So let’s talk about insider trading

So let’s talk about insider trading. A great American dream. Like having your own private copy of tomorrow’s Wall Street Journal delivered this afternoon, in time to place your trades before the markets close. Is it any wonder most people find the concept irresistible?

The Securities and Exchange Commission generally uses the term “insider” to identify those individuals – corporate officers, directors, employees, and other professional advisers -who have access to material information before it is available to the public. Insiders are permitted to trade as long as the trading does not take advantage of the confidential information and breach their fiduciary duty to the company. Such trades must also be disclosed to the SEC.

Illegal securities trading by an insider is a key Department of Justice and SEC enforcement priority. The SEC has initiated about one insider trading action a week since 2009 and the feds show no signs of slowing down. But what Congress should look at is changing the penalties for insider trading.

The government has won a number of high-profile cases, including one against the Galleon hedge fund manager Raj Rajaratnam, who was found guilty and given an 11-year prison term. Nearly two dozen people associated with Rajaratnam’ s insider trading scheme pleaded guilty or were convicted.

Rajat Gupta, the former chief of McKinsey and Co. who also served as a director for Goldman Sachs and Procter & Gamble, was the highest profile executive convicted of illegally passing confidential information to Rajaratnam. He was sentenced two years in Club Fed.

There has been extensive debate as to whether insider trading should be banned. The theory most often used by the SEC and the courts is that insider trading undermines investor confidence in the integrity of the markets. Shareholders and outside investors are at a disadvantage when they trade against insiders. If they aren’t protected, capital markets would be damaged as fear of trading with insiders might stop potential buyers from coming to the market.

On the other hand, some economists say insider trading benefits markets and improves the accuracy and efficiency of stock prices. Milton Friedman, for example, questioned whether insider trading is harmful and worthy of legal action. He was as decent a human being as you could find, regardless of whether  you agree with his support of unrestrained free-market capitalism.

Friedman believed that trading on material, non-public information benefits investors by more quickly introducing new information through prices into the securities market. And better information makes for more efficient markets.

Others argue the ethical questions raised by exploiting uninformed investors for personal gain are valid enough to justify prohibiting insider trading on material non-public information obtained in breach of a fiduciary duty.

For certain, these are difficult policy questions. But when it comes to meting out punishment for engaging in illegal insider trading for personal gain, the real punishment should be for the guilty to give up their lifestyle.

Instead of meting out prison terms that cost the American taxpayer $30,000 per person per year, guilty parties should be sentenced to live at the standard of the average American. That can be accomplished by imposing a fine equal to the perpetrator’s assets, then paying part of it back to them over their lifetime by giving them an amount equal to the median income.

Perpetrators could also spend the rest of their working lives performing community service. So bankers who profited from the housing crisis could work in homeless shelters. This would be a classic example of the punishment fitting the crime.

originally published: July 27, 2013

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