Sunday, October 25, 2009

How to Solve Insider Trading: Let the Criminals Decide what’s a Crime!

Learning to Love Insider Trading
Here's a hot tip: Want to keep companies honest, make the markets work more efficiently and encourage investors to diversify? Let insiders buy and sell, argues Donald J. Boudreaux.

So reads the deliberately eye-catching headline on the front page of the “Life & Style” section in this weekend’s Wall Street Journal.

And while we’re as contrarian as the next stock market follower, and weren't much surprised that the government finally cracked down on the practice of gaming quarterly earnings through relentless pursuit of “The Call”—complete with the early-morning arrest of a well-fed hedge fund manager—we can’t help but admit that our immediate thought before we even got to the body of the article was this:

Donald J. Boudreaux must be a professor...And a tenured one, at that.

Not that there’s anything wrong with being a tenured college professor, to be sure.

It’s just that, of all the constituencies in the financial markets who might have a strong opinion on the merits or demerits of insider trading—small investors, day-traders, mutual fund analysts, hedge fund managers, CEOs and even professional arbitrageurs—who but someone completely outside the day-to-day function of the equity markets would offer advice that is so theoretically sound, and yet so useless in practice?

Here’s how Mr. Boudreaux sums it up right at the top:

The reassuring truth: Insider trading is impossible to police and helpful to markets and investors. Parsing the difference between legal and illegal insider trading is futile—and a disservice to all investors. Far from being so injurious to the economy that its practice must be criminalized, insiders buying and selling stocks based on their knowledge play a critical role in keeping asset prices honest—in keeping prices from lying to the public about corporate realities.

According to Mr. Boudreaux, allowing insiders to trade on what is happening within their companies—without restriction—would allow all the news that’s not currently in print to be reflected in the markets immediately, so that instead of “lying to the public,” asset prices would be kept “honest.”

Like Communism when it is being taught in the sunless confines of a lecture hall, this sounds pleasing to the ear. However, also like Communism—as anybody who actually lived in East Germany or Poland or Russia (and still, today, Cuba) knows—it’s lousy in practice, and for the very same reason: human beings don't act according to nice theories.

But before we look at what’s wrong with Mr. Boudreaux’s nice theory, let’s look at the specifics of his case.

First, he postulates a company, “Acme Inc.” that is run by an “unscrupulous management” team that misleads investors as to the true state of affairs inside Acme Inc. Not only do the investors lose a bundle when things hit the fan, but, as Boudreaux correctly notes, the economy as a whole suffers because capital which has been wasted on this company might otherwise have been employed in a productive business.

Boudreaux concludes the Acme case thusly:

It’s in the public interest, therefore, that prices adjust as quickly and as completely as possible to underlying economic realities—that prices adjust to convey to market participants as clearly as possible the true state of those realities.

“Well, yeah,” sharp-eyed readers would no doubt say to Mr. Boudreaux, “it is important that prices reflect reality…so why is it that every time professional short-sellers attempt to 'convey to market participants as clearly as possible the true state of those realities,' they get rewarded as follows:

1. Temporary bans on short-selling, and/or
2. Federal subpoenas into their short-selling activity, and/or
3. Congressional investigations into short-selling, and/or
4. Innumerable TV appearances by insufferable CEOs bashing short-sellers?”

In other words, where in the world did Mr. Boudreaux get the idea that “market participants” care about “the true state” of reality?

Perhaps from a book by some efficient-market theorist, but wherever he got it, he ignores that flaw in the logic and pushes ahead with his legalize-insider-trading reform proposal by quoting—pay attention, now—an attorney who authored a book 43 years ago:

“I don’t think the [Enron-era] scandals would ever have erupted if we had allowed insider trading [said the attorney] because there would be plenty of people in those companies who would know exactly what was going on, and who couldn’t resist the temptation to get rich by trading on the information, and the stock market would have reflected those problems months and months earlier than they did under this cockamamie regulatory system we have.”

