Insider Trading: Victimless Crime?

Trade and Economics - October 5, 2021

Should so-called victimless crimes be prohibited by law?…

One of the most fascinating issues in political theory is that of victimless crimes. I have recently discussed two of them, prostitution and pornography. Radical feminists reject the idea that they are victimless, asserting that they involve the systemic degradation and exploitation of women by the ‘patriarchy’. I find their position less than convincing, although I would concede that both activities reveal deficiencies or imperfections in human beings. They may be vices, but they should not become crimes, as St. Thomas Aquinas argued more than eight centuries ago. Government should leave alone vices which are not harmful to others and concentrate on suppressing those which threaten ordinary citizens, such as theft and murder. I would now like to take my inspiration from the philosopher-saint on the same issue, victimless crimes, but analysing a different example, insider trading. Should it be legal? Where are the victims?

The Merchant from Alexandria

In Summa Theologiae Aquinas briefly discusses a famous case which is directly relevant to the subject. It was originally introduced by Stoic philosophers, according to the Roman lawyer Cicero in his book On Duties (De Officiis, Book III, xii–xiii). There had been a famine on the island of Rhodos. A merchant from Alexandria arrives on his ship which is heavily laden with wheat. He expects more merchants to be on their way to the island because he could see their sails on the distant horizon. The question is whether the merchant has to reveal this to the islanders. It would definitely deprive him of the chance to sell his wheat at a much higher price than would otherwise be the case. In antiquity, opinion on this question was divided. Diogenes from Babylon argued that the merchant was obliged to inform his customers of known defects of the good he was selling, but that he was permitted to try and get the highest price possible for it. Diogenes made a helpful distinction between concealing something about a good from others and not taking the initiative of informing them of something which might change their evaluation of it. The merchant was not forcing the islanders to buy his wheat, Diogenes pointed out. They did so only if they wanted and needed it. Antipater of Tarsus disagreed. The merchant was a member of the same moral community as the islanders and thus he had an obligation to them not to take advantage of the situation.

While Cicero himself concurred with Antipater, Aquinas disagrees with both of them (Second Part of Second Part, Question 77, Article 3):

An item’s defects make the item less valuable in the present than it seems to be, whereas in the example described in the objection the item is expected to be of less value in the future because of an impending arrival of merchants that the buyers know nothing about. Hence, a seller who sells his item at the price that he finds does not seem to be acting contrary to justice if he does not expound upon the future. However, if he were to expound upon the future or to lower the price, then he would be a man of more abundant virtue—even though he does not seem to be obligated to do this by a demand of justice.

Here, Aquinas points out that no fraud is involved. The merchant is not selling a defective good; he is not cheating his customers, even if he may be lacking in generosity. Although the philosopher-saint does not explicitly say so, it seems that for his argument he relies on uncertainty about the future: Whereas the merchant has seen the sails of other merchant ships on the horizon, he cannot be sure that they will arrive safely in Rhodos. He is not bound to lower the price others are willing to pay him, on the basis of educated guesswork. Another argument which could strengthen Diogenes’ and Aquinas’ case is from self-ownership: If people own themselves, then they presumably also own the knowledge which they have acquired without violating any moral or legal rules. It is theirs, and theirs alone, to choose whether or not they reveal it in business transactions with others. Moreover, certainly the islanders are no victims. The merchant from Alexandria is the first to bring them desperately needed wheat, after a famine. They are better off after the deal, even if they could have been still better off if they had known what the merchant knew.

The Modern Investor

Aquinas’ example has a direct bearing on contemporary controversies about insider trading in stock markets. They are typically about an investor who receives some non-public information and acts on it, selling stock in a company which according to his information will be worth less in a while, or buying stock in a company which according to his information will be worth more. He is not really harming anyone else by trading in this way. People buy and sell stock all the time, on the basis of their information, policies, preferences, research, hunches, and tips, and the information of this investor just happened to be more reliable than that of others. It is true that other investors do not make the same profit this particular investor made, but they did not possess the same information, either, at the time of the trade. They usually are neither better nor worse off by the transaction. You can hardly lose on a stock you have never owned. Far from harming others, the investing insider in fact usually benefits the economy because he speeds up necessary price adjustments, especially in the capital market, and useful corporate restructuring. He identifies earlier than others that some companies are either under-valued or over-valued, and as he acts on this he brings this to the attention of others, and the information he possessed becomes public. As Friedrich von Hayek convincingly demonstrated, in the market order prices act as signals to people on what to do, and the better the prices reflect reality, the more efficient the system becomes. In the capital market, mergers and acquisitions are parts of a discovery process, in which the most efficient utilisation and composition of capital are found. This is what makes capitalism dynamic: it is corrigible and innovative.

