove their allegations of insider trading. Legal experts predict that the government will expand its eavesdropping on the financial community in light of this courtroom “success.”
More generally, Murray Rothbard argued that every firm on Wall Street is technically engaging in “insider trading.” If they literally relied only on information that was available to the public, how could they make any money? Thus, the government has the statutory authority to harass or even shut down anybody in the financial sector who doesn’t play ball. In Making Economic Sense, Rothbard declared,
There is another critical aspect to the current Reign of Terror over Wall Street. Freedom of speech, and the right of privacy, particularly cherished possessions of man, have disappeared. Wall Streeters are literally afraid to talk to one another, because muttering over a martini that “Hey, Jim, it looks like XYZ will merge,” or even, “Arbus is coming out soon with a hot new product,” might well mean indictment, heavy fines, and jail terms. And where are the intrepid guardians of the First Amendment in all this?
But of course, it is literally impossible to stamp out insider trading, or Wall Streeters talking to another, just as even the Soviet Union, with all its awesome powers of enforcement, has been unable to stamp out dissent or “black (free) market” currency trading. But what the outlawry of insider trading (or of “currency smuggling,” the latest investment banker offense to be indicted) does is to give the federal government a hunting license to go after any person or firm who may be out of power in the financial-political struggles among our power elites. (Just as outlawing food would give a hunting license to get after people out of power who are caught eating.) It is surely no accident that the indictments have been centered in groups of investment bankers who are now out of power.
To drive home just how arbitrary and non-criminal “insider trading” really is, consider this scenario: Suppose someone had been planning on buying shares of Acme, but just before doing so, he caught wind of a bad earnings report. In light of the new information (which was not yet public), the person refrained from his intended purchase. Should this person be prosecuted for insider non-trading?
Conclusion
Raj Rajaratnam and (even more likely) some of his collaborators may indeed have violated genuine contractual obligations and fiduciary duties to their clients. To the extent that is true, some of their activity might have been illegal even in a truly free-market society.
In general, however, the practice of “insider trading” would not be a criminal offense, because it is impossible to define the concept in a way that wouldn’t bar legitimate speculative research and trading. In practice, these laws give the government a very blunt club with which to knock down any profitable firm it wishes.
Robert Murphy is an adjunct scholar of the Mises Institute,
where he teaches at the Mises Academy. He runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, The Politically Incorrect Guide to the Great Depression and the New Deal, and his newest book, Lessons for the Young Economist.
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If you’re an active investor who occasionally buys or sells a stock based on tips, you might be understandably nervous about the massive insider trading crackdown surrounding Galleon Group. The now-defunct hedge fund is linked to 22 guilty pleas and more than two dozen arrests involving an array of alleged conspirators, including lawyers, consultants and investment managers.
And Galleon is only the latest in a bevy of recent insider-trading prosecutions, including one case filed against a group of technology salespeople who traded Apple shares based, allegedly, on confidential information and another case that nabbed a doctor for blabbing about clinical trials for a new drug.Yet if people couldnt trade on tips, Jim Cramer, the host of CNBCs Mad Money program, would be out of work. In reality, it is perfectly legal (although potentially unwise) to trade on some tips that you hear or overhear. Illegal insider trading is all about facts and circumstances. Which situations constitute illegal insider trading and which dont?
TAKE OUR QUIZ: ARE YOU GUILTY OF INSIDER TRADING?
Situation #1: Coffee Talk
You are standing in line at Starbucks, and a well-dressed couple in front of you is talking about retiring to Majorca after they sell their company. You recognize them as the founders of a publicly traded company and figure out that the deal hasnt yet been announced. You snap up as many shares as you can afford and make a killing when the takeover is announced. Is this insider trading?
No. If this couple bought or sold shares — or called you and tipped you off in private — it would be a violation. But illegal insider trading requires that you not only trade on the basis of important nonpublic information but that you also have some sort of duty to keep the information confidential. Former football coach Barry Switzer was sued for insider trading following a similar scenario in 1981, but he won the case because he had no duty to ignore a conversation he overheard in a public place.