This presumes, first, that the corrupt insiders would share their misdeeds with “plenty of people” in the company, which is the second of many howlers on which Mr. Boudreaux hangs his unfortunate thesis.

It also presumes that lower-level employees, upon sniffing out the fraud, would sell stock in order to make money on the impending collapse.

Having shorted many stocks—including some outright frauds—over the years, we could have assured Mr. Boudreaux, had he asked us, that most lower-level employees, even those working at what are proved to have been frauds, never ever believe they are working for a fraud.

What they believe is that they are working on the side of good and righteousness, and that it is the short-sellers who are working on the side of evil and badness, and merely promoting negative news to profit from the demise of their very fine company.

And they fervently hope this is true because they want their stock options to make them rich.

Does anybody out there besides us recall how the Enron trading room broke into cheers when Jeff Skilling called a pesky, skeptical short-seller a very bad word on a conference call?

The fact is, despite repeated warnings from such short-sellers—Jim Chanos called it “a hedge fund in drag”—nobody wanted to hear about the financial rot within Enron until after the stock had collapsed, taking many innocents, both inside the company and outside the company, with it.

In the words of Paul Simon, “a man hears what he wants to hear and disregards the rest.”

Moving on, we come to the third howler within Boudreaux’s case: that the side-effect of unrestricted insider trading would be to eliminate the individual investor from direct investment in the equity markets, and that this would be “a good thing”:

Another potential benefit [he writes] of lifting the ban on insider trading is explained by Harvard University economist Jeffrey Miron: “In a world with no ban, small investors might fear to trade individual stocks and would face a greater incentive to diversify; that is also a good thing.”

In other words, we should disenfranchise those very investors who seek financial security through prudent investment in common equities by allowing insiders to control the stock market to their own, insider-information-advantaged benefit.

Mr. Boudreaux has clearly never read “Reminiscences of a Stock Operator,” in which the very “world with no ban” posited by his Harvard economist is described in colorful detail. Had he read this classic, Boudreaux would have known that such a “world with no ban” once existed, and that the result was such abuse and dysfunction to the central fact of capital markets—raising capital for profitable enterprises—that the Securities and Exchange Commission was created to end the abuse and dysfunction.

But that ignorance doesn’t stop him.

No, he sets up his forth howler, declaring—in the manner of the High School Senior who hasn’t made his case but nevertheless declares it made—that insider trading prohibitions are biased anyway:

Not only do insider-trading prohibitions slow economic growth, promote corporate mismanagement and discourage investment diversification, their application also is unavoidably biased.

The bias, he claims, exists because law enforcement officials only go after insiders who act on information, which he says ignores those insiders who benefit by not acting because of inside information—the example being an insider who chooses not to sell shares in a drug company after learning of an impending FDA drug approval.

This he construes as bias, and he then makes up—out of whole cloth—a fact to support this assertion of bias:

And because opportunities to profit through insider ‘non-trading’ might well occur with the same frequency as opportunities to profit through insider trading, as many as half of those investment decisions influenced by inside information might be undetectable.

By now, we have concluded that our initial instinct about Mr. Boudreaux is correct: who else but a Tenured College Professor would argue that “undetectable” investment decisions occur with the same frequency as detectable ones?

Unfettered by logic or facts, Our Tenured College Professor plows ahead—hey, if you can make up stuff in the Wall Street Journal, the world is your oyster!—and lays out what surely must be the most convoluted paragraph ever conceived and executed in that paper:

This bias is not only a source of prosecutorial unfairness; its existence casts doubt on the assumption that insider trading is so harmful that it must be treated as a criminal offense. After all, if capital markets continue to function as well as they do given that many investment decisions potentially influenced by inside information are unstoppable because they are undetectable, why believe that the detectable portion of investment decisions influenced by inside information would be harmful if they were legal?

The mind reels with this logical back-flip—he has invented a fact (“many investment decisions are potentially influenced by inside information”) and proposed decriminalizing insider trading as a result of that made-up fact.

But he doesn’t stop there.

Instead, OTCP proceeds to contradict his message entirely and say that harmful “inside information” does, in fact, exist.

