Insider Trading: The Rule of Unreason

In 1962, Ayn Rand wrote:

It is a grave error to suppose that a dictatorship rules a nation by means of strict, rigid laws which are obeyed and enforced with rigorous, military precision. Such a rule would be evil, but almost bearable; men could endure the harshest edicts, provided these edicts were known, specific, and stable; it is not the known that breaks men’s spirits, but the unpredictable. A dictatorship has to be capricious; it has to rule by means of the unexpected, the incomprehensible, the wantonly irrational; it has to deal not in death, but in sudden death; a state of chronic uncertainty is what men are psychologically unable to bear.

She goes on to observe, “The American businessmen have had to live in that state for seventy years.” Rand was talking about antitrust laws. But she could just as easily have been talking about laws that punish insider trading.

Yesterday, the Supreme Court heard arguments in Salman v. United States, a case that illustrates the vague, arbitrary, and capricious nature of insider trading “laws.”

Insider trading laws restrict people’s ability to buy and sell securities based on “material nonpublic information.” But what the government considers insider trading is often so nebulous that it amounts to ex post facto law: in many cases, it is impossible to know whether you’ve committed a crime until the government says you committed one.

Take the Salman case, in which Bassam Salman was convicted for trading on information he got from his brother-in-law, Mounir Kara, who got it from his brother, Maher Kara, who obtained the information from his work in the health care investment banking group at Citigroup.

Although no one disputes that Salman traded on information passed down from his brother-in-law, it’s hardly an open-and-shut case. It’s not always illegal for an outsider to trade on a tip from an insider. If a stranger who worked at Citigroup had revealed the information during a casual chat at a bus stop, Salman would not have been committing a crime trading on the information. But an outsider can be considered an insider by the law under certain circumstances. A 2014 federal appeals court ruled that the recipient of insider information can be penalized if he knew that the individual providing the tip was revealing confidential information in exchange for a “personal benefit.”

The question in the Salman case, then, is whether Maher received a personal benefit when he revealed information he learned at Citigroup. Maher did not trade on the information, nor did he receive any material benefit from his brother’s and brother-in-law’s trading activities. But a lower court held that because Maher passed along the information to help out the people he loved, that was enough of a personal benefit to make the action criminal. This led Cato’s Thaya Brook Knight to quip, “If they had loved each other less, would Salman still be facing prison?” 

But what’s outrageous here is not that the government is treating satisfaction from helping a family member as a personal benefit — it’s that everyone agrees that the law did not clearly spell out that Salman’s action was illegal. According to accounts of Wednesday’s oral arguments, America’s greatest legal thinkers are struggling to define what counts as a “person benefit” rendering a trade criminal — and yet Americans are being sent to prison for failing to divine the whims of regulators and prosecutors.

Don’t make the mistake of thinking this particular case is somehow unique. In case after case what you find is twisting, changing, expanding definitions of what insider trading is — definitions that are only made explicit after the government’s axe has fallen.

Just one example. (You can find many more in Daniel Fischel’s excellent book Payback: The Conspiracy to Destroy Michael Milken and His Financial Revolution.) One of the most important Supreme Court insider trading cases, Dirks v. SEC, started when security analyst Raymond Dirks received a tip about fraud going on at the Equity Funding insurance company. Dirks tried to bring the fraud to the attention of the press and the government, but when no one paid attention, Dirks told his clients, who sold their shares in Equity Funding.

The fraud eventually came to light, Equity Funding’s stock collapsed, and — you can guess what happened next — the SEC went after Dirks for illegal insider trading since he got the initial tip about the fraud from Ronald Secrist, a former Equity Funding employee. According to the SEC, securities laws “require equal information among all traders” — which must have come as news to traders like Dirks, who made a living in large measure by digging up more information than their rivals.

The case eventually went to the Supreme Court, which ruled in Dirks’s favor, rejecting the SEC’s “equal information” notion. But the very fact that Dirks was targeted to begin with reveals how “flexible” insider trading laws are. And make no mistake: the government

likes things that way. As the Wall Street Journal points out:

Congress has never clearly defined insider trading. The Securities and Exchange Commission could define it more clearly, but it resists doing so because the ambiguity benefits regulators and prosecutors who can make up their own standard case by case. The result is arbitrary enforcement that aggrandizes prosecutors at the expense of the rule of law.

All of this would be bad enough if insider trading laws were just lousy attempts to define a legitimate crime. But in reality what they criminalize is voluntary behavior that violates no one’s rights.

The stock market exists so that people can buy and sell securities in the pursuit of their self-interest. A trade involves a buyer bidding for a security and a seller accepting or rejecting the bid. Both sides are acting on their knowledge and judgment about the value of the security, and neither presumes that their knowledge and judgment is identical to their counterparty’s. On the contrary, most trades occur precisely because people have different beliefs about the value of a security, and each party enters the transaction knowing he might be wrong. The fact that one person has inside knowledge makes absolutely no difference to the nature of the transaction. There’s no fraud involved. No deception. It’s completely voluntary.

Take the Salman case. We don’t know who he bought his stock from. What we do know is Salman didn’t take anything from them, except an unexpected windfall they no doubt regretted missing out on. But missing out on a rising stock price isn’t a harm, let alone a rights violation. It’s a risk you assume whenever you trade.

A proper legal system has one function: to protect individual rights. That means barring force and fraud. If someone wants to argue that some of the actions that currently fall under “insider trading” involve rights violations, then I’m all ears. But often those who argue for criminalizing insider trading don’t bother trying to identify a victim whose rights have been violated. Instead, they appeal to various government “interests,” such as maximizing market efficiency, bolstering investor confidence in markets, or putting the small investor on a level playing field with professionals.

These are bad arguments even on their own terms (see, for instance, here, here, here, and here), but they all miss the point. The government has an awesome power — the power to legally use physical force — and that power should be used only to protect the freedom of its citizens. To throw people in prison in the name of “efficiency” or “investor confidence” is the real crime.