Last week, hedge fund tycoon Raj Rajaratnam was sentenced to a record 11 years in prison for insider trading: making a killing by buying and selling stocks using information that most of us didn't and couldn't know. The media emphasized the "symbolic significance" of the long sentence. But as the Securities and Exchange Commission and the Department of Justice celebrated, others asked: "Why do we even have these rules? How do you draw the line between smart research and illegal information? Why not let a free market run free?"
Public opinion on the issue is clear. Most people believe that insider trading is simply unfair. Few things anger common citizens more than knowing that privileged people can get rich fast while they have to work hard for an honest living. They also recognize that insider traders profit at the expense of other traders. Public outrage at Rajaratnam's insider profits — more than $50 million, according to the judge — fueled extraordinary media coverage of what was actually a tedious and boring trial.
But what seems cut and dried to the public is a more nuanced issue to market experts, economists and legal scholars. Their arguments pro and con are being aired again in the wake of Rajaratnam's sentencing.
Those opposed to restricting insider trading note that insider trading makes prices more informative, which is beneficial to the economy. That is, allowing insiders to trade freely on what they know ensures that stock prices quickly reflect true value as that value changes.
They also observe that if insider trader were legal, insiders would race to the market to trade on new information before others could. This race would cause prices to adjust quickly and thereby limit their profits. In contrast, when insider trading is illegal, those in the know trade slowly to avoid detection, which increases their profits.
Another argument says insider trading may not really hurt shareholders in the long run. That's because the opportunity to trade legally on insider information could be a valuable employment benefit for senior managers. Corporations then could pay them less, a savings to shareholders that would largely offset their losses to insider trading. (This scenario may explain why in Japan, where insider trading laws are not seriously enforced, CEOs are paid less than CEOs in the U.S. and yet are often as wealthy as their American counterparts.)
Finally, opponents of insider trading laws point to the high cost of enforcement and the danger of selective prosecutions as reasons to do away with the laws. The economic and social costs, they fear, may be greater than the benefits.
There are familiar answers to these arguments. Those who favor insider trading laws first echo public sentiment: The perceived unfairness of insider trading undermines investor confidence in the markets, they say. Investors do not want to play in markets that they believe are rigged against them.
On top of that, the benefit of more informative prices created by insider trading generally is small because the public often finds out what the insiders knew just hours or days later.
And if insiders were allowed to buy or sell freely, Wall Street dealers would lose more when they inevitably unknowingly trade with insiders, which would make the dealers less eager to do business with anyone. That would create less liquidity in the markets, transaction costs would rise, which in turn would discourage public investors and increase the cost of capital.
Oddly, the most important argument against legalizing insider trading is rarely discussed: If insider trading were legal, corporate insiders would hide information from their boards of directors and from the public to maximize their trading profits.
Corporate directors must be well informed to effectively advise corporate managers and to ensure that invested shareholder capital is well managed. Likewise, investors must be well informed to make good investment decisions. Good and timely corporate information is essential for economic efficiency.
The greatest dangers from unrestricted insider trading come from the negative impact that it would have on corporate governance and on the public financial disclosures that investors rely on to make good decisions.
The financial crisis revealed large problems with corporate governance and financial disclosure. Eliminating insider trading rules would only make them worse.
The SEC's efforts to enforce insider trading laws, with the Rajaratnam prosecution front and center, are a bid to restore its reputation and to restore public investor confidence in the markets in the aftermath of financial crisis and scandal. But more important, enforcement efforts reduce the incentives that corporate managers have to withhold information so necessary to the efficient operation of our capital market system.
Larry Harris is a professor of finance and business economics and holds the Fred V. Keenan Chair in Finance at the USC Marshall School of Business. He was chief economist of the SEC from 2002 to 2004.