Proponents of insider trading laws typically claim that the laws are necessary to prevent a kind of “fraud” or “unfairness” in the securities markets. The idea is that it’s unfair for someone to trade on information that is not available to the public, because they have an advantage that allows them to “harm” others when they buy stock whose price will go up or sell stock whose price will go down. One of the jurors in Martha Stewart’s criminal trial captured this attitude after Stewart was convicted of lying to investigators after selling stock based on an inside tip: "Maybe it's a victory for the little guys who lose money in the market because of these kinds of transactions."
Keep this argument in mind as you consider the following:
Two researchers recently discovered an uncanny correlation between SEC investigations and SEC employees selling shares in companies that were under investigation — right before the investigations were made public. By selling shares in this manner, according to the researchers, SEC employees were able to earn positive returns on their portfolios. Here’s their study. When the SEC learned about the findings, it was undeterred. Of course we sell shares in the companies we are investigating, the SEC said. Otherwise, we would have a conflict of interest.
So to sum up the SEC’s position: In order to avoid a conflict, which would be unethical, they need to sell shares based on nonpublic information, which is illegal, and, according to their own rationale, unethical and harmful to investors — so much so that people convicted of insider trading typically pay hefty fines and spend time in jail.
Could it be that the SEC does not really believe the argument that insider trading “harms” or “defrauds” anyone?
It shouldn’t believe that argument, nor should anyone else. Trading based on nonpublic information is not fraud, and it makes no sense to say that it harms other investors. Fraud occurs when someone steals something of value by means of a lie or misrepresentation. So selling a worthless piece of paper by pretending it is actual stock in a company would be fraud. But selling an actual share of stock because you have information you think will cause the stock’s price to decline is not fraud. It’s just what people do in the market.
Securities markets exist because people with differing views of the value of securities — which means different knowledge and information about a wide range of things — want to trade them with each other. When you buy stock, you are guaranteed only to get what you paid for, which is stock in a given company at a given market price. When you sell, you are guaranteed to receive the price at which you sold. That’s it. No one promises that you will profit from your transaction, so there’s nothing “unfair” or “fraudulent” about them having more information than you about where the price is likely to go. In fact, the built-in assumption of the market is that buyer and seller disagree about the future value of the stock, which is why one is buying and the other selling.
For anyone who thinks it is “unfair” for the other guy in a transaction to know more than you, ask yourself, what would “fairness” look like? Should he have to guarantee that you both have the same amount of knowledge or information, which would be impossible? Should he be able to buy or sell only if he thinks you will make money and he won’t? That would defeat the purpose of trading securities.
Insider trading laws are based on an egalitarian view of markets in which everyone must have equal information, equal knowledge, and equal expertise. But that’s not what markets are or could possibly be. If you don’t like that — if you’re troubled by the possibility that the guy on the other end of a stock transaction might know more than you about where the price might go — then the answer is to avoid stocks. Invest in mutual funds or put your money in the bank.
Of course, none of this means that companies can’t voluntarily impose conditions on the stock trading of their employees if they think certain types of trades would pose conflicts of interest, and they can require that all sorts of information remain confidential, which companies do now. But those are issues for the company to decide. The government’s only role should be to enforce contracts and prevent theft and fraud.
Nor does the fact that insider trading laws make no sense get the SEC off the hook in this situation. The SEC is right that owning shares in companies they are investigating is a conflict of interest, but they should not be permitted to do something that would land the rest of us in jail. So long as we have these laws on the books, I say SEC employees shouldn’t be able to own securities at all.
If the SEC is going to enforce a kind of “information equality” on the market, it has no right to act as though it is “more equal” than the rest of us.