Congress needs to define insider trading quickly

Sunday, 5-April-2015

Did you know that trading on insider information, as long as the person who provided it to you did not receive a financial benefit in return, has essentially been legal since December?  If you were unaware of that, you probably are not the only one.  This is an important story that has surprisingly not been talked about very much in financial circles.  Yet it is one that needs to be fixed quickly.

 

If you are new to this issue, I recommend checking out this excellent NY Times story as the best way to get up to speed.  In short, a U.S. appeals court ruled in December that insider trading can only be prosecuted if the person who provided the confidential information received a personal benefit “of some consequence” in return for doing so.  The ruling was subsequently upheld last week.  This means that if someone at a corporation leaks confidential information out of friendship, or just because they can’t keep a good secret, it is okay to trade on it and make a lot of money.

 

I know that sounds nonsensical, but it is true.  The problem stems from the fact that there is no federal law defining what insider trading is.  Therefore, federal courts have been required to come up with their own definitions in the past.  The one in December was the narrowest of such definitions, which means it will likely be the benchmark for most other cases going forward.  That will make it very hard for prosecutors to bring cases to trial where there was not an obvious exchange of money for the information. 

 

With the ruling in December having been upheld last week, there seems to be only one realistic solution to the problem now.  Congress can fix it by finally passing a new law that clearly defines insider trading.  In my opinion, they need to do so quickly.  There are two main constituents who are hurt by the court’s narrow definition of insider trading.

 

1.  Individual investors like you and I – By making it okay for investors to trade on information passed along by friendly tippers, the only people who will likely benefit are those large funds with unequal access to companies.  All other investors (individual investors, medium-to-small funds without great access, etc.) are put at a big disadvantage under such a scenario.  That is unacceptable.  All investors should be concerned because it produces a lack of faith that will harm our markets as a whole.  For free markets to work correctly, basic tenants of transparency and fairness must apply.

 

2.  Companies – Corporate leaders should be equally irked about this decision because it takes away a large disincentive for employees to leak important information.   While it is true that corporations have their own confidentiality policies in place, more information is surely going leak out if employees know there is no chance of a federal insider trading prosecution for doing so.  That is clearly bad for business.  I’ll bet most corporate leaders are unaware of this issue, and I hope it becomes more widely known to them.  Corporations can be a strong voice in lobbying Congress to get something done quickly.

 

The bottom line is that the recent court rulings only benefit a small group of ultra-connected investors, and hurt almost everyone else.  I see no legitimate benefit to the broader business community, let alone overall society, by having such a weak definition of insider trading in place.  It would be crazy if we allow that to be the status quo.  While there is certainly a lot of gridlock in Washington these days, this seems like an issue that nearly everyone can get behind.  Let’s hope Congress solves the problem by clearly defining this quickly.

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