It is of course relevant that the information utilised in insider trading is received legitimitely and does not involve breach of trust. One example of breach of trust would be if the employees of a financial firm would be under a contract (a fiduciary relationship) that any non-public information they receive should be utilised for the benefit of the firm only and not for themselves personally, whereas they would try to circumvent the contract by letting their friends or family act on their information. Another example of breach of trust would be if a public servant would intentionally reveal to an investor information which was supposed to be strictly confidential, enabling the investor to make a profit (and perhaps then share it with the official, for example in consultancy fees after the official’s retirement). Possibly George Soros just acted on his own hunch when he in 1992 betted against the British pound and broke the Bank of England, making a billion dollars and forcing the United Kingdom out of the European Exchange Rate Mechanism, ERM. But if he acted on a tip from inside the German Bundesbank that it would not give unlimited liquidity support to the Bank of England, then his insider trading involved the breach of trust by some Bundesbank members of staff.

There may have been in Iceland an instance of such breach of trust although it has never been investigated, for some reason. In late 2007, the then Vice-Chairman of the Independence Party, Thorgerdur K. Gunnarsdottir, then Minister of Education, attended a confidential meeting with the Prime Minister and the Governor of the Central Bank of Iceland, CBI, where the Governor expressed his great concern that the banking sector might collapse. While the minister angrily protested at the meeting (as both the Prime Minister and the CBI Governor have told me), she and her husband, a senior manager in one of the banks, in early 2008 sought and received an exemption from the bank’s rules on staff ownership of stock and purchase options. This enabled them to move their liabilities into a limited company with the result that her husband suffered much less loss than most other employees of the bank from its eventual failure. Again, on 30 September 2008 when the CBI Governor demanded a meeting with the government, telling the ministers that the banking sector was about to collapse, she and her husband sold their disposable remaining stock in the bank, the same day. In both cases the minister seems to have acted on confidential warnings, although it may be said in her defence that the vulnerability of the banks was common knowledge.

Insider Trading Not Necessarily Fraud

One way of illuminating the difference between insider trading and fraud is to look at horse racing. You may act on a tip that a certain horse will win in a forthcoming race, perhaps because somebody observed how much faster it could gallop than the other horses or because somebody knew that it was quite a magnificent animal. When you place a bet on that horse, it is insider trading. Although you win and other bettors lose, it is difficult to see how you were harming them. You were under no obligation to disclose your non-public information to them. It is different if you try somehow to rig the race, like the trainer John Straker did in Arthur Conan Doyle’s famous short story about Silver Blaze. This would be fraud, not insider trading. You would be harming others who have a legitimate expectation that the race will be fair. Incidentally, this is the problem with so-called shorting which became common in financial markets in the first decade of the twenty-first century. If you place a bet against a bank surviving, you have a vested interest in the bank failing, and then there is a temptation to bring this about. The Icelanders observed how some British hedge fund managers did this in early 2008 when they realised that the Icelandic banks were vulnerable because they had grown beyond what the Central Bank of Iceland and the Treasury could on their own support if there would be a severe credit crunch. What the hedge fund managers did was to place bets against the Icelandic banks and plant stories in the British press about their vulnerabilities. The fact that their prophecies eventually came true does not necessarily mean that they did not commit fraud: these may have been self-fulfilling prophecies, common in the jittery financial markets, often governed by herd instinct.

Note however that the information utilised in insider trading is not always certain. It is often educated guesswork. The merchant from Alexandria saw the sails of other ships on the horizon. But unexpected rough waters might destroy them before they could reach Rhodos. Therefore Aquinas found him not obliged to reveal his fleeting observation to the islanders. Likewise, at the last minute, a company board might suddenly decide not to take over another company even if this had been prepared for some time while insiders had been utilising their non-public knowledge of the plan quietly to buy stock in the other company. Note also an important asymmetry in the treatment of insiders. If the information is of such a kind that the investor does not act on it, for example that he should not sell stock which he already holds in a company or that he should not buy stock in another company, he is as ‘guilty’ of insider trading as another investor who buys or sells stock according to non-public information. But it lies in the nature of such non-action that it is not easily detected by any regulators. It would not be implausible to assume that perhaps half of the non-public information investors receive would be of this kind. This would imply that only half of those engaged in insider trading are ever detected which seems to introduce discretion and arbitrariness into the process.

