There is no “how to” in this article. There is no investment advice. Instead, for the astute, there are objective, honest, and practical principles hiding within this opinion piece which could potentially give any investor an advantage over others in the financial markets.
I know the usual responses having to do with fairness and equity, and even fiduciary duty. But is the simple act of trading on information that isn’t widely known morally wrong? Today, the Securities and Exchange Commission (SEC) publishes a running total of the insider trading cases it pursues. If the SEC is going after these people, they must have done something wrong, right?
Today, insider trading cases often hinge on the accusation of either a breach of contract or a breach of fiduciary duty. Practically every case that comes across a prosecutor’s desk involves some type of immorality. But, it goes beyond that. The “moral crime” of insider trading allows otherwise honest people to be smeared. The very phrase has become so dirty that the general public believes that there’s no way it could possibly be moral. But, historically, it was not considered an immoral activity. When the market was more free than controlled, it was somewhat common for corporate insiders (i.e. CEOs of companies) to profit from information that was not made public. For example, the famous railroad builder James J. Hill took no salary for himself for decades while he built his empire. Instead, he profited from the gains in the stock of the Great Northern railroad he owned.
What Hill was doing then would, today, be considered “insider trading.” During Hill’s time, however, there was no SEC, and companies were free to write corporate by-laws and employer-employee contracts any way they wanted. If a corporation wanted to allow its employees to engage in insider trading, they could.
If a company thought employees were abusing the practice, it could prohibit it or fire the employee. But it was actually uncommon for companies to prohibit trading on inside information, and the government respected the contract rights of companies and employees.
Moreover, companies at that time realized that insider trading wasn’t harmful to anyone. Why? Because trading on insider information doesn’t really impact the price of a stock; information does. It’s the nature of the information itself that is responsible for a stock’s price. As far as financial markets are concerned, it doesn’t matter how information makes it to the marketplace. All that matters is that it gets there – and the more information traders have, the better.
When there’s no breach of contractual fiduciary responsibility, and no fraud involved, there’s no crime. At this point, you’ll probably hear people cry, “but it’s unfair.” But is it?
It’s only in the financial world where earned profits and unequal outcomes are seen as unfair.
For example, suppose a journalist is about to break a story about some political scandal. This is the scandal of the century. It implicates the President of the United States, and several cabinet members, and could radically change politics forever. To get his story, the journalist had to rely on secret contacts. He also had to keep the story “hush, hush” for several months while gathering and verifying all of the details. He scooped all of his peers. Is he sent to jail? Hell no. He wins the Pulizter Prize. Yet, if this were the financial world, and he had used non-public information to scoop other investors, he’d be guilty of the crime of “insider trading.”
Or what about a man who pursues a woman he’s interested in, and comes up with a great first-date idea based on information provided by mutual friends of theirs – information that’s not widely known (i.e. it’s non-public)? Is the man morally corrupt? Should he be sent to jail? No, of course not.
What about a scientist who does original research, uncovers the cure for all cancers, yet sells his non-public information (and invention) to drug companies for billions ahead of everyone else? Is he a criminal? Hardly. He’s a hero. He just cured cancer.
What’s so different about a man pursuing a romantic interest, or a journalist scooping a story, or a scientist making the discovery of the century, and someone investing on non-public information for profit?
To the critics, there is a difference. The difference is in the minutia of the specific examples. The critics embrace a mystical premise that the “pie of wealth” is limited, and that it’s divided up amongst people. Some people get more (presumably by unfair means) and others get less. They reject the idea of a dynamic pie that grows larger and makes everyone better off. These critics cannot or will not think in principles. To them, there is no common theme running through all of these examples.
Back in reality, one man’s gain in romance doesn’t prevent others from finding love elsewhere. Likewise, the journalist’s story doesn’t prevent other journalists from being successful in their own endeavors. There are so many scientific discoveries to be made, the cure for cancer doesn’t prevent other scientists from finding cures for other, perhaps more insidious, illnesses or… making new discoveries that improve life for everyone on Earth. It’s the same in the financial markets – someone’s gain is not someone else’s loss.
In fact, when you trade value for value, everyone involved in the trade wins. A journalist only has a secret source because the informant finds the journalist’s proposal to work together appealing in some way. A man only gets a date with a woman because she finds his offer attractive. A scientist that sells the cure for cancer clearly benefits monetarily, but so does the drug company.
But what about the people not involved in the trade? What happens to them? Well, if they are rational, they might benefit as well. Take the case of the scientist or the journalist. If you suffer from cancer, would you benefit from the scientist’s hard work? What about the journalist? If you knew about the scandal, do you think that would allow you to make a more informed choice during the next election?
Now, what about insider trading? Suppose that you learn about a company’s new product line ahead of everyone else – you have access to private documents that detail what the product is. Let’s assume that it’s also not against company policy to trade on this information, and you gained that information honestly through your own efforts. You know this will be a revolutionary discovery, so you decide to invest.
When the press release hits, the company’s stock soars. You’re a multimillionaire. You spend some of that money, but you reinvest the rest for potentially more profit – you benefit and so do others as a natural consequence. But who loses? No one. In fact, this kind of scenario was somewhat common in the 1920s. During that time, stock pools were large “pools” of money that were invested in the stock market. Normally, a stock pool collected money from numerous investors, and a fund manager was appointed to invest that money into a particular stock or group of stocks.
It’s been hypothesized that the sheer volume of money in these pools was used to influence stock prices to the detriment of other investors not involved in the stock pool. In The Stock Pools and the Securities Exchange Act, Paul G Mahoney of the University of Virginia School of Law shows that:
It is likely that some pools were formed to trade on the basis of non-public information, which explains why contemporary observers claimed that the price of the target stock frequently rose just after formation of a pool. Company insiders participated in some pools. Moreover, because bankers and brokers commonly sat on the boards of industrial companies, a brokerage firm that operated a pool would sometimes have a partner who was also an insider of the subject company.
This squares with other research done on the stock pools of the 1920s:
…when available, against the list of directors and officers contained in Moody’s Manuals, we can determine that at least 12 of the 55 pools in our sample included a corporate officer or director.
This same research suggests that:
We find abnormal trading volume during pools, consistent with market manipulation, but this trading led to only modest increases in price in the short run and no abnormal performance in the long run. Thus, there is no evidence that the stock pools harmed small investors.
The fact that there were insiders sitting on some of these stock pools, yet there was no evidence that any outside investors were harmed, demonstrates something very important – stock pools did not harm investors and, by extension, insiders sitting on these pools did not cause harm to other investors in the financial markets. Why do we have insider trading laws then?
Well, the answer is actually very simple. Some people believe that making money is morally suspect – that the profit motive is morally suspect. They refuse to accept that one person can gain an advantage over another without harming that other person or anyone else in the process. This is exactly how our securities laws were drafted – in the absence of any evidence of wrongdoing on the part of insiders or harm to investors.
Rather than protecting investors, the SEC only gets in the way, preventing employers from freely contracting with employees to allow insider trading. Instead of prohibiting the right to contract, we should protect it. Instead of punishing insiders for their accomplishments in the financial markets, we should repeal insider trading laws. We should let people trade on information they’ve rightfully earned.
But… we don’t.