Insider trading investigations increasingly rely on blue collar tactics such as FBI raids and the resulting publicity, as well as wired cooperating witnesses and similar techniques. The high profile raids by dozens of FBI agents on three hedge funds last week are becoming emblematic of the tactics being used. The subsequent arrest of an expert network employee gives some notion about the scope of the on-going investigations by the Manhattan U.S. Attorneys Office and the SEC.
Ensuring against insider trading is important. It hurts all market participants and is not, as some claim, a “victimless crime.” Insider trading harms corporate shareholders because their trust and confidential information is abused. Market participants are injured because they trade on the assumption that those on the other side of the transactions are acting lawfully and not using inside information to gain an unlawful advantage. The markets are injured because effective price discovery depends on the communication of information which is translated into price, not a select group of traders using unlawfully obtained data.
Enforcing the law properly also means not harming the markets and market participants in the name of protecting them. Raiding three legitimate trading operations as the government did last week sends a clear message that all market participants should beware. While a grand jury subpoena could have secured the same information for the government, it would not have generated the massive publicity of coordinated FBI raids across the country as if mobsters were the targets. Now the three hedge funds must struggle to save their businesses in the wake of effectively being called scofflaws by the government. For the hedge funds, unfortunately, there is no opportunity to defend.
The scope of the inquiries may also harm some market participants, perhaps even the traders and markets the government claims it is protecting. All securities traders rely on the markets for effective price discovery. The information known and knowable about a company and its shares is absorbed into the price of the stock. The more efficient this process, the better the price discovery. At the same time, all investors are encouraged by the SEC to make use of available information before entering into a securities transaction. This applies to small investor making a decisions about their 401ks, as well as professionals such as those who operate hedge funds.
Some sophisticated experts, such as hedge fund operations, gather information through “expert networks.” Those entities are designed to furnish investor clients with better insight into a line of business or a particular company in much the same way as specialized analysts who work for brokerage firms. This may give some traders an informational advantage over others. The securities laws were not intended, however, to discourage detailed research and hard work. Nor were they intended to guarantee that every investor has the same information, a notion called “parity of information,” which the Supreme Court has rejected.
Rather, the statutes safeguard against wrongful informational disparities. It is for this reason that insider trading is defined in terms of acquiring information not from hard work but through a “breach of duty” or “a violation of trust” or from “misappropriation.” Those concepts do not denote more research or carefully study a line of business or a company to determine trends. They are the antithesis of hard work. Those concepts represent a short cut called theft.
The tactics being used in the current insider trading investigations threatens to disrupt and harm the balance between careful, meticulous information gathering and insider trading. They also at least suggest that the government may be considering an expansion of the definition of insider trading, moving toward an inappropriate parity of information standard. Headline grabbing FBI raids intimidate and harm traders without necessarily protecting legitimate market participants and the markets. Signaling that the inquiries are targeting legitimate sources of information such as expert networks and that the government is recruiting an ever expanding network of mob style wired informants can only serve to further intimidate traders and researchers who routinely gather bits and pieces of information which improve price discovery. When this happens, the efficiency of the markets and price discovery is undermined and compromised, harming all market participants.
All of this suggests that while law enforcement and market regulators need to police for insider trading, it is essential that they carefully select the techniques they use and take precautions against harming those they are claiming to protect.