Three Prisoners, No Criminals

In the United States, the most notorious insider traders are often said to be financial analyst Michael Milken and lifestyle expert Martha Stewart. Milken had become one of the richest men in North America as a pioneer in issuing high-yield bonds and facilitating leveraged buyouts and hostile takeovers. In the process he had made many enemies, not least among traditional Wall Street financiers and corporate managers who suddenly found themselves challenged. In fact high-yield bonds, also called junk bonds, had existed long before Milken. They were bonds with lower credit ratings and consequently paying higher interest rates than ordinary bonds. It seems to me that they were what in the distant past used to be called usury loans, high-risk loans bearing high interest rates, which suggests that to some Milken may have appeared to be a modern version of Shylock. He was widely accused of illegal insider trading, while ironically one reason for his unpopularity was that he was not an insider, but an outsider, not a part of the business establishment. The Securities and Exchange Commission, SEC, imposed its own broad interpretation of illegal insider trading on the financial market and started investigating Milken, and so did the politically ambitious U.S. Attorney for the Southern District of New York, Rudolph Giuliani. In 1989, Milken was indicted on 98 counts of racketeering and fraud. The target of heavy-handed government tactics, including threats of investigating and indicting his relatives, he decided to plead guilty to six counts of securities and tax law violations. He agreed to pay $200 million in fines to the SEC, and $400 million to investors, and after a civil lawsuit he paid a further $500 million to investors. Milken was however never found guilty of any insider trading. In a closely-argued book, Payback: The Conspiracy to Destroy Michael Milken and his Financial Revolution, Chicago professor Daniel Fischel argues that the pursuit of Milken was a vengeful response by the establishment to his success.

Martha Stewart had become wealthy as a result of her skill in designing and marketing home products, with her own magazine and television show. In late 2001, she sold her shares in a biopharmaceutical company after receiving a tip from her broker that the director of the company was selling all his shares in the expectation of an adverse ruling by the Federal Drug Administration, FDA, on one of its products. Two years later Stewart was indicted on securities fraud and obstruction of justice. In her case, the old saying certainly came true that what matters is not the crime, but the cover-up. She was eventually convicted of obstruction of justice, in particular of making false statements to federal investigators and sentenced to five months in prison and a relatively small fine. Note that she was not convicted of insider trading. But here again the question is who was harmed by her acting on the tip. What is really worrisome is the enormous bargaining power government has because even if you have not committed any crime intentionally, it can wreck your life.

The Icelandic case is a bit different. In late 2008, only a few weeks before the bank collapse, the Permanent Secretary at the Ministry of Finance, Baldur Gudlaugsson, had sold shares in one of the Icelandic banks which he had not bought but received in 2005 as a result of the takeover of a shipping line in which he had held shares. The Icelandic Financial Supervisory Authority, IFSA, had investigated his sale of the bank shares but announced to him in May 2009 that it had found no grounds for continuing with the case. But after Gudlaugsson refused to step down from his position as Permanent Secretary when a left-wing government took power in Iceland, the case was reopened and Gudlaugsson was indicted by a Special Prosecutor dealing with cases related to the bank collapse. In 2012 he was convicted of insider trading, receiving a two-year prison sentence, out of which he served one year. Gudlaugsson said in his defence that he did not need any insider information to know what everybody knew in Iceland at the time, in autumn 2008, that the banks were in great trouble. (His defence was more plausible than that of Gunnarsdottir would be, for two reasons: there was no exemption from any rules, and in the autumn of 2008 it was much more obvious than early in the year that the banks were in great trouble.) But Gudlaugsson was pursued with even more zeal than Milken and Stewart. Not only had the investigation of him been reopened without any significant new evidence appearing, but he was also convicted of a crime different from what he had been charged with: under Icelandic law, a non-trivial distinction is made between temporary insiders and secondary insiders. Gudlaugsson had been charged as a secondary insider, but convicted as a temporary insider, an astonishing error by the Icelandic Supreme Court. Moreover, four years after his conviction it emerged that one of the Supreme Court judges in his case had owned a lot of stock in the same bank, and unlike Gudlaugsson, he had not sold it and subsequently suffered a significant loss in the collapse. Gudlaugsson had clearly been deprived of his right to a fair hearing by an independent and impartial tribunal. Be that as it may, all three cases show how dangerous it is to criminalise such an ambiguous and elusive activity as insider trading.

Is Insider Trading Morally Reprehensible?

There is thus a strong case for legalising insider trading, while maintaining clear and strictly enforced rules against breach of trust and fraud. The benefits of insider trading are larger than the costs, and usually nobody is harmed in the sense that his rights are violated. Normally people do not have a claim on information others have acquired. But an interesting philosophical question remains about the moral standing of insider trading. Is it a vice which just has to be tolerated, like prostitution? I do not think so. I tend to agree with Aquinas who argued that the merchant from Alexandria who did not reveal his non-public information to the islanders of Rhodos was not unjust, although he may have been ungenerous. But generosity is only one of the virtues. Thriftiness is another virtue: you have to make good use of your limited resources, and one of them is your knowledge. Thriftiness is of course not avarice, which certainly is a vice. But usually venture capitalists, entrepreneurs and innovators are thrifty rather than avaricious. They just need every penny they can spare for what Joseph Schumpeter perceptively called capitalism’s creative destruction.