What's the Problem with Insider Trading...and the Old Kristin?

So, I was going to deliver the second of my lighthearted jabs about the engines of Wall Street, but something got in my way. A stray comment uttered by the Ex (not the financial instrument, the person), of all people.

It was over eggs this weekend. In the midst of one of my grand, interminable Shakespearean soliloquies about the state of Wall Street, I was stopped dead in my tracks. I was speaking about the Galleon case and the way in which I thought the SEC was using it to make a point when the Ex suddenly interrupted me. To be honest, I was surprised that I hadn't yet put her to sleep, but I guess, whether she liked it or not, all that brunch tea was keeping her up.

"So, you're saying these guys were arrested for insider trading?"
"Yes," I replied, not sure what she was getting at.
"Well, what's so bad about that?"
"It's illegal."
"Why?"
"I don't know. It's against the law," I said, attempting to overpower her with the full force of my tautological reasoning.
"Seems like a stupid rule to me."

On that note, the conversation ended, and we turned to more important matters, like whether the new, emaciated Kristin (of The Hills and Laguna Beach fame) looked better than the original, plumper girl-next-door Kristin (for what it's worth, I preferred the original). Yet, I couldn't help thinking about the Ex's comment long after we'd finished the discussion: what was so bad about insider trading anyway?

Coincidentally enough, as we were watching The Hills later that afternoon and I'd become bored with the skinny Kristin, I turned to my phone to read an article on the WSJ online about the very topic that had been troubling me.

Though the Ex doesn't care about finance and doesn't pretend to know much about it, she was amidst some impressive company in believing that insider trading shouldn't be regulated. The Journal editorial, penned by Economics Department Chair Donald Boudreaux of George Mason and featuring the comments of Professor Jeffrey Miron of Harvard, supplied some arguments in support of the Ex's view. None of them were very convincing.

The main argument advanced in the article was that insider trading would lead to greater market efficiency -- as prices would reflect all information, not merely all publicly available news. I must admit that on the face of it, this type of claim is appealing. After all, who doesn't want more efficient markets? There's just a small problem -- it's not at all clear that more insider trading would meaningfully improve efficiency. For one, insiders account for a very small share of overall stock ownership, particularly among the largest and most widely held stocks. According to one study based on a sample of 1300 large firms covered by the Value Line Investment Survey, the median percentage of insider ownership is less than 5%. So, for the stocks that count, it takes a large (and arguably unwarranted) leap to conclude that insiders have the market power to significantly move prices.

This isn't to suggest that insiders don't matter at all. But if insiders can meaningfully affect efficiency, they can do so under the present regime, which permits company officers to buy and sell their firm's stock provided they report their transactions (usually through Form 4). I am somewhat surprised the editorial makes such scant mention of the legal ways in which insiders can now express their views. Yes, a discussion of currently allowed insider practices would weaken the efficiency argument, yet it would highlight a far more powerful critique of the present system. The fact is insider trading is actually permitted, so if the SEC is so concerned about leveling the playing field, why doesn't it force all company officers to hold their company stock in blind trusts? To the extent the present regulatory regime is flawed, I think it's impaired by inconsistency in application.

To his credit, Boudreaux does make this point (in a roundabout way), but he spends far too much time on an inconsistency argument of a different sort. Boudreaux asserts that insider trading enforcement is inherently biased since it's far easier to prosecute a wrongdoer for conducting a transaction on the basis of insider information than for choosing to forego a trade because of insider knowledge. However, given the SEC’s reliance on informants (as in the Galleon case), it wouldn't be out of the realm of possibility for the organization to uncover credible evidence linking insider information to the decision not to trade. Still, Boudreaux’s point is a fair one since, whether the SEC has the ability to or not, I don’t think the enforcement organization has ever prosecuted somebody for using insider information as the basis for a choice not to trade. But I don’t think this shortcoming matters that much, or at least it’s not significant enough to warrant the abolition of insider trading regulations. To be sure, it would be nice if the SEC could easily catch all acts of insider trading (or non-trading, as it were), but the fact that certain instances of wrongdoing are quite difficult to detect doesn’t mean that we should throw in the towel and give up on prosecuting the instances that are much easier to catch.

