How insider trading laws became the crooks' best friend

Andrew Verstein’s blog post on “Insider Tainting: Strategic Tipping of Material Non-Public Information” at the CLS Blue Sky Blog made me think about the numerous ways in which insider trading laws have become the crooks’ best friend. Verstein gives an example based on a controversial real life episode, but I would prefer to rephrase it as a purely hypothetical situation:

Consider a small company (let us call it SmallCo) which has not been doing too well. The company plans to issue new shares to shore up its capital though this would dilute the existing shareholders. At this point of time, SmallCo's CEO comes to know that the largest shareholder in the company (let us call him John) is on the verge of selling his shares. If John sells his block, that would send a negative signal to the market about SmallCo's prospects and would frustrate its plans to raise new capital. More menacingly, if John’s stake ends up in the hands of an activist investor, that would lead to a lot of pressure on the existing management and even a change of management – SmallCo's CEO could end up losing his job. The CEO comes up with a brilliant plan to stop John from selling his stake (and save his job): he simply calls up John and informs him of the confidential plan to sell new shares. John is now “tainted” with insider information, and may not be able to sell his stake without attracting insider trading laws.

While this is a shocking illustration of how a crooked CEO may be able to recruit the securities regulator itself as his partner in market manipulation, the more important question to ask is why did the securities regulator choose to frame laws that end up having this perverse effect. In my opinion, the true reason for this is the regulatory capture of securities regulators worldwide by the intermediaries that they regulate.

As part of this argument, I would like to draw on a brilliant blog post by Judge Rakoff in 2013 on “Why Have No High Level Executives Been Prosecuted In Connection With The Financial Crisis?” (I blogged about this piece at that time). Rakoff quickly dismisses the argument that no fraud was committed, and that the Global Financial Crisis was simply a result of negligence, of the kind of inordinate risk-taking commonly called a ‘bubble.’ The judge cites various official reports to demonstrate that “in the aftermath of the financial crisis, the prevailing view of many government officials (as well as others) was that the crisis was in material respects the product of intentional fraud.” He then articulates what he regards as the most important reason why no such prosecutions happened:

First, the prosecutors had other priorities.

...

Alternative priorities, in short, is, I submit, one of the reasons the financial fraud cases were not brought, especially cases against high level individuals that would take many years, many investigators, and a great deal of expertise to investigate.

Insider trading prosecutions (Martha Stewart, Raj Rajaratnam and Rajat Gupta) and Ponzi scheme prosecutions (Bernie Madoff) in my view played an important role here. The public’s anger was assuaged by prosecuting some high profile individuals, and this served to deflect attention from the fact that the executives running the large institutions escaped scot-free.

What is interesting about insider trading prosecution is that it allows financial sector regulators to target people who are outside (or at the periphery of) the financial system. It is therefore extremely attractive to regulators who have been captured by its regulatees. It is able to project an image of being a very tough regulator without causing much harm to its own regulatees.

This perspective explains several puzzling facts about the evolution of insider trading law:

Insider trading law and enforcement has expanded though there has been a strong academic argument going back half a century for legalizing insider trading (see for example, Henry Manne and Hu and Noe). Even if one does not go that far, there is a strong argument for decriminalizing insider trading and making it purely a civil liability. I have been making this argument for nearly 15 years now (see for example here).
Regulators have progressively sought to enlarge the definition of insider trading to cover many legitimate activities on the ground that without such an expansive definition, insider trading becomes hard to prove. I often joke that the prohibition of “insider trading” has gradually morphed into the prohibition of “informed trading.”
Regulators have rarely used their powers judiciously and have typically tended to pursue specific high-profile cases for extraneous reasons.

Posted at 4:44 pm IST on Fri, 29 Sep 2017 permanent link

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