Sunday, 25 October 2009

That Time of Year: WSJ Op-Ed Defends Insider Trading

I say "that time of year" because periodically (okay, maybe not every year, but as sure as the swallows land at Capistrano), the WSJ runs an op-ed piece that defends the practice of insider trading.

This year's version is written by Donald J. Boudreaux and, owing to its sort of porky length, I am betting that it appears only online and not in the print Journal. Boudreaux makes enough sense that, if you want to see the real fright gallery for this Halloween-timed piece, check out the comments section afterwards. You'll find a lot of people -- they smell like traders to me; they have that sort of smart knowingness about the markets on a very micro level -- cheering him on. Clearly Boudreaux managed to quickly assemble his own amen corner.

So what is wrong with insider trading? Boudreaux offers many reasons why it's actually a good thing. But does his exuberant defense capture the whole picture?

First, what is insider trading? It's pretty much what it sounds like: insiders buying and selling stocks of publicly traded companies based on knowledge that they have that others don't. Obvious example: You know, as a director on the board of Cisco, that the company will be bought out by the Chinese at a 30 percent premium. The formal announcement will come in two weeks. So in the meantime you buy every share you can lay your hands on. When Cisco pops say $15 a share, you cash in.

That's illegal. In Boudreaux's world, it wouldn't be (though, as he proposes, Cisco would be left to define its own narrow or broad version of "insider trading" -- for example, it could mandate that no insiders can trade on information related to takeovers/mergers. The company then would be free to sue any violators itself; federal regulators wouldn't get involved).

Let's look at what Boudreaux is saying, bit by bit. First, he points out that regulating insider trading is a messy, imperfect business to begin with. The application of the enforcement rules is unavoidably biased. Here he makes an interesting (and valid) point:
These prohibitions are meant to prevent all insiders with non-public information from profiting from the use of such information before it becomes public. It follows that unbiased application of these prohibitions should target not only traders whose inside information prompts them to actively buy or sell assets, but also traders whose inside information prompts them not to make asset purchases or sales that they would have made were it not for their inside information.
Okay, here's what he's saying, in easier-to-parse English: Insider trading catches only sins of commission, not sins of omission. It catches people who are buying and selling (they leave a paper trail, alas), but not those who would have bought and sold, if not for their privileged information.

So picture Fred, who's working for King Kazoo. He's a mid-level manager who happens to glimpse a copy of King Kazoo's sales for August, on the desk of his boss. At lunch, Fred was planning to place an order to sell 5,000 shares of King Kazoo. But he sees kazoo sales rocketed higher in August. The stock is going to soar. Fred thinks to himself, "Ah, maybe better not call my broker after all." And when the stock subsequently jumps 20 percent, Fred is sitting pretty.

That's not insider trading. Fred never made a trade. But it is insider knowledge that leads to a profitable advantage. And it's undetectable. We can't hook up Thought Monitors to everyone who works at, or deals with, a public company to see what they would have done had they not seen Document X or heard Y.

It's a problem for sure. But I think it's a problem of a different order of magnitude that we might just have to swallow hard and live with. It's a different order of magnitude because out-of-the-blue or less-motivated decisions to buy or sell stock (as with Fred above) are going to be smaller than motivated decisions to buy or sell based on a clear advantage. Okay, that's confusing, so here's what I mean more plainly: Fred was going to sell 5,000 shares and decides not to, seeing the great August sales figures. Now if insider trading were allowed and Fred was thus encouraged to profit off any information he had, he'd certainly be motivated to go out and buy a bunch of shares. But I think he would try to buy a much larger chunk of shares -- maybe 50,000 -- knowing he can make a bucketload of money.

So here's the contrast: the action he doesn't take is more likely based on a weak-motivation decision (he's going to sell the shares to generate a little cash, he has a vague feeling the stock will drop, he had a bad burrito last night and just doesn't feel like owning as much stock). But the action he does take -- buying or selling -- is based on a strong-motivation decision (he's almost certain the shares are heading higher). And when he acts on strong motivation, many more shares are likely to be involved.

The upshot is that I don't think the "sins of omission" are excusable, just that they tend to be less bad, so it's not worth getting too overexercised on that point.

Moving on: the core of Boudreaux's argument would warm the cockles of the heart of any efficient market theorist. Remember, that theory holds that the price of any stock, in an efficient manner, adjusts to reflect all relevant, available information. So, in this ideal world, the price of Kazoo stock is exactly what it should be.

