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Why Insider Trading Shouldn’t Be Illegal


A professional athlete in trouble with the law is not always front-page news anymore, but the case of Mychal Kendricks stands out from the usual. The biggest difference is that his crime is one more often associated with the SEC (Securities and Exchange Commission) than the SEC (Southeastern Conference). Specifically, he pled guilty earlier this month to felony insider trading violations.

As the Philadelphia Inquirer’s Tommy Rowan described it, the former Philadelphia Eagles player “admitted to swapping cash, NFL tickets, and access to lavish parties with a Wall Street-connected friend for nonpublic market-shifting information.” Paying for stock tips is not a crime in itself, but because the information Kendricks’s friend gave him was not public, the transaction became a felony.

On the other side of the country, another securities law violation made the news. In August, Elon Musk tweeted that he was considering taking his publicly traded company, Tesla Motors, private, possibly with Saudi financing. Mere hot air from a Silicon Valley blowhard? Maybe. But it also may have run afoul of the securities laws governing what corporate executives may say when discussing their company and requiring that executives’ statements about material information be true.

Do Something, Anything!

Does any of this sound like something that should land a person in federal prison? Is this what our distant ancestors had in mind when they came together to construct the first government? The United States has many laws and even more regulations, so many that we seem to have forgotten the point of it all. What do we gain by having insider trading laws? Have any of the federal securities laws passed since the New Deal done anything to make financial markets any less of an insider’s game?

The Securities Acts of 1933 and 1934 were passed because New Deal lawmakers believed the markets were corrupt, that investors were being lied to, and that insiders protected their own and fleeced a gullible public. Later, the Sarbanes-Oxley and Dodd-Frank acts were passed, also following economic downturns, ostensibly to remedy some fault in the marketplace. All of these acts were born foremost out of Congress’s desire to be seen to “do something” about market crashes that wiped out people’s investments.

The real problem Congress wanted to fix is that markets go down as well as up. Were Americans really angry at the lack of regulation after these crashes? Or were they mad that they lost money and the economy turned sour? It is far more likely the latter, and the former was merely a scapegoat for that economic frustration. Regulation has never prevented a market crash, but it is a kind of “something” that Congress can do. So they did it.

What’s The Point?

Regulations try to clean up something that is inherently dirty. Financial markets have always been more complicated than the ordinary person could understand. Innovations of the late 20th and early 21st centuries have made that even truer. The steep learning curve makes for a world where insiders have an advantage, even before inside information enters the picture.

Securities laws try to guarantee equal information to all investors: an impossibility. People learn things or somehow figure them out, and they use that knowledge to invest. That is the nature of markets, and something no law will ever stamp out.

Now, to say a law will not deter all crime is not always a reasonable criticism. Laws against homicide do not prevent murder, yet no one proposes repealing them. We see murder as a wrong and wish to set it outside the bounds of normal society. We prevent it where we can, and where we can’t we at least want to punish the perpetrator and keep him from doing it again.

This is the logic for laws against most of the old crimes, the sorts of things that every society bans. But does it carry over into prohibitions on insider trading or improper marketing of securities?

Laws against murder can at least be said to deter some murdering. Securities laws, on the other hand, only make people hide their actions better. Moreover, they provide new opportunity for unscrupulous players to take advantage of investors by presenting an image of financial markets as a safe place, a level playing field. By tempting ordinary people into the venue for risk, the laws actually do regular folks a disservice.

That is not to say, as senators Bernie Sanders and Elizabeth Warren do, that the game is “rigged.” There is no shadowy cabal of plutocrats meeting in exclusive clubs to set traps for the unwary. But there is a system where deep knowledge of the game and the players is needed to win.

Instead of pushing unsophisticated investors into the markets, we should be warning them of the market’s perils. Removing all of the voluminous regulation will let people know that they are free to invest, but should not expect to get the same results as an insider. Let people have an honest look at what financial markets really are, and they can invest at their own risk.

Heavy Regulation Only Benefits Insiders More

The false impression of integrity is the biggest issue, but there are even more problems with securities regulations than that. In finance, as in any industry, the more heavily regulated a field is the more the existing players are entrenched. Firms active in an industry at the time a regulation is passed are familiar with the industry’s general contours.

Any changes that regulations make to their standard operating procedures do not require much of a shift. For a new entrant into the market, however, each layer of regulation adds more to the learning curve, which discourages newcomers. Regulated industries thus quickly become old boys’ clubs.

Regulation also favors large firms over small ones. Every new regulation on the financial industry requires lawyers to sort out the law and direct the firms on proper behavior. For a multi-billion-dollar operation, this is just another cost of doing business. They have in-house lawyers and access to top-tier law firms. New laws increase those legal costs temporarily, but it is a cost they can easily bear. For smaller firms, the costs do not scale down proportionally.

Gaining a legal understanding of a new law or regulation takes the same level of expense for small firms as for big ones, but the cost makes up a far larger proportion of their budget. Without the economies of scale available to the biggest players, small firms are increasingly squeezed out, leading to greater consolidation of wealth and power in the remaining firms. Big government and big business thus work together to squeeze out competition, and the revolving door between regulator and industry ensures that nothing changes.

There are also serious conflicts between some securities laws—especially the ones Musk is accused of transgressing—and the First Amendment. It should bother any citizen of a free country when government investigators look into someone’s behavior on account of something he said (or in this case, tweeted). The freedoms to speak and to publish are core elements of our American heritage.

SEC regulations of this type have been justified by a line of cases that hived off certain conversations as “commercial speech,” then proclaimed the First Amendment does not cover them. There were once exceptions for obscenity and speech about private matters, too, but courts eventually realized that the government does not get to pick and choose what kinds of speech are legal. A similar reckoning for commercial speech is long overdue.

Old Laws Are Good Enough

Proponents of the status quo will say that without securities regulation, the markets will become irredeemably corrupt. But remedies for corruption existed before the New Deal and continue in force today in the common law offense of fraud.

In a world free of securities regulation, cheaters would not be able to run wild; common-law fraud would still bar bad business behavior.

Fraud is variously defined, but generally it is correct to say, as the Second Restatement of Torts does, that anyone “who fraudulently makes a misrepresentation of fact, opinion, intention or law for the purpose of inducing another to act or to refrain from action in reliance upon it, is subject to liability to the other in deceit for pecuniary loss caused to him by his justifiable reliance upon the misrepresentation.”

There’s a lot of legal language there but, as with most common-law offenses, it means about what people think it does. If you lie to cheat someone, you’ve committed fraud, and could face civil or criminal penalties. Almost every variety of financial swindle meets this definition.

In a world free of securities regulation, cheaters would not be able to run wild; common-law fraud would still bar bad business behavior. People could tweet what they want and tell each other information they have learned from various sources, but they couldn’t lie to investors to rip them off.

That is really all we need. Repealing the other laws would lay bare the truth of the financial industry, but it would not lead to anarchy. Investors would still be protected from getting ripped off, and would gain added protection in the knowledge that financial markets are not a level playing field. Everyone is free to enter them, but no one should expect that any law will make the outsider’s knowledge and ability equal to the insider’s.

As with any sort of gambling, if we play at all, we should play at our own risk.