Insider Trading and Arm’s-Length Investing

by Reihan Salam

In light of the new vogue for revisiting insider trading laws, I thought I’d share an old column I published in The Daily back in 2011, when we were young and innocent. This morning, Matt Yglesias made a strong case against legalizing insider trading, on the grounds that it has the potential to cause serious corporate governance challenges, among other things. The argument I make below is less susceptible to this charge, as it takes more of a “let’s burn the whole thing down and start all over again” approach — which is to say a wildly unrealistic approach.

Very few Americans will shed a tear for Raj Rajaratnam, the billionaire hedge fund manager convicted this week of insider trading, and that is fair enough. Of the hundreds of thousands of men and women we lock up every year, Rajaratnam is hardly the most sympathetic. Though the federal government’s case against Rajaratnam may have overreached in some respects, there is no question that he bribed people like disgraced former Intel executive Rajiv Goel into betraying their employers, and that alone merits jail time.

But Rajaratnam’s crimes are just a symptom of a much bigger problem.As the economist Amar Bhidé argues in A Call for Judgment, insider trading rules have helped create a centralized and super-sized financial sector that is sapping the real economy of its growth potential, leaving all of us poorer than we can and should be.

After the Crash of 1929, small investors fled the stock market en masse, convinced that it was rigged against them. In 1934, the Roosevelt administration created the Securities and Exchange Commission as part of an effort to restore confidence in the stock market. The SEC’s central goal was to protect the interests of small investors. Publicly-traded companies had to disclose information about their financial condition and who was running the show. Over time, these disclosure requirements expanded as the SEC demanded more information about the inner workings of public companies. In addition, the Securities Exchange Act put in place rules against insider trading.

The basic idea behind these rules is that officers, directors, and stockholders that own at least 10% of a company should not be allowed to use inside information to influence their investment decisions. Say a senior executive knows that his company is about to post huge losses in the next quarter. He might use this information to dump the company’s stock before outside investors catch wind of the bad news and the stock price plummets. Similarly, investors who own a big stake in a company can bend the ear of directors or executives to gain the material nonpublic information, i.e., information that only insiders have that could effect the movement of the stock price. The SEC demands that insiders file statements that reveal all of the equity securities they own, to guard against just this kind of behavior.

The result of these regulations is that American investors, large and small, keep the executives running the big public companies they invest in at arm’s length. They don’t forge long-term relationships based in mutual trust. Instead, thousands of anonymous investors pump money in and out of these companies, knowing nothing more than what appears in annual and quarterly reports. As Bhidé puts it, “the oversight and counsel provided by one shareholder benefits all others, with the result that all of them may shirk their responsibilities.” Once a company has thousands of shareholders, and each of those shareholders own shares in dozens or even hundreds of companies, who exactly is going to take the time to provide real oversight and counsel?

As a result, the executives and directors of big public companies can get away with almost anything, as their investors are widely dispersed and legally barred from profiting from any effort to get under the hood of the company. The corporate scandals that marked the Enron era, the headlong rush into toxic assets, the corruption of corporate boards — all can be traced to the resulting lack of accountability. Ironically enough, insider trading rules work all too well. They’ve not only restored confidence in the stock market. They’ve created the illusion that it is safe to invest in a company without doing any due diligence of your own.

Contrast this with venture capitalists, who devote considerable energy to getting to know the entrepreneurs they back. It’s not unusual for VCs to offer advice to the start-ups they invest in, and to devour all of the information they can to keep their partners on track. The best VCs understand that it is this nitty-gritty engagement in their investments can make all the difference between success and failure. It allows them to recognize when a bad quarter is just a speed bump and when it is a sign of trouble. Steven Levy’s In the Plex recounts the many times Google’s earliest backers fretted over this or that decision made by Larry Page and Sergey Brin. But these savvy VCs had a basic confidence in Larry and Sergey rooted in actual give-and-take conversations stretching over months.

Though Google eventually went public, It is hardly surprising that a growing number of promising start-ups are delaying going public as long as possible, and many others are choosing to remain in private hands.

In an alternate universe, the Raj Rajaratnams of the world wouldn’t spend all of their time goosing stock prices to make fast money. They’d make long-term investments, and devote their considerable brainpower to helping businesses achieve sustainable growth. And this, in turn, would make for a healthier, and richer, American economy. We won’t get from here to there overnight, but rolling back insider trading rules would be an excellent first step.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.