Is Insider Trading Law Penalizing Free Market Capitalism?

Splashed across seemingly every major business page yesterday was the latest breathy reportage on alleged “insider trading.” This time it largely centers on former Goldman Sachs (NYSE:GS) (editor’s note: I worked for Goldman Sachs from 1998-2001) board member Raj Gupta passing along non-public information about a looming investment from Warren Buffett to Galleon Group founder Raj Rajaratnam.

The story goes that upon hearing of Buffett’s plan to send $5 billion Goldman’s (NYSE:GS) way, Rajaratnam purchased GS (NYSE:GS) shares, then sold them the next day for a profit of $900,000. For the Wall Street types and financial journalists of this generation who learned about insider trading from noted financial whiz Oliver Stone’s Wall Street, and from discredited books such as “Den of Thieves”, Rajaratnam’s actions smack of inside dealings that should lead to wiretapped meetings in Central Park, followed by imprisonment for the individual who transacted on the information.

Maybe in Hollywood the above scenario would/should play out, but back in the real world it’s time for everyone to grow up. Whatever the “laws” are that relate to the highly ambiguous notion of “insider trading”, rational minds should acknowledge that nothing untoward occurred. More to the point, we should be cheering intrepid individuals such as Rajaratnam for bringing necessary information to share prices, and Gupta too should be exalted for providing it.

To understand why, it has to be remembered that we live in a world of limited capital. And when information is withheld from the stock market, there exists the potential for capital to be destroyed for investors not being able to buy and sell shares the value of which contains all material information.

Naysayers will of course say that Rajaratnam was the lucky beneficiary of news that all investors would have enjoyed being privy to, but this bit of 20/20 hindsight is not worthy of serious discussion. To put it simply, good information is in the eye of the beholder, and it says here that the market sleuths who regularly transact based on non-public information probably lose money as often as they make it.

As evidenced by there existing differing views on every unemployment rate¬†reading, company earnings report and legislative decision, information that one individual may view as good, another will view as bad, and another will be indifferent toward. Rajaratnam’s actions point to him viewing Gupta’s tip as good for Goldman (NYSE:GS) shares.

Of course that was hardly a certainty, so in committing some of Galleon’s capital, Rajaratnam had no way of knowing if his bet would be rewarded. Assuming certainty on his part, it’s a fair bet that someone of his means would have purchased a great deal more in the way of GS (NYSE:GS) shares, and given the state of the markets at the time, there would have been many willing sellers.

In Rajaratnam’s case, his willingness to dip his toe in the water on a speculation not only provided the markets with necessary liquidity, but the short-term profits achieved gave investors highly useful information about market psychology. Though Rajaratnam’s actions weren’t compassionate (business is about profits), his courageous jump into the shares of a company that investors were fleeing gave other investors – large and small – better information about how to proceed.

The logical response to the above suggestion is that a Buffett investment is as good as gold, and that any investor would have done as Rajaratnam did, but the subsequent decline of Goldman’s (NYSE:GS) shares disproves this very assumption. Indeed, despite Buffett’s seal of approval, GS (NYSE:GS) shares ultimately declined from roughly $133 all the way to $52, and only bounced back once it became apparent that the firm would be the beneficiary of a backdoor bailout via an overnight switch to “bank-holding company” status.

Also not discussed by those eager to turn the Rajaratnam/Gupta exchanges into the Madoff story of 2011 is whether this non-scandal would be one at all if Rajaratnam had lost his shirt on the Goldman (NYSE:GS) share purchase. “Insider trading” history tells us it wouldn’t be, that if Galleon had been blown up for betting the wrong way on non-public information that it would have died as so many hedge funds did back then, with no mention of the fund’s voracious appetite for allegedly privileged intelligence.

The above brings up yet another “insider trading” law asymmetry. As it is, the SEC can’t prosecute without a transaction, so if an investor in possession of non-public information chooses not to buy or sell based on quality information, and as such benefits as much as an information-rich individual who does transact, there’s no crime for the former.

What’s apparently also not a crime is to lose a lot of money while in possession of supposed wisdom that the general public isn’t privy to. This is important because once again, good/bad information is very much in the eye of the beholder, but the investors who seemingly break the law while transacting the wrong way with non-public information are simply allowed to fail, free of frog-marches.

On the other hand, if investors bet the right way, make money, and in doing so provide the broad marketplace with precious price signals, the SEC will proceed to wreck their reputations and careers. The asymmetries of “insider trading” laws are substantial, but seemingly so wrapped up is the commentariat in some Oliver Stone vision of what¬†shouldn’t be a crime, no one bothers to point out that failed “law breakers” and inactive “law breakers” get off without so much as a hand-slap, while the successes are dragged through the mud.

Legal history combined with an unfortunate new strain of Americanism that embraces drawing blood from the rich and powerful ensure that Gupta and Rajaratnam face some rough days ahead. That’s unfortunate, because if we ever start acting like adults, we’ll realize that the “law” when it comes to “insider trading” is the problem, not individuals who disseminate and act on information that leads to efficiently priced markets, capital preservation, and economic growth.

John Tamny is a senior economic advisor to Toreador Research & Trading, a senior economist with H.C. Wainwright Economics, and editor of RealClearMarkets and Forbes.

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