Situation #2: Office Eavesdrop
Youre a janitor at a major company. You hear members of the companys board convening outside the room youre cleaning and decide to hide in the closet. The board okays a deal to sell the company for a fat premium to the current share price. You load up on the shares. Illegal insider trading?
Definitely. This is not a public place, and youd be in a position to understand that confidential information was being disclosed, which changes the calculus, says Andrew Stoltmann, a Chicago-based securities lawyer.
Situation #3: Stranger Danger
You hop in a cab at JFK and are startled by the drivers Armani suit and solid-gold pinkie ring. You learn that the driver is merely taking this shift as a favor for a friend. The driver is now happily retired, living on his investment portfolio. When you whine about your own, he says: Look, Ill give you a break. Buy as much stock in Google as you can. You do. Insider trading?
No . It may be unwise — because the cab driver could as clueless as you — but you have no reason to believe hes telling you anything thats not public information.
Situation #4: Proud Papa
Once again a cab driver is offering stock tips, but this time he mentions that his son is an attorney at Skadden, Arps, Slate, Meagher Flom, a major law firm in the merger game. Insider trading?
This scenario could qualify as insider trading. Its all about whether you have reason to believe that youre receiving important, nonpublic information from a person who has a duty to keep that information private. The cab drivers trading would definitely be verboten. Yours is in a hard-to-defend gray area, says Stoltmann.
Situation #5: Mass Exodus
You read a few years back that executives at Countrywide Financial, the big mortgage lender, were unloading their stock. You decided that they must know something you didnt, so you followed suit and sold your shares, too. Now you worry that the Feds are going to come after you. Insider trading?
For you? No. For them? Maybe. Executives can sell their own companys stock without running afoul of the rules as long as theyre not trading based on information they havent shared with the public. The SEC sued Countrywides CEO, Angelo Mozilo, and several other insiders in 2009 (after the company had been acquired by Bank of America), alleging that they had improperly traded on undisclosed information about the evil lurking inside the companys loan portfolio. Mozilo, who netted some $140 million selling Countrywide stock before the company collapsed, eventually settled the suit without admitting or denying guilt by paying $67.5 million in fines and disgorging profits.
As for you: Mozilos trades were disclosed in SEC filings and in numerous news stories. Trading based on publicly available information is perfectly legal.
Situation #6: Disgruntled Employee
A woman in your Bunco group says shes about to quit her job because she cant stand the strain of working in a medical office where all the patients are dying. Because of previous casual conversations, you know that patients in this office are involved in early trials of a new drug. You know what the drug is and who makes it. You sell short shares of the drugs developer, betting that the stock will fall in value. Did you violate insider-trading rules?
This probably would not qualify as insider trading. Your playing partner is sharing information thats so general it cant be used to gauge whether the clinical trial will result in failure. Thus, the tip fails the materiality test. Its not significant enough to the companys stock price. And because the woman is just sharing information about the status of the offices patients and not the trial (including whether the ailing patients are taking the new drug or a placebo), no one appears to have a duty to keep quiet.
Situation #7: Disgruntled Employees Boss
Your friends boss calls and begs you to talk your friend out of quitting. The boss tells you confidentially that the drug trial your friend is upset about will soon be terminated because the drug is probably responsible for the deaths of those in the trial. You sell the developers stock short. Are you violating insider-trading rules now?
Yes. Youve been fed important information from an insider, who has said that the information was confidential. The SEC recently filed an insider-trading case against two individuals — a hedge fund manager named Joseph Chip Skowron and a medical researcher, named Yves Benhamou, who was overseeing a drug trial. The SEC alleges that Skowron paid Benhamou with envelopes stuffed with cash for confidential information about the results, which he then used to avoid tens of millions in stock losses on his holdings in Human Genome Sciences. Benhamou pled guilty; the case against Skowron is pending. The hedge fund Skowron worked for settled without admitting or denying guilt.
Situation #8: Shared Broker
Your broker calls and says you need to get out of ImClone Systems now because the CEO, who is also his client, is selling all his shares. Insider trading?
