Maybe insider trading should be legal

OMG, you whispered something to someone who whispered to somebody on the subway and a guy overheard and made a trade and NOW YOU ARE ALL GOING TO JAIL! What the heck is happening? Every fund in the world is being raided, people are being threatened on the eve of Thanksgiving with prosecution, and all we want to do is just relax and get back to being scammed in this rigged market. Why are these billionaires even risking jail with at the very least a very gray area of the law is the main question I have. But first, should insider trading even be illegal?

Lets look back at an ancient case: the Galleon insider buying of Hilton (HLT) the day before it was acquired by Blackstone. Galleon supposedly paid an analyst $10,000 to give up the information on this merger.  Galleon made $4,000,000 on the trade.

On July 3, 2007, after the market closed, Blackstone announced they were buying Hilton. Raj had known and made a ton of money. Everyone knew at the time there was insider trading involved. I even went on CNBC that very weekend to discuss what had happened.

On July 2, the day before the deal was announced, Hilton shares were at $33.87. On July 3, Hilton shares made one of their biggest moves ever, closing almost 7% higher at $36.05 on double the normal volume before the deal was announced. And, by the way, it was a half day in the markets that day. Then Blackstone offered $47.50 a share for Hilton. It was clear even then that someone big had known something and had acted illegally on that information. In a column for the Financial Times I wrote “Certainly they’ll catch one or two criminals here” and they did. Its very hard to track down insider trading and I give the SEC kudos for doing a great job here. Did they catch all the culprits? Probably not, but they certainly made anyone thinking of doing this crime very very scared.

But should insider trading even be illegal? The obvious answer is of course it should be, else the average investor will get taken advantage of. If some players in a market have an advantage, then some have a disadvantage and that’s not fair. However, I’m not sure its so black and white. Here are the benefits of making insider trading legal:

  • The more information in a market, any market, the more efficient prices become. If informed investors start buying or selling based on privileged information, asset prices will rise to their “correct” level. For instance, in the Hilton case, we probably would have seen a smooth progression of the stock price from33 to45 over the prior month as talks progressed, instead of the spike in just one day.
  • Fraud will be exposed earlier. This is a very key point to the argument. Enron is an example where tens of thousands of investors got burned because they were piling into the stocks during the later stages of its fraud. If insiders were selling we would’ve seen a much swifter move down, and probable fraud exposed.
  • Companies will either become more transparent, to keep the retail investor happy, or will themselves enforce secrecy rather than being complacent with the idea that the law somehow protects their secrets.
  • One concern is that there will be a flight of liquidity because people will be concerned about the legitimacy of our markets. Rather, the opposite will occur. More enforcement dollars will be used to uncover actual frauds such as the next Enron or Worldcom. Arguably, these frauds are a thousand times more dangerous for the retail investor than what is probably a victimless crime such as insider trading.
  • Insider trading is almost impossible to prosecute and the government wastes countless dollars trying.

I’m simply raising the question. Could legal insider trading lead to a more efficient market that would ultimately benefit investors and allow investigators to probe elsewhere? I’m scared about all the ponzi schemes, the mini-Madoffs, left uncovered. What do you think?

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