But, of course, this overlooks something (actually a big something, in that it doesn't account for bubbles, momentum movements and the myriad irrationalities of human nature, but we'll let that part go for now). Kazoo stock can't be perfectly priced (even disregarding the irrational stuff), because the market doesn't have all the relevant information. Insiders do possess much of this information. And so, by allowing them to add their "information" to the market's understanding of the stock, this gives us a better approximation of its true value. And this is good, Boudreaux points out, for many reasons:
Suppose that unscrupulous management drives Acme Inc. to the verge of bankruptcy. Being unscrupulous, Acme's managers succeed for a time in hiding its perilous financial condition from the public. During this lying time, Acme's share price will be too high. Investors will buy Acme shares at prices that conceal the company's imminent doom. Creditors will extend financing to Acme on terms that do not compensate those creditors for the true risks that they are unknowingly undertaking. Perhaps some of Acme's employees will turn down good job offers at other firms in order to remain at what they are misled to believe is a financially solid Acme Inc.
In economist speak, capital (human and otherwise), is being misallocated in this scenario. Acme may receive too much credit, on too generous terms, because its stock price shows a healthy company that does not indeed exist. Talented managers at Acme -- who could be launching profitable startups or using their expertise to propel other firms to greatness -- are instead pouring their valuable time into a black hole of a company that's about to declare bankruptcy.

The argument appears compelling. Where does it break down? I think it's on the shareholder side, with the help of a feedback loop. Because while I think Boudreaux is on the cusp of a valid point with his "economic inefficiency argument," I think he misses badly on the share-price analysis, and this flaw then turns around and undercuts his efficiency point.

So let's look at this more closely, using the Acme example that Boudreaux himself has provided. Imagine Acme is a paragon of insider trading -- by this I mean that everybody has free rein to trade on whatever insider information they can obtain. A Boudreaux-ian would say, "Great, the stock price is really accurate and very efficient. The markets must love that!"

But do they? What are the two bedrock principles most often cited when discussing ideal markets? Free and fair. Certainly the Boudreaux world qualifies on number one. But it falls far short on number two. So what are the implications?

Let's go back to what a fluidly functioning market is all about. There are buyers. There are sellers. Shares change hands, and a moment later the stock ticks higher or lower. For that transaction, at that instant in time, there is a winner. And there is a loser. I personally think this is a more useful paradigm for understanding stock trades, especially shorter term, than that of "mispricing."

So let's imagine there are two investors in Boudreaux's world, Joe Insider and Ted Outsider. Acme is at $30 a share. Joe Insider sees evidence of the company's shakiness. Ted is unfortunately oblivious. Joe starts to sell. Ted sees a buying opportunity and scoops up cheap shares of Acme. Meanwhile Acme falls all the way to $10 a share.

Now, you can argue that a certain amount of mispricing was eliminated during this process. Acme now trades at a "truer" price. But let's examine what happened in the market. Ted realizes he's been had. He took the wrong side of the trade; Joe took the right side because he knew what was really going on.

Okay, Acme now trades at $10. That's good because the price is now more accurate, right? So now Ted should feel more comfortable about buying up more Acme shares because it's settled at this fair $10 price. So he snatches up Acme at $10 each. At the same time, Joe sees inside evidence that the price is going to drop even further. He dumps his holdings, does some short-selling, and makes a profit when the stock hits $3. Ted, meanwhile, takes a bath again.

Now Ted is irked. He's still got some shares, which slowly climb back to $10. At this price, he figures, "That's it. I'm out of this turkey." But at the same time, on the inside Joe sees that Acme is on the verge of acquiring a patent that will turn the company around. And so Joe grabs a whole bunch of shares, Ted divests his, and Acme has a super run up to $20 a share.

What does it mean when you have a situation like this? Ted, who is an active trader and contributing to making the market more liquid, is probably going to steer away from companies with heavy levels of insider trading. Why? This one doesn't take a rocket scientist folks: for every trade, there's a winner and a loser, and going up against insiders on his trades more often than not, Ted's going to turn out to be the loser.

Acme's stock then becomes more illiquid. Not good.

Boudreaux does claim that firms such as Acme will enjoy a lower cost of capital because their stock prices reflect a truer value of the company. But is that really so? Could their cost of capital actually be higher?

How so? On the equity side, the broader investment community will be more reluctant to put money in a company where insiders have the advantage in stock trades, by virtue of the information only they possess. More and more investors may take a pass in trading these shares, as it becomes clear that in any trade, you are increasingly likely to be across from an insider who has an edge. The stock price will naturally fall when a smaller pool of investment dollars is chasing a given set of shares. And so the company may, paradoxically, appear to be weaker than it actually is.

This is the feedback loop part.

What else will happen at Acme, if it becomes a haven for insider trading? Well, other unpleasant possibilities: there could be information hoarding, because information is clearly money, and if you have it and others don't, then that money is all yours to make. Also, insiders at Acme might form links to big money hedge funds, selling them information (which would appear to be legal in this brave new world -- if you can profit on insider information, why can't you then take partners or sell that information for others to profit on), as these large funds would be able to leverage the insiders' information more effectively.

Is this really the world we want? Insider trading occurs unfortunately all too frequently right now. It is hard to police; that's undeniably true. But once you take the "fair" out of "fair" market, what do you have left?