This week I stumbled across a short note in the Wall Street Journal that was probably overlooked by most readers:
Associated PressNEW YORK — A former Oppenheimer & Co. Inc. financial adviser has pleaded guilty to insider trading charges in New York City.
David Hobson entered the plea to conspiracy to commit securities fraud and securities fraud Tuesday in Manhattan federal court.
He admitted teaming up with a childhood friend, Michael Maciocio, at Pfizer Inc. to trade on secrets about potential Pfizer acquisitions. The 47-year-old Providence, Rhode Island man is set to be sentenced on March 2.
His plea deal called for him to serve between two years and 2½ years in prison, though he can argue for additional leniency. Without a plea deal, he would have faced up to 25 years in prison.
Hobson agreed to forfeit $385,000. Prosecutors say illegal trades made over $350,000 between 2008 and April 2014.
A little more searching turned up the following:
“I apologize to the court,” Hobson said as he explained that he shared his profits with Maciocio and some of his clients.
U.S. Attorney Preet Bharara said the prosecution was part of a larger effort by his office to make the securities markets fair.
Maciocio, 46, pleaded guilty in May to conspiracy and securities fraud. He’s awaiting sentencing.
As I read about yet another broker caught up in yet another insider trading case, I was reminded of a recent Yale Law Review article by Richard Epstein (Returning to Common-Law Principles of Insider Trading After United States v. Newman) in which he presents a long and well-argued case against the current insider trading laws (and their weak intellectual underpinning). I have written elsewhere that I think insider trading should be legalized for many reasons, and Epstein’s article — while not going that far — does illustrate all of the major problems with trying to prosecute an activity that (a) is inherent to efficient financial markets and (b) are unnecssary. Let me reiterate the logic behind those two claims, starting with the latter.
First of all, there is no need for laws to make insider trading illegal because the market is more than able to guard against insider trading that harms buyers and sellers without the government getting involved. As Epstein notes:
The risks of fraud and manipulation are so deadly to the market that private firms have every incentive to seek out the optimal solution to insider trading, whether by directors, officers, or ordinary employees, wholly apart from any government sanctions, in order to preserve the value of their shares.
Epstein gives examples of this very phenomenon at work and concludes, correctly, that private firms will protect themselves against the wrong kind of insider trading simply from fear of reputational damage sufficient enough to cause fatal damage to the firm:
The general lesson on insider misappropriation is this: any firm that uses inside information to trade against its own customers will not last long in the marketplace, as potential clients will move elsewhere for their business. Here is the proof: all law firms and all investment banks have elaborate rules in place that limit the ability of their partners and associates to trade on information they acquire in the ordinary course of business, many of which right now go beyond the SEC requirements.51 At this level reputational constraints are so powerful that any lawyer, banker, or accountant caught using confidential information for his own benefit would be signing his professional death warrant. The problem of the misuse of confidential information of course goes beyond the securities context, so the security-specific rules are often supplemented by legal constraints on the overall practice of law, which imposes, most notably, duties of confidentiality for lawyer-client communications52 and work product privilege.53 It is unlikely that the SEC is the best actor to catch the odd case that might slip through these two types of sanctions, given the strong private incentives to make sure that errors of this sort do not happen.
As Epstein further notes:
For example, in one recent account, Goldman Sachs took prophylactic steps “to block bankers and other employees from trading individual stocks and debt securities in their own personal accounts, or investing in certain hedge funds.”54 For a firm whose practice extends to all market groups, the broad rule is likely needed to assure Goldman that its traders will not trade against Goldman itself with firm information, and it allows Goldman to reassure its clients that their information will not go astray when entrusted to Goldman’s employees in a sensitive deal.
In other words, if insider trading is a bad thing, then any market’s participants have the strongest possible incentive to eliminate and sanction it. The government does not need to interfere in a market’s inherently corrective dynamics unless those dynamics have failed. If Wall Street were really harmed by such activities, it’s the banks themselves that would have censured it long ago, as they have with outright fraud or theft. The author rightly adds that for most firms this would be the preferred approach:
Private parties are likely to prefer working within a framework that combines a private set of ex ante precautions, ex post firm sanctions, and a large reputational hit. Yet even though the general legal climate has moved toward criminal sanctions, it is less likely that private firms, such as Goldman Sachs, would move toward that solution if left to their own devices.
If the government gets involved, then it must be because (a) the market players themselves are not stopping fraudulent insider trading sufficiently (which makes no sense of it really harms market participants) or (b) because someone in the government thinks it should be illegal even if it is not wrong. Perhaps, supporters of insider trading laws should stop and ask themselves, why has not Wall Street itself exterminated insider trading if it is so toxic to fair markets? The answer is it that it is not; in fact, in many cases trading by insiders would actually help investors more accurately price an investment, as Epstein highlights with several examples such as this one:
…in SEC v. Texas Gulf Sulphur Co.,26 a group of insiders purchased shares of the company knowing that the firm had discovered valuable copper deposits near Timmins, Ontario, which the firm desired to keep confidential until it completed the acquisition of nearby lands.27 Secrecy benefited the shareholders, because at this point it would have been foolish to publicly disclose these discoveries, which would allow competitors to hone in on the same territory and thereby drive up the acquisition cost of nearby land. Similarly, it would have been equally improvident for the insiders to dole out that information piecemeal to their friends and business associates, knowing that any actions that these people took to acquire nearby properties would necessarily work to the detriment of the shareholders.28 In contrast to these two scenarios, allowing the insiders to trade on that information could have driven up share prices in ways that reflected the value of that information, without disclosing its source. Insider trading could thus have led to more accurate pricing that in turn would have reduced sharp fluctuations in share values when the information did come to light.29
As this example notes, and as I have written in another post:
…insider trading has the capacity to (a) move the market towards correct pricing more quickly and (b) further remove the illusion that retail stock prices really reflect the true value of a company. After all, which of the following scenarios is better?
