New York City businessman Telemaque Lavidas was recently found guilty of insider trading. He was charged with utilizing inside information about a U.S. biotechnology company, and passing it on to Georgios Nikas, a Greek entrepreneur.
Lavidas and all others charged with this so-called “crime” should be freed, immediately. Insider trading should be legalized forthwith: it is a victimless crime.
Consider the following. A is a wealthy investor, B is a helicopter pilot and a geologist. A is looking for gold, or diamonds, or oil, or copper or some other such mineral. He hires B to go “out there” and seek promising rock formations. In the first contract, A offers B a large salary, say $500,000 per year, plus all expenses, and requires the B share information about his discoveries with no one else. In the second contract, A offers B a small salary, say $50,000 per year, again plus all expenses, but now allows B to share information about his discoveries with a few friends and family members, and to use this knowledge on his own account (so as to purchase likely mineral rich lands for himself).
No one would quarrel with the first contract. If B spills the beans, he should be considered guilty of contract violation, and theft, but not insider trading.
But why is the second contract illegal? In the first case, A bears the lion’s share of the risk, B very little, and all the discovery benefits accrue to A. In the second, A takes on a much smaller share of the risk (he pays B a small salary), B takes on a larger share, and all the discovery benefits accrue to both in some agreed upon fashion. A contract is a contract is a contract. Contracts are the very foundation of the free economy. Unless something is seriously untoward, the second agreement, too, should be considered valid.
Why do most people recoil from this eminently reasonable conclusion?
It is because they view information not as an economic good, but rather as something vaguely offensive when commodified. You have inside information? Fine. No harm, no foul. But, you have the audacity to sell it, to benefit from it yourself? Then, all legal hell breaks loose with popular support. But a reductio ad absurdum ought to put paid to that sort of thinking. The cello teacher has inside information about playing that instrument. She’s good at it, you’re not. This woman should make her knowledge about the cello available to you for free? That is the logical implication of laws against selling, or benefiting from, inside information. Were we to generalize from this, politicians would be correct: no institution of higher learning ought to be allow to charge tuition! Communism opposes the commodification of pretty much everything. Those who support insider trading prohibitions are thus, in effect, whether they realize it or not, partial communists.
Where are the victims? Who lost out, who has any rights in the matter, from the second contract between A and B? No one, that is who. Well, yes had B told all to everyone about which land is likely to be mineral-laden, the present owners would have been able to sell their terrain for a higher price. But they had no right to this information in the first place.
Not only are there no victims despoiled of anything to which they have a right, but insider trading is a benefit to the wider economic community. It is an aphorism in economics that the equilibrium price, or wage, or interest rate is the most efficient one. At other levels, shortages and surpluses ensue. Happily, while the market exceedingly rarely attains this happy situation, it is always moving in that direction.
How does insider trading impact this phenomenon? Simple: this behavior moves us closer, more quickly, to the situation where supply and demand equate with one another. The more correct information that registers in markets, the better for the economy; the more accurate are prices, which are necessary for rational resource allocation. Inside information is information. If it is allowed to be incorporated in prices, the more accurate they become. But when the law criminalizes such behavior, less of it will occur.
The real problem is not inside traders, who incorporate what tends to be correct information into the market process. It is, rather, “outside traders,” whose knowledge of the market is negative. They are the ones who tend to move us away from the equilibrium markets, in effect, are seeking. Their only saving grace is that when they invest, they tend to lose money and thus have less sway over prices. On the other hand, “there’s a sucker born every day,” so they keep on entering the financial fray. Well, they are not criminals, either.
Free all political prisoners. Free all perpetrators of victimless crimes. Free all insider trader convicts. Michael Milken was recently pardoned for this “crime.” All of his fellow “criminals” in this regard should be treated in the same manner.
READER COMMENTS
Garrett
Jul 14 2020 at 8:21am
This would be a better essay if you engaged with the primary argument in support of insider trading laws, which is that they reduce adverse selection risk for market makers. Less chance of adverse selection means market makers can set tighter bid-ask spreads, which means lower overall trading costs in the market.
_quanttrader_
Jul 14 2020 at 8:27am
I agree with Garrett.