Maybe. The SEC filed suit against homemaking personality Martha Stewart in 2003 with these exact facts. Stewart did end up going to prison — but not for insider trading. She was convicted of obstructing justice and lying to prosecutors. Stewart settled the SECs insider-trading case, paying a fine and agreeing to never violate securities laws in the future. The settlement eliminated the need for a trial as well as a definitive answer about whether she had a duty to ignore the tip. But the case was complicated by the fact that Stewart had once been a stockbroker. The SEC contended that she should have known better.
Situation #9: Gordon Gekko
Youre a hedge fund manager, buying and selling stocks constantly. You pay a series of experts to feed you hush-hush information about pending mergers, and you earn millions in profits by buying shares of takeover targets before deals are announced. Insider trading?
Absolutely. If you bribed or bought insider information and traded on it, youre going to prison.
Situation #10: Information Seeker
Youre a hedge fund manager, and you pay dozens of analysts and consultants to provide seasoned advice about stocks to buy and sell. Some of those consultants may have access to secret information, but you trade based on a wide array of factors, including examination of public documents and detailed analysis about industries and companies operating within them. Insider trading?
This situation probably would not be considered insider trading. The key to the case against Galleon CEO Raj Rajaratnam hinges, says Stoltmann, on whether his lawyers were able to establish that his trading was based on assembling a mosaic of information or whether he paid consulants to feed him insider tips. The former, says Stoltmann, is perfectly legal. The latter is not.
After reading the NY Times account of David Sokol’s trading in Lubrizol just prior to pitching the stock to his boss, Warren Buffett , it seems crystal clear that Sokol engaged in insider trading.
But why should anyone be surprised by this? In my view Buffett and Berkshire have always been the ultimate insiders. Because of Warren’s status as a living investment legend he has access to all kinds of information average Joe investors only read about weeks later in the financial papers. I assume that having “insider” access is part of the culture at Berkshire, just as it is at big money hedge funds.
For example at the depths of the financial crisis, it was Buffett that got the call from Goldman Sachs offering him a sweet deal on 10% yielding $5 billion in preferred stock. Buffett also got a load of stock warrants.
Who get’s to buy $5 billion in Goldman Sach’s preferreds with a junk bond yield? No one but Berkshire Hathaway. Warren got a similarly sweet deal from General Electric at the depths of the financial crisis.
At the time of the Goldman purchase, in the Fall of 2008, Warren was being asked to lend a big vote of confidence to the American financial system by making a big investment in the world’s best known investment bank. Buffett’s profit on the whole Goldman rescue, including preferred dividends and stock warrant profits, will be north of $3.7 billion. Not a bad ROI for a $5 billion cash outlay. It’s the kind of profits you would expect “insiders” to make, not average Joe investors.
So as Raj Rajaratnam’s trial plays out in the media, investors should keep in mind that in the clubby moneyed world of giant hedge funds ( Berkshire is the probably biggest and most successful quasi-hedge fund ever), insider trading is pretty much commonplace. The smart money guys get information earlier than the rest of us, they act on it and make huge profits.
Don’t be surprised if people connected with some of the hottest new tech companies find themselves hauled into court on insider trading charges.
Many in Silicon Valley apparently believe that insider trading rules don’t apply to buying or selling stakes in non-public companies like Twitter and Facebook.
Recently, in an article about a Facebook employee who allegedly bought shares in his the company in advance of an investment by Goldman Sachs (NYSE: gs), Sarah Lacy and Michael Arrington of TechCrunch wrote: “In a public company this would almost certainly violate a number of federal laws. However, say sources, the fact that Facebook is not (technically) a publicly traded company means those laws don’t apply.”
Henry Blodget of Business Insider recently voiced a similar thought in an article about the venture capitalist John Doeer.
“Legendary venture capitalist John Doerr is said to have once described his investment philosophy as ‘no conflict, no interest.’
In other words, when Doerr and venture capital firm Kleiner Perkins aren’t privileged enough to enjoy a potential conflict of interest with respect to a potential investment, they have no interest in making the investment.
In the public markets, some investors might describe this as having ‘an edge.’ Others might describe it as investing with the benefit of influence and information that other investors don’t have. Others might say, at least in some cases, that it might be investing with inside information-a.k.a., insider trading.