He now postulates a big software company that wants to take over a small software company—which takeover would be “undermined” if the news leaked:

The big company, therefore, has a legitimate interest in preventing insiders from trading on the knowledge that it plans to acquire the smaller firm. And the general public has an interest in permitting the company (and other firms in similar circumstances) to prevent trading on such inside information.

Zounds! We now have “bad” inside information, whereas just a few paragraphs before we only had “good” inside information!

So how does OTCP reconcile the notion that managers at lousy, fraud-infested companies like Enron should be allowed to trade their own stock with abandon and yet acquisition-hungry software companies ought not to have to suffer day-trading by their own lawyers, auditors and acquisition staff?

He’d leave it to the companies themselves:

Each corporation should be free to specify in its by-laws the types of information that insiders may not trade on. Any insiders who trade on such information would violate that firm's by-laws and, hence, subject themselves to suit by that firm. Corporations whose by-laws prohibit all or some insider trading will have standing to sue anyone who violates their by-laws. People who trade on inside information not protected by corporate by-laws would be acting perfectly legally.

The reeling mind now staggers at the embedded cost of this notion.

As if Sarbanes-Oxley wasn’t enough of a burden, now every small public company must police the various types of stock trading by its own lawyers and scientists and truck drivers, parsing whether or not their trades were based on a certain type of information contained in the corporate by-laws or not?

Unfortunately, OTCP doesn’t stop there.

He proceeds to describe how different companies would have different insider-trading prohibitions. (Non-tenured readers who actually change jobs once in a while can imagine the nightmare involved in getting up to speed on the nuances of insider-trading restrictions at each new job.)

There's more, but let's end it by simply noting that, as Marx and Engels in The Communist Manifesto constructed a seductive theoretical framework for the political organization of human beings on the basis of a faulty reading of human nature, OTCP has constructed a seductive theoretical framework for the regulation of “insider information” based on the same faulty reading of human nature as Marx and Engels.

They mistakenly assumed that human beings are not willing to do whatever they must for their own survival, even if it hurts somebody else.

Yet as anybody who knows anything about Wall Street (and Main Street, by the way—witness the recent Jersey City corruption crackdown) knows, when there is money to be made by exploiting a system, it will be exploited.

So how to deal with insider trading?

It’s certainly not remotely “impossible to police,” as OTCP declared right at the start.

We’ll explain ourselves via an example from the real world, not a theoretical world lovingly constructed in the pages of the Wall Street Journal.

Here goes.

Last year—July 28th, 2008 to be precise—shares in a company called Virtual Radiologic (ticker VRAD), which does off-site reading of radiology images for hospitals, suddenly nose-dived in the last hour or two of trading, closing down 15%, or $2.54 per share on a whopping 200,000 shares.

That was four-times the average daily trading volume of the three previous, uneventful days.

As an investor who follows a variety of companies, including VRAD—although we did not have a position in VRAD shares at the time—we noticed the end-of-day collapse and immediately wondered who knew something, and what that something might be.

Nine minutes after the market closed that day, we found out: the company reported lousy earnings.

Here’s how the news appeared on the tape:

Virtual Radiologic reports Q2 EPS of $0.13 vs $0.16 two ests; revs increased 22% YoY to $25.9 mln vs $27.03 mln two ests…Co sees FY08 $0.70-0.74 vs $0.84 two analyst ests; sees revs $108-111 mln vs $116.30 mln two analyst ests.

So, even as the press release was being readied for zipping to the PR Newswire, somebody was selling Virtual Radiologic stock.

In size.

And when trading resumed the following morning—after a grumpy conference call with Wall Street’s Finest—VRAD shares opened down at $9.83 and kept going down until the close, stopping at $9.24 on total volume of 1.387 million shares.

That’s what we’d call a likely case of insider trading.

Now, we don’t know anything else about the matter outside of these facts:

1. A stock got hit hard into the close, on unusually high volume;
2. Immediately after the close, bad news was released;
3. The stock opened down the next morning on enormous volume.

