Tuesday, September 26, 2006

Fighting the good fight against insider trading

Linda Thomsen, Director of the SEC's Division of Enforcement, testified before the U.S. Senate Judiciary Committee today on the SEC's fight against insider traders. (See Testimony Concerning Insider Trading.) The speech is mostly boring, as you might expect from Congressional testimony. But there are a few interesting points we can deduce:

  1. Since 2001, the SEC has brought more than 300 insider trading cases. When you think about the size of the U.S. market, this sounds rather low (unless the U.S. market is really clean), so it seems likely that a lot of insider trading goes undetected and unprosecuted. On the other hand, this translates into 60 cases of insider trading per year, against only a dozen or so enforcement cases of all types brought by (for example) UK financial regulators.
  2. Insider trading cases are very hard to prove, and they almost always boil down to circumstantial evidence.
  3. Of the 44 insider trading cases the SEC has brought this year, 5 involved trading by hedge funds.
  4. All really good insider trading cases (like the Reebok/Pajcin-Plotkin-Croatian grandma case) involve strippers or porn stars. (Hey, if you are going to break federal securities laws, the Marylin Starr case sets a very high bar.)
Thomsen's testimony is interesting for several reasons. The first is because not everyone believes insider-trading should be illegal (though those who make this argument most frequently tend to be ivory-tower conservative law professors or very very old economists. For example, Henry Manne or Milton Friedman.) These theorists believe that markets efficiently and quickly incorporate all available information into a stock's price, so insider trading merely puts new information into the market more quickly. (Some others, mostly idiots, suggest that laws against insider trading aren't "fair" because if I learn a secret about a company, it's not fair if the government says I can't make a lot of money off of it before it becomes public.) And, indeed, for decades insider trading wasn't even illegal in most countries. The Germans didn't outlaw it until 1987, and they were basically dragged into it by the Americans. While most countries now have laws against insider trading, most don't really enforce them. (And by "insider trading" I don't mean all trading by insiders, but trading based on "material non-public information" when you've got a duty not to trade, and a whole bunch of other legal stuff I don't really understand.)

On the other hand, where would you, as a non-insider, rather invest? On the U.S. stock market, or in India or China? Sure, you might make a lot of money in India or China, but you might make a lot of money in Las Vegas, too. Just keep in mind, though, that the house always wins in the end.

The second reason this is interesting, though, has to do with the SEC's priorities. Thomsen testifies that insider trading consistently ranks as a priority for the SEC enforcement staff. Should it? Sure, 300 cases in 5 years is a lot, and Thomsen says that in many cases the SEC has been successful in freezing millions of dollars the insiders have acquired on trades based on inside information. But even if you added up all the funds improperly acquired from all these cases over the past 5 years, they still pale in comparison to investor losses in just one financial fraud scandal like Enron.

That said, securities law enforcement is all about risk, and risk abatement is as much about responding to actual risk as it is to perceived risk. If market efficiency is determined by how risky investor perceive the market to be, and insider trading is perceived to be a serious threat to the integrity of a stock market (even if it is not), it might make sense for a law enforcement agency to devote inordinate resources to combating it.

Finally, if you do believe markets are efficient in one form or another (in other words, as one of my old Nobel-winning professors used to say, "what makes you think you are smarter than the combined wisdom of 50 million investors?"), smart investors are basically those who free-ride on the research of all those schmucks out there who haven't figured out that index funds are the way to go. In that sense, can a little insider trading be a good thing, if it holds out the (false) hope that you can beat the market? After all, if we all were smart and just decided to free-ride on the price-setting mechanism of other people's research, there would be no other people doing research, right?


SmoothB said...

Ah, it's worse than that -- if we all believed in the efficient market, or if we all were truth seekers (and especially if this was common knowledge), then no one could ever disagree, so there could be no trading. There has to be a bit of noise trading to make the whole thing work, as Fischer Black pointed out.

SmoothB said...

The bit about China and India is a bit unfair, isn't it? Presumably there are a whole bunch of reasons why you might not want to invest in China or India (China's "keep the profits for yourself" tendencies not being the least)

M.D. Fatwa said...

The problem with China isn't that the company keeps the profits for itself (which it will), but it will explain this by saying that is either has no profits or that it has reinvested all its profits into R&D (which it hasn't). And you won't be able to call them a liar on it because their financial statements seem to support their position. Of course, if these financial statements were actually audited using even a semi-competent auditing standard, the charade would fall apart.

Also, volatility in Chinese and Indian markets indicate that there is always significant trading ahead of any good or bad news being made public. Arguably, this is your efficient market in action, but it's hard to see how this has lowered the cost of capital for companies on the Shanghai Stock Exchange.