But in private markets there are no clear rules about insider trading.”
Based on discussions I’ve had with other folks in the tech start-up scene, this interpretation is very common.
“It’s very widespread,” Silicon Alley Insider reporter Nick Carlson told me.
Wrong
It’s also wrong. Insider trading rules aren’t limited to stocks traded on public stock markets-they apply to every kind of security interest or option to buy shares.
But armed with this mistaken interpretation, it seems likely that people in the tech sector are probably buying or selling stakes in companies while in possession of material non-public information.
Companies like SecondMarket put investors together with shareholders of non-public companies. This allows people – mostly early stage venture capital investors or employees who were compensated in shares – to monetize their stakes without waiting for an IPO or a buyout.
It’s easy to see how insider trading can develop in such illiquid and non-transparent markets. If, for instance, you are a Facebook employee who has been privy to internal discussions about a possible acquisition of the social-media start-up Foursquare, you might decide to invest in Foursquare ahead of the acquisition.
Or maybe you’re a venture capitalist who has chatted with Foursquare founder Dennis Crowley about a not yet publicly announced new feature that you think will really improve user experiences. Based on the chat, you buy up some shares on Second Market.
In either case, you’d be engaging in illegal insider trading that could land you in court facing the Securities and Exchange Commission or even criminal charges.
Insider trading is barred under Section 10(b) of the Exchange Act of 1934 and Rule 10b-5, a regulation that the SEC made to implement that provision of the Exchange Act. They bar anyone from using “any deceptive device” in connection with the purchase or sale of securities.
The SEC long ago persuaded the courts that using “material non-public information” to make trades was a form of fraud that was barred under the act-giving birth to the rule against insider trading.
While it’s true that most insider trading cases involve the purchase or sale of stocks that are traded on public exchanges, there’s nothing in the rule or the case law that limits enforcement to public stocks. Buying or selling any security-including privately held shares of non-public companies – while possessing material non-public information is potentially insider trading punishable under the law, regardless of where the sales take place.
The SEC is now on notice that the tech sector seems to have adopted the mistaken belief that buying stakes in private companies while possessing inside information is not illegal.
Facebook fired a senior employee who bought Facebook shares through secondary markets in violation of the company’s policy on insider trading, according to people with direct knowledge of the matter.
The episode could bring further scrutiny to markets that deal in shares of private companies like Facebook, Twitter, LinkedIn and Zynga. The Securities and Exchange Commission began an inquiry into these markets last year.
The employee, Michael Brown, worked in corporate development. In a statement e-mailed by his lawyer, Edward Swanson, Mr. Brown said: “I did buy Facebook stock on the secondary market in early September 2010, and I did so with the absolute best of intentions and only because I believe in Facebook.”
Mr. Brown’s ouster was first reported by TechCrunch.
TechCrunch initially wrote that Mr. Brown had bought the shares ahead of a $1.5 billion financing round led by Goldman Sachs in January.
In an apparent reference to that report, Mr. Brown said: “False and damaging information has been published about my actions.” He added that he had no knowledge of the Goldman Sachs deal “until it appeared in the press in January 2011.”
TechCrunch updated its story Friday morning, saying that Mr. Brown may have bought the shares in September.
Facebook fired Mr. Brown a few weeks ago, according to the people with knowledge of the firing, who agreed to speak on the condition of anonymity because they were not authorized to discuss it.
Stephen Diamond, a professor at Santa Clara University who teaches securities law, said that many of the legal restrictions on insider trading applied equally to private and public company shares.
“If the employee had material information which he did not share with the seller, he could be charged with violating the law,” Professor Diamond said.
The episode could also bring further scrutiny from the S.E.C. to exchanges like SecondMarket and SharesPost, he said.
“This could be evidence that the control procedures in these markets are not sufficient,” Professor Diamond said.
According to Mr. Brown’s LinkedIn profile, he had been employed at Facebook since April 2009. Before that he worked at Foundation Capital, a Silicon Valley venture investing firm.
“I am saddened by the course of events that led to my departure and the incorrect reporting of it,” Mr. Brown said. “I am now focused on moving on past this unfortunate series of events.”
