STOCK Act passes, but misses the point: Insider trading should be legal

The Stop Trading on Congressional Knowledge (STOCK) Act has been passed with bipartisan support in both houses of Congress and is awaiting President Barack Obama’s signature. The act bans insider trading by members and employees of Congress by prohibiting them from trading based on non-public information that they may have.

Although there was some debate on specifics of the bill, one position was not represented at all. It is the position held by Professor Don Boudreaux of George Masson University and many others: that insider trading is beneficial and should be legal. I will go even further, and say that legalizing insider trading is the correct ethical choice and that keeping it illegal is unethical.

Before this position can be understood, it is necessary to determine why we have insider trading laws in the first place. What is the goal of the legislation? There are at least two main goals that insider trading laws try to accomplish: promote fairness and prevent fraud. Proponents of insider trading laws argue that it is unfair that insiders are able to act in advance of market action because of knowledge they have of non-public information, therefore they should not be allowed to do it in order to promote fairness. Also, the market action insiders avoid may have been caused by fraudulent actions of the insiders themselves, but by preventing them from selling their own stock, they are tied to the outcomes of their actions which will incentivize them to not commit fraudulent actions. How effective are insider trading laws in achieving these two goals?

Imagine a large publically traded company. Mr. Bigshot is a high-level insider in the company who learns that massive amounts of accounting fraud have been taking place. He isn’t about to be a whistle blower, that would ruin the price of the company’s stock, of which he owns many, and inflict a personal fiscal loss. He won’t sell the stock either because he doesn’t want to risk getting caught breaking insider trading laws. Instead he embarks on a massive cover up to prevent knowledge of the fraud from reaching the public and tanking his company’s stock price. The fraud remains, unaddressed and unbeknownst to thousands of innocent investors who own stock in the company. Eventually, the fraud comes out, the stock price falls to $0, and Mr. Bigshot and the thousands of investors lose their investments. The illustration shows that even though Mr. Bigshot got his justice, many innocent people are harmed as well, and the goals of promoting fairness and preventing fraud were not accomplished.

The end might be “fair” for Mr. Bigshot, but what about the innocent investors? For them, the outcome was far from fair. The price of the company’s stock reflected a strong, healthy company, not the fraudulent fake that it actually was. The investors were being told a lie that was required by insider trading law. 

The second goal however, was obviously not accomplished, as the fraud continued unaddressed and eventually brought down the entire company. Those who remember the Enron debacle should find this illustration familiar. Insider trading laws did not prevent the accounting fraud that eventually led to Enron’s demise, even though multiple insiders owned stock in the company, and innocent investors felt the pain brought on by the exposed fraud. If insider trading had been legal however, a much better ending would have occurred.

Imagine the situation, but this time insider trading is legal. Mr. Bigshot finds out about the fraud and once again, for the same reasons, he doesn’t blow the whistle and tries to cover up the situation. This time however, also he, along with the other insiders, sells the stock they have in the company in order to avoid financial loss if the fraud is discovered. As a result, the price of the company’s stock falls and more accurately represents the value of the company’s stock. Investor’s do not know about the fraud, but they do know that the company stock is no longer worth the higher price. They are no longer making their market decisions off of false information, unlike the first example where the price is held artificially high as a direct result of insider trading laws. When the fraud becomes public, it is true that Mr. Bigshot does not suffer the financial loss that he would have under insider trading laws, but neither do many of the private investors.

Is this outcome more fair? Investors are no longer making their decisions off of false information nor are being passed the financial repercussions of fraudulent actions that they had no knowledge of or control over. Does the outcome prevent fraud? No, but neither do existing insider trading laws as shown above.

An initial reaction of many to this argument is that fraud is being incentivized because insiders can get away fiscally unscathed even if the fraud is caught. I disagree. The main concern of these immoral people is to make money. They do not gain anything when the fraud is discovered and constantly bankrupting companies and starting from square one is not a sound strategy to maximize the amount of money they have.

Neither outcome is perfect. On one hand, Mr. Bigshot doesn’t feel the full repercussions of his actions, but on the other, innocent investors do feel the repercussions of the fraud even though they had nothing to do with it. It is easy to defend either side, but for me, it is a question of ethics. I am a firm believer in the principle that it is better to let 10 guilty men get away then punish one man who is innocent. A law that passes the financial punishment created by fraud upon those who are not responsible for it is not ethical by my standards.