We know nothing about who was trading the stock, or what they knew, or how they knew it.

We had no position in the shares and didn’t bother to follow up on the situation, because, frankly, it seemed so obvious an insider had acted on material non-public information that we expected to see some kind of insider-trading charges hit the tape shortly.

One year later, we’re still waiting, and still we know nothing more than what we observed that day.

The point of the story is this: the answer to the question of dealing with insider information is not to promote a system that already didn’t work back before the SEC was created to deal with a system that didn't work. It is to deal with obvious stuff, like what we believe must have occurred with VRAD on a fine July day in 2008, swiftly.

Communism didn’t work for the simple reason that those who were first in line stole the means of production from the poor shlubs with whom they were supposed to share those means of production.

And unfettered insider information won’t work, for precisely the same reason.

Jeff Matthews
I Am Not Making This Up

© 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.


Tom said...

John Carney says he is going to respond to this post.
Obviously he can't argue for non-enforcement of existing laws (which is what Carney's post plainly does), that just leads to theft and chaos.
SAI can be fun to read, but when it touches on global warming or laws that Blodget might have happily disregarded, it goes very loopy very fast.

Len said...

Amen, Mr. Matthews!!!

Greg said...

For those with long memories, the WSJ had the same idea in the mid-80's during the last flood of insider trading scandals. If I remember correctly, they ran several op-eds on the theme, as well as some unsigned editorials. It was as dumb an idea then as it is now.

Anonymous said...

This article is another example of the Foxification of the WSJ. No doubt the ivory tower plodder will be receiving further research funding after bringing this misunderstood topic to the public for discussion.

In a related issue about the market being able to police fraud I suggest your readers watch the Frontline episode where Mr. Greenspan must come to grips with the shortcomings of his own free market ways.

Josh said...

I think one of the simplest arguments against it is that every trade has someone on the other side. Moving the market to reflect all inside information comes at the expense of everyone without inside information in this world. If I know there is negative news in the pipeline two months out, I have an awful long time to build up a position. It's almost not even worth pointing out the absurdity of this guy's argument, but someone certainly had to do it lest it be accepted as intelligent.

Anonymous said...

The other big issue that the editorial seemed to completely overlook is that permitting insider trading encourages executives to conceal information rather than reveal it, so as to profit for longer off non-public information. It's easy to hide millions of dollars of trading in highly-liquid multi-billion dollar stocks if you have some time. If executives can build a position over a period of weeks while delaying positive news, they will do so. Likewise, if they can unload stock while avoiding disclosure, they will do so (see Angelo Mozilo at Countrywide). Why do we want to give insiders a stronger incentive (lack of punishment) to keep information secret and trade big swings in their stock? From a public policy perspective, I don't want the same person controlling two levers that let them put money in their own pocket at the expense of everyone else.

Jeff Matthews said...

I wish our last "Anonymous" had left his or her name.

Well said, and accurate.


PT said...

Jeff: matt Taibbi goes over the same talking point as used by Goldman. Just FYI.

Jeff Matthews said...

Matt Tiabbi is the Rolling Stone conspiracy-theorist anti-Goldman jihadist, and I don't see how he could possibly grasp the issues involved here.


Anonymous said...

Unrelated, but I would like to suggest a drop box for "Least Helpful Call..." nominations, because I've seen some whoppers this season.

Graham Hussein Prannagh said...

After a while away from your blog it's as fine as ever. I should note that I tried to read a feature in the Journal recently about knowledge management and was aghast at its inanity. It seems that apart from core reportage, which the Journal is still doing quite well, its ability to source good feature writing is declining precipitously.

HawkeMissile said...

Mr. Matthews, did you notify the SEC of your suspicions with respect to VRAD's trading last year?

I would like to follow-up with you on this matter if you have interest.

Jeff Matthews said...

Hawke Missile: You either didn't actually read the blog, or didn't really believe it meant what it said. Well, it means exactly what it says, and thus there is nothing to follow up on my end.