Investors would stay away from markets where they can easily be picked off. This reduces liquidity.
Matthias Görgens
Jul 14 2020 at 10:05am
Don’t market makers already mostly solve that problem by paying for retail order flow?
Garrett
Jul 14 2020 at 11:05am
Most equity volume is institutions, not retail.
Jim
Jul 14 2020 at 10:22am
“You have inside information? Fine. No harm, no foul. But, you have the audacity to sell it, to benefit from it yourself? Then, all legal hell breaks loose with popular support.”
This is not an accurate statement of the law of insider trading.
As Matt Levine writes:
“The law doesn’t say that any time you trade on material nonpublic information it’s illegal. The law, to oversimplify a complicated area, makes it illegal to trade on material nonpublic information that you obtained in violation of a duty to someone: It’s illegal for corporate executives to trade on corporate information for their private gain, or to give that information to their buddies in exchange for a personal benefit, or for outsiders to obtain information in confidence and then betray that confidence by trading on it. The real issue is never whether the trading was unfair to the people on the other side; it’s whether the information was misappropriated from its rightful owners.”
The rightful owner of the information is the company. So the issue with a corporate executive selling information is not the sale of the information—it’s the fact that the information doesn’t belong to the executive, and so the executive is breaching a duty of confidentiality in using that information for his own purposes (either trading on it himself or giving it away to others).
The Department of Justice’s press release in the criminal case you mention makes this clear: “In violation of his duties of confidentiality to Ariad, Athanase Lavidas provided TELEMAQUE LAVIDAS with tips about three major corporate developments at Ariad.”
Athanase was Telemaque’s father, and a member of Ariad’s board. The information he obtained belonged to Ariad, so he violated his duty of confidentiality in giving it to his son. (It’s not clear in the press release, but presumably Telemaque knew or should have known that the information given to him by his father belonged to the company, which is why he couldn’t give it to his friend to trade on.)
Thus, going back to your contract example: the second contract (in which B and his friends buy land) is valid. Even leaving aside that insider trading law only applies to securities (not land), I don’t think there’s anything illegal about it. And it’s not analogous to insider trading cases, precisely because A allowed B to use the information in that way/sell it.
Standard disclaimer: the above is not legal advice.
Scott Sumner
Jul 14 2020 at 12:33pm
I’m no expert here, but surely everyone agrees that it’s not OK to violate contractual obligations when engaging in trading. If that’s all there was to insider trading laws, then they would not be very controversial. But unless I’m mistaken, the laws go much further, don’t they? Suppose I overhear a stock tip while at a gathering of business executives, but I’m not an employee of the company. Can I trade on that?
Dylan
Jul 14 2020 at 4:52pm
Not legal advice, but my understanding is yes, assuming you otherwise don’t have a connection to the execs. Simpler case, you’re on a crowded subway and you look over the shoulder of some stranger and you see him working on documents for an upcoming acquisition. Trading on that info is legal.
Disclaimer: I also learned just about everything I know about insider trading from Matt Levine (and from multiple viewings of Trading Places)
Jim
Jul 14 2020 at 11:48pm
Scott,
You’re right that the laws go further than violating contractual obligations not to trade.
Dylan is right that if you’re on the subway and see some documents containing insider information, you can trade on that (not legal advice!).
Your example (you overhear a stock tip while at a gathering of business execs, but you don’t work for their company) is a little harder. If you have no connection to them, you should be in the clear to trade on it. If you’re an outside lawyer or accountant for that company, and there as a result of that relationship, you definitely can’t. If you’re an employee of the catering company that was hired for the event, I’m not sure off-hand whether you can trade (unless there’s a contract saying anything overheard is confidential, etc.)
The key thing is liability is based on the violation of some kind of obligation to the owner of the information (such as the duty of loyalty or confidentiality). Contrary to the article, it is not based on whether you sell the information, however.
There’s two main reasons this goes beyond violating contractual obligations.
There’s no requirement for a specific contractual provision against insider trading. Rather, liability is typically premised off of fiduciary duties, which may be implied. If you’re a board member for a company, you have duties to the company even absent a contractual provision.