- The CEO of a corporation who knows the company’s share price will take a major hit in a year quietly resigns, sells off his stock and waits patiently for the company to fail, even as outsider investors continue to support the stock.
- The CEO sells as soon as he gets the news, signals the market something is wrong, which allows the outsiders to avoid the stock in the first place.
For me, the latter is preferable, and so I have no issue with executives moving equity prices based on non-public information. Not only that, I think making insider trading legal would forces shareholders to require greater transparency, demanding to know what execs know at the same time. This would be good for business and investors.
Returning now to my first argument against insider trading laws, insider trading is not wrong today not because of some solid ethical or legal argument, but because the S.E.C. has said it is, plain and simple. In doing so, not only has the S.E.C. created a class of criminals that should not exist, it has hindered innovation, often to the detriment of smaller firms. That may seems like an outrageous claim to make, but Esptein agrees:
…innovation depends on astute individuals finding ways to take advantage of gaps in markets, and it is through their effort to obtain extra returns that the system starts to hum. There are always entrepreneurial individuals who invest resources in an effort to locate new bits of information that will give them a leg up, which translates into higher rates of return for greater amounts of work. The more people who seek to exploit this information, the better markets will work. As stated in the Newman amicus brief authored by Professors Stephen Bainbridge, Todd Henderson, and Jonathan Macey, the information these entrepreneurs “obtain and pass on to their clients enables more accurate pricing in capital markets and helps to assure that capital will ultimately be allocated to the highest value users.”96 That flexibility could prove especially important to smallcap and midcap firms, which, while publicly traded, are not normally followed by a cadre of analysts. The prospect of some type of exclusive arrangement might increase analyst interest in following these firms’ stock. On balance, more information in a world where some firms—through their analysts—have the inside track may well prove better than the alternative world where no investor has an incentive to follow these firms’ stocks at all.
What about fairness for the “small investor,” some would ask? This brings me to my point about the illusion of value. In the majority of everyday transactions ordinary people make, there is a great deal of information asymmetry. Most used car buyers know less about the cars they are buying than the sellers do. The same goes for house buyers and job applicants. This asymmetry causes buyers to seek extra information (often at a cost) to hedge their risk. Why should stock buying be any different? Why the obsession with trying, in vain, to create the illusion of information symmetry in stock transactions when that symmetry is patently false and possibly detrimental to market efficiency? Again, Epstein states it best:
It is important, therefore, to stress that cases of asymmetrical information need not involve some form of financial unfairness. The party who gets the extra information has often put in greater effort to acquire it. And the parties who lack information have the opportunity and motivation to acquire it as quickly as possible. Indeed, in many cases the optimal strategy for the small investor is to ally himself with some large public firm by buying shares in a mutual fund that has the resources to thrive in dynamic markets with asymmetrical information…
To be sure, there are powerful instincts today on behalf of protecting the small investor who chooses to trade on his own account. The efficiency losses of that protectionist strategy seem clear, so it is fair to ask exactly from where the benefits come. In this sense, there is no instinct to protect poor or ignorant people, because few individuals of either type are active as individual players in the securities market. Rather, the more modest objective is for the SEC to protect that small sliver of individuals who wish to manage their own portfolios with complex trading strategies that often do not work well at all.113 But the SEC is the wrong institution to attack this problem, for financial education on such matters as index funds and portfolio diversification is better provided for by private firms operating independent of the SEC.
Do we really need all these people to go to jail just to protect the few small investors who demand a “level playing field,” even though they know it is impossible to create? The right answer is no. Insider trading is a matter for banks, trading firms, and investors to sort out without government interference. If tomorrow we make insider trading legal, then the burden for managing it will fall onto the investment banks and trading houses, which is where it should be. If customers are hurt by actors who violate a buyer or seller’s information privacy, then its the customers who will demand protection against that possibility. I actually think that most investors will not ask for this protection at all; on the contrary, as countless S.E.C cases have shown most customers will reward handsomely banks that are the most clever and efficient at gathering insider information and using it to make money for their clients. This world, a world where everyone understand and admits that inside edges “can and will be used against you,” will put small investors in a much better place, for they will know, without a shadow of a doubt, what all large investors know: that traders like David Hobson lurk in every corner of Wall Street and they are working for or against you every trading hour. Selecting a few traders here and there to prosecute is dangerous and, as Epstein notes, actually does more harm than good:
The current situation, of course, allows for criminal prosecutions for trading on inside information, and the above analysis offers guidelines as to how that should be done—if it is to be done at all. The central takeaway is that the sole violation that matters is the deliberate use or sharing of information contrary to the wish of the firm that has supplied it in the first place. These unauthorized uses should impose liability on the immediate recipient and any person who takes with knowledge of the illegal release. That prohibition should apply under a constructive trust theory, whether or not the recipient is deemed to have in fact some relationship of trust and confidence with the corporation, and it should apply wholly without regard to whether the party who leaked the information received some return benefit, tangible or intangible. Following these simple principles should vastly improve the overall operation of the securities law, which is now in a sad state of intellectual and administrative disarray.
He’s right, and the sooner we move to remove these laws from the books — and the sooner we accept that anyone buying a stock either has better (rarely) or worse (usually) information than the seller — the better off all investors, large and small, will be.