Insider Trading Debates

Print Friendly, PDF & Email

Raj Rajaratnam

Insider trading is back in the news. The SEC has shown heightened interest in prosecuting these cases, evidenced by the high-profile arrest of Galleon hedge fund manager, Raj Rajaratnam, on civil and criminal charges.

One thing to keep in mind is that insider trading is not defined in the federal securities laws. The SEC has developed insider trading through an interpretation of Section 10(b) of the Securities Exchange Act of 1934 that insider trading is a “deceptive device” under that section and and the anti-fraud provisions of Rule 10b-5.

Given that, there has always been some academic discussion about whether insider trading should be illegal. That discussion moved to the front burner after an opinion piece by Donald J. Boudreaux in the Wall Street Journal: Learning to Love Insider Trading. Donald J. Boudreaux is Professor of Economics at George Mason University and a Senior Fellow at the Mercatus Center.

Mr. Boudreaux latches on to the argument that insider trading allows better information into the markets, allowing for greater economic efficiency. “When insiders trade on their nonpublic, nonproprietary information, they cause asset prices to reflect that information sooner than otherwise and therefore prompt other market participants to make better decisions.” He thinks the capital markets will reward companies that self-impose restrictions on insider trading and punish those that don’t. So, market discipline is better than government regulation and prosecution.

I see some interesting things in this argument. Obviously, we would need prompt and transparent information on when insiders make trades. Delayed reporting undercuts this efficient market argument.

The bigger problem is the shifting of rewards to individuals. It seems inherently unfair that an insider could get a windfall profit from information that is not available to a wider audience. The insider is always going to have better information and should always be ahead of the market.

I could see the perverse effect of insiders purposefully delaying the public release of information to increase their own personal reward. Even worse, they could give false signals to the public in order to sell their shares at a higher level or buy at a cheaper price.

In the end you prosecute companies for poor disclosure, while individuals inside the company profit. You still end up with the government looking over the corporate shoulder at the information they disclose and who benefits from it. Then the government decided whether or not to prosecute.

Regardless, the arguments are purely academic. Insider trading is illegal and compliance officers need to be vigilant to make sure it does not occur. The downfall of Galleon and Raj Rajaratnam should be a stark examples. The indictment on insider trading charges sent them plummeting into the abyss. Galleon has gone from managing billions to possibly going out of business in the course of a week.

References:

Author: Doug Cornelius

You can find out more about Doug on the About Doug page

3 thoughts on “Insider Trading Debates”

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.