Martha Stewart’s case, despite public perception to the contrary, turns not on insider trading, but on obstruction of justice, lying to investigators. Dean emeritus Henry Manne of the George Mason University School of Law, author of Insider Trading and the Stock Market, argues that authorities find insider trading virtually impossible to stop, let alone prove. His solution? Legalize insider trading.
I interviewed Professor Manne. These excerpts follow:
Larry Elder: Professor, this whole subject of advocating that insider trading be legal freaks a lot of people out. Many people are shocked to find out that it wasn’t until the ’60s that the Securities and Exchange Commission (SEC), in fact, outlawed insider trading. How was it that up until then, somehow, some way, the stock market operated OK with insider trading being legal? I remember watching footage of millionaires jumping from buildings during the stock market crash. If insider trading protected all these bigwigs from being surprised, how then did so many rich people lose money during the crash?
Professor Manne: I don’t think that that crash really was involved much with insider trading at all.
Elder: That’s my point. If insider trading gave rich people such an advantage, they would have gotten out, and the so-called little guy would have been stuck.
Manne: That’s right. Congress needed some kind of morality story to hinge everything on, and the very phrase, “insider trading,” suggested to people that something evil has been done. The SEC, at least since the 1960s, has been very successful in making this into one of the most egregious evils in the world. If you want to say that anyone’s really done something terrible, it’s not incest, or murder, or treason, it’s insider trading. That’s the bad thing. Now, they’ve done that without any evidence whatever to back up that notion.
Elder: In one article you wrote at least four arguments in favor of insider trading. One was that people would perceive it to be cynical, and that it really can’t be stopped. It cannot be effectively enforced.
Manne: That’s, of course, why they didn’t indict Martha Stewart for insider trading. The SEC does not win many of the cases they bring, and they don’t bring many. It’s really very interesting to wonder what kind of law is this that is so difficult to prove that you’ve got a case. We know trillions and trillions of dollars are going through the hands of people who have better information than other people. That’s what makes the market work . . . makes it efficient . . .
Elder: A “little guy” hearing this is going to say, “Well, I’m not an insider — how could it not harm me that I’m not privy to information that other people are privy to?”
Manne: That was one of the very first myths in this field since my book in 1966. The serious scholars don’t make that argument at all any more, because it’s very clear that that person is in the stock market, an anonymous market, to sell the shares and doesn’t care who buys them. If there’s information out there, it may be an insider has it. It doesn’t make any difference. Once you make a decision to sell, you don’t lose anything when there’s an additional buyer in the market, because that person happens to have information. That’s absurd.
Elder: Another argument you make is that it helps to move the price of a share to its “correct level.” What do you mean?
Manne: It’s very important in the world of finance that shares be accurately priced. There are many things that turn on that — compensation does, the whole takeover field turns on it, people’s investment decisions turn on it, so it’s very important that we have actual reflection of what’s going on. Well, how do you get that? The SEC says, well, we’ll get reports that come out three or six months later, and that will inform the market of what’s going on. That’s baloney. The way the market works is that informed people do their trading, and every time they trade on good news, they drive the price up — every time they trade on bad news, they drive the price down.
Elder: Let’s talk about the recent state of corporate accounting scandals: Enron, Global Crossing, etc. What impact would insider trading have had on these kinds of scandals?
Manne: I don’t think the scandals would ever have erupted if we had allowed insider trading . . . 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.
Professor Manne: The SEC is just disgraceful on this — they insist that the traditional accounting forms will convey the kind of information you need for valuing stocks. That’s just absurd. The Sarbanes-Oxley bill that was recently passed that regulates accounting makes about as much sense as Congress saying that we’ve got to perfect the system of astrology.
Larry Elder: Would you also not say that so many states have passed laws that stop corporate takeovers, and those laws also have hurt, because takeover artists are always looking for these kinds of accounting irregularities . . . ?
Manne: Absolutely. If there was ever any really evil special interest legislation, it’s that state law that prevents takeovers. There’s federal law that does that, and that has cost the American investors tens of trillions of dollars. . . . We have no idea how big it is, because it allows inefficiency to continue. The SEC regulation and the new Sarbanes-Oxley regulation of accounting encouraged the production of useless information, making it more difficult to get the valuable kind. And the only way you’re really going to get it is by letting lots of people have access to information in a free market and a free-for-all — let them use their information just like you let anyone use his private property in the market to benefit himself.
Elder: You say that use of insider trading by CEOs would be a desirable form of incentive compensation. Explain that.
Manne: I didn’t limit that to CEOs, but one of the problems has long been how to compensate really entrepreneurial kinds of people in large bureaucratic companies. If you just give them salary, they won’t have any incentive to go out and really take any risks or try anything new. But insider trading gives you all the correct incentives for that.
Ken (a caller): My disagreement is, if you have insider trading, at least in some cases, if the principals of the company know that the stock is about to tank because they didn’t get a patent, they know that, their friends know that, they get rich selling the stock, but some poor guy who hasn’t heard the information on the news yet, because it hasn’t been released, buys the stock and it tanks the next day.
Manne: The law determines when these disclosures can be made. Now the poor guy out there who doesn’t have the information — he’s in the market whether or not anything else has happened, his allowing insider trading doesn’t speed up the time the actual disclosure will occur. . . . Do you think it’s unfair that they make money? . . . I do know that in the competitive market, no one will continue to make abnormal returns without somebody coming in and competing away those profits. That’s how the market works.
Elder: Ken’s argument is, let’s say there’s a pharmaceutical company that applied for FDA approval. . . . The news media thinks they’re going to get the approval, but the company gets the bad news: They don’t get the approval, so they short-sell the stock.
Manne: Same thing. Short-sales will have the same impact on market price, and you want it to go down. You want that information into the capital markets just as fast as you possibly can get it there.
Elder: There are professionals who look at what the insiders in a company do, whether they buy . . . sell . . . short-sell, that’s what they do for a living. They sit there and monitor the tape and when they see a bunch of people short-selling, they then react to that.
Manne: That’s right. That’s fortuitous. You can also say, well, they’re not producing anything socially valuable . . . they’re just leeches. The world is full of that kind of accident . . . people do make money by trading on their knowledge that insiders are trading.
Elder: And finally, worldwide, is insider trading pretty much banned at virtually every other stock exchange? I think I read that insider trading was legal in Japan. Am I wrong?
Manne: It’s not legal on the books, but they have never had an enforcement action. Effectively, it’s still legal there. And that’s true in every country in the world that has these laws. I maintain that it’s true in the U.S., but nobody can really notice it because you get these enormous headlines — Martha Stewart and ImClone and problems like that — and you think, oh, boy, the securities policemen are really doing they’re job — they’re doing nothing. They’re making headlines. They’re not making enforcement of that law, because it’s really impossible to do.
For more information, read Henry Manne’s book, Insider Trading and the Stock Market.