While I have a problem with this argument advanced by Boudreaux, it’s Miron’s defense of insider trading that baffles me the most. I took his class on libertarian economics at Harvard, and when I decided to show up every now and then, I heard him make a number of provocative but strong claims. Miron’s arguments about insider trading aren’t among this number -- they may be provocative, yet they aren’t very strong. One of his main points is that insider trading will lead individual investors to diversify their holdings. The reasoning is that individuals will become wary about putting all their eggs in one basket out of fear that insiders will have a decisive advantage in a regime without regulations. Yet, if individuals fear that insiders will have an advantage, why will they invest at all (either in one stock or a basket of them)? Indeed, in making the argument, Miron acknowledges a problem with an entirely unregulated system -- insiders will be seen as having a significant investing advantage, an even greater one than they hold now. As Miron himself unwittingly suggests, it’s hard to believe that a non-insider in his right mind would participate in such a market.

And, I guess, when it comes down to it, that’s the reason we need at least some rules against insider trading (imposed by the government, not corporations). There are no doubt problems with our existing framework, but further tipping the scales in favor of insiders would dissuade individuals and institutions from making much needed investments in the nation’s capital markets. I wish I’d been able to tell the Ex something along those lines following our conversation. In all honesty, I’m not sure it would’ve mattered. After telling her that I preferred the old Kristin over the new one, I lost every bit of her confidence.

A Ship of Fools?

First, I’ll preemptively apologize for the nautical allusion – yes, Galleon is a hedge fund named after a boat as basically every media outlet has realized, and yes, it is now sinking (couldn’t resist that last double entendre, sorry).

After reading the SEC complaint in full, I wanted to call attention to an earlier post about my surprise regarding the paltry size of the alleged insider trading. Noting that $20 million was an infinitesimal fraction of Galleon’s assets under management and Rajaratnam’s wealth, I gave three possible explanations for the activities. At the time, having not read the complaint, I forgot to mention a fourth possible cause – perhaps the companies in question were too small to permit large scale insider trading. As several insiders have found out, attempting to commit large scale fraud with small stocks is very stupid. The SEC isn’t run by rocket scientists, but they will catch you.

To be more specific, when people have insider information, they often try to maximize gains by trading options. As I noted in an earlier post, options provide leverage, magnifying wins and losses. If you know what’s going to happen to a stock on account of insider information, trading options therefore seems like a great bet – you’ll get the best bang for your buck. Indeed, it can be quite lucrative. However, in many cases, it can be a big red flag to the SEC. Many stocks don’t support very liquid options markets. This is to say, the open interest (number of existing options contracts on a stock) and volume are often very small, so it takes only a few extra trades to cause a big spike in activity. And the SEC will catch such volume spikes as Reza Saleh recently found out the hard way when he bought 9,332 Perot Systems call options on insider knowledge of a buyout.

So, returning to the Galleon case, I’m not that surprised that some of the reported gains were quite small. For example, options on Polycom (one of the companies in question) have very low open interest and rarely trade. The complaint alleges that one of the parties purchased 200 Polycom calls from April 13 to April 18, 2006 at $1.35 a piece. Now, this was a very small outlay (resulting in a profit of only $22,000), but anything larger could have tipped off regulators then and there since on average only about 200 calls trade per day in the stock.

But the same can’t be said for some of the other companies in the complaint. Google, for example, supports a much more liquid market. One of the parties purchased 566 put options in the two weeks leading up to Google’s 2007 second quarter earnings announcement. While this trade led to more than $500,000 in profits, the party probably could’ve put on much more of it without alerting regulators. By my estimates, roughly 7500 puts on Google exchange hands every day. Now I don’t know how the SEC’s volume spike algorithm works, but I see no reason why the party couldn’t have bought 500 puts (across strikes) per day without tipping off regulators. If the party had amassed 2500 puts in total, it would still probably account for less than a quarter of the open interest across strikes and would’ve made several million dollars more in the process.

Was this person just overly concerned about getting caught or simply a fool?