The duty can effectively travel to someone else. The classic example is the CEO who tips insider information to their sibling. If the CEO:
receives cut of the profits, intended the information as a valuable gift, or
receives some other personal benefit; and
the tippee either knows or should know about both the above benefit and that the CEO was breaching a duty;
then if the tippee trades, the tippee is liable for insider trading. (The tipper is also liable.)
One of the reasons why insider trading law is controversial is that the “other personal benefit” has been construed very broadly at times. For example, in one case (Newman) the tipper received minor career advice. A court found that was enough to constitute a personal benefit, but the conviction was overturned on appeal. So that’s not enough any more, but at least at one point, prosecutors were bringing cases like that.
Alan Goldhammer
Jul 14 2020 at 10:23am
As one whose working career was in the biopharma industry and now I run a small home investment office, I think the initial premise here is wrong. Say I run a COVID-19 vaccine company and have early inside access to some unfavorable results. The price of the company has been vastly inflated by current hysteria about COVID-19 (rightly or wrongly) and the pressing need for a vaccine. I and other senior management sell of some of the stock holdings prior to release of the results. Should this behavior not be punished?
robc
Jul 14 2020 at 10:39am
Punished for correcting the market?
The price is wrong, your selling sends a signal that the price is wrong and it gets corrected, whether you release the info or not!
Rebes
Jul 14 2020 at 3:54pm
In Alan’s example, he runs the Company. The way for him to send a signal to the market is to announce the unfavorable results, not to sell his stock.
Jon Murphy
Jul 14 2020 at 11:35am
Yeah, I’m with robc here. It’s not obvious to me why you think the behavior should be punished. Of anything, shouldn’t it be praised since you are sending the signal to not be irrationally optimistic about your firm’s prospects for a vaccine in the near term?
robc
Jul 14 2020 at 12:30pm
There is a regulation that I think goes hand-in-hand with this. Insider sales/purchases should be announced in advance. Maybe 24 hours?
Jonathan Monroe
Jul 14 2020 at 12:35pm
Given the existence of laws against insider trading, you would be defrauding your counterparty (who made the trade based on the implied represenation that you were not illegally insider trading).
This isn’t an argument for bans on insider trading being good policy, but it is a moral justification consistent with libertarian ethics for locking people who knowingly violate them in cages.
If laws against insider trading didn’t exist, would the market ban the practice? I think they probably would, either by companies requiring executives and other key employees to sign non-insider-trading agreements, or by stock exchanges prohibiting insider trading in the shares they list.
Jonathan S
Jul 14 2020 at 11:52pm
My understanding is that insider trading laws are intended to prevent passive shareholders from being on the wrong end of the stick.
The passive shareholder has a few options:
Stop passive investing
Invest in transparent companies
Find ways to gain insider information
A few considerations:
Since when are investors entitled to making money? Insider trading laws seem to be a form of insurance for the passive investor. The market should be able to shake this out on its own.
From a productivity standpoint, how detrimental are insider trading laws? In a way, insider trading seems like a private version of rent seeking. Couldn’t a counter-example be that insider trading would be like a store clerk stealing cash out of the register? If that is the case, wouldn’t it make sense for corporate shareholders/owners to have private rules against insider trading?
At the end of the day, more informed private investment decisions should mitigate the issues surrounding insider trading.
James
Jul 15 2020 at 1:39am
Passive funds are not the ones harmed by insider trading.
Passives trade very little as compared to actively managed portfolios so it is unlikely that passive investors will be on the other side of an insider trade.
Active investors on the other side of the trade will certainly lose, but being on the wrong side of a profitable trade leads to losses whether the other party is acting on insider information or not.
Profitable trading does affect passive investors in a different way. Say a corporate event causes a stock to go from a previous close of 50 to a new close at 60 in one day when knowledge of that event becomes public. If a speculator (using insider knowledge or not) buys on the day before the event and bids up the previous day’s close from 50 to 51, and then the next day the stock goes to 60, then the speculator’s actions have made that stock less volatile. If that stock had a meaningful weight in the index, then the passive investor’s realized vol decreases.
Jonathan S
Jul 15 2020 at 1:15pm
Wouldn’t an actively managed portfolio be considered a passive shareholder? Passive shareholders are those that have an ownership stake, but are not involved in the business operations.
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