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In and Out
Jonathan Berry
September 2002 | Martha ain't no criminal

Flaming wrecks of BMWs, Jaguars, and Lexuses litter Wall Street. From the lampposts dangle the swaying corpses of corporate executives, hung by their silk neckties, run through with fountain pens, stock certificates stuffed down their throats - and all for naught. These sacrifices by desperate cultists of the NYSE have failed to rouse the Bull from his slumber, deep beneath the site of the fallen World Trade Center. The Bear rages, unchecked.

Anti-business hysteria is running rampant, as the credit-fueled boom of the Nineties collapsed with the Twin Towers into the frantic bust of the Naughts. Mix in a little accounting fraud and the predictable result is an outcry for more legislation, to get tough on delinquent companies. As usual, the reforms demanded are about as sophisticated as "liquidate the kulaks!" To today's regulation-happy politician, if one law against fraud is good, one hundred laws must be better. Lest one blame only the Democrats in office, President Bush recently gave a speech in which he called for over a dozen reforms to corporate law including a proposed law to criminalize document shredding as obstruction of justice, even when said documents have not even been subpoenaed. Will a company have to check with the Securities and Exchange Commission every time it wants to get rid of old records?

Lying beside the corpses of Enron, Global Crossing, and WorldCom is ImClone, killed by a mob of investors and politicians with pitchforks and torches. While the first three were indeed monsters, the last was simply misunderstood. The ImClone executives currently under governmental scrutiny are probably "guilty" of insider trading, that is, possessing informed predictions on a company's future by virtue of working there, and acting upon that information. In the case of ImClone, then-CEO Samuel Waksal got wind of the fact that the FDA had rejected Erbitux, ImClone's new cancer-treatment drug two days before the FDA was to make that information public. So Waksal decided to sell off his shares in the company. Most of his transactions were blocked by his broker, who tried to enforce the law. His friends—including the arbiter of good taste Martha Stewart—however, were able to sell most of their shares. For that offense, Waksal could die of old age in prison and Martha Stewart will have to start redecorating at Club Fed. The problem with the punishment that he and Martha are likely to receive is that in regards to selling some of their shares, they have done nothing wrong.

The stock market runs on the fact that no party in any transaction knows the exact same things as any other party in that transaction. If all actors in the stock market had perfect knowledge, there could be no stock sales —in the real world, when a share of stock is sold, it is because the seller believes it will fall in value, whereas the buyer believes it will rise in value. If perfect knowledge allowed both parties to know which way a stock would move, there could be no sale—if it was going to rise, the seller would not sell it, and if it was going to fall, the buyer would not buy it.

If a stockbroker and a corporate employee each correctly anticipate a stock price change, why is only the corporate employee a felon if he acts on that knowledge? Why ought he go to jail, just because he knew more (or surmised more correctly) about his company than the investor he sold his stock to? What fraud did he commit? When a stock certificate is sold, all that happens is ownership of a fraction of a company is transferred from one man to another. When a farmer sells some of his farm land, he is not required to give the purchaser his thoughts on how fertile the land is—all he is required to do is not lie about the nature of the property.

In reality, insider trading is simply an organic, natural component of the free market. "Insiders" possess certain information about the businesses that employ them, information that can educate guesses on future business performance. They represent but one kind of agent in the information market (which is created by the fact that humans are individuals with individual minds and knowledge), a market anyone can join simply by doing research. Stockbrokers get paid for navigating the information market. Insiders don't have any sort of monopoly in the information market, they just have their own special inroad to it.

Furthermore, by disrupting the flow of information, insider-trading laws actually hurt the small-time investor, the very party they were designed to protect. Every transaction (and even every announced, but incomplete transaction, where a buyer can't find a seller, or vice versa) is a signal, telling how much value a given good has been agreed to have, be it a consumer good or share of stock. In other words, if the average investor sees the price of a stock dropping dramatically, he knows that maybe buying that stock isn't all that great of an idea or that he should do some further research to see if it's worth it.

Introduce government regulations, however, and signals start getting misread or lost. Insider trading laws artificially discourage businessmen, those whose actions convey the most information about their businesses, from buying or selling at natural times to do so, and thus information is actually squelched, instead of being naturally disseminated. Since Waksal was generally kept from acting on information that the rest of the public could access only two days later, there were people out there—average Americans who thought that FDA approval was a foregone conclusion—who purchased shares of ImClone stock only to watch them plummet after the FDA made its announcement. If Waksal were allowed to complete his transaction, which would have made the price of ImClone fall, he could have probably saved many unsuspecting investors by keeping them from pouring more money into the company.

Of course, there's also a practical concern to deal with when implementing insider-trading laws: enforcement. Who, exactly, is an insider? Only executives? Which executives? What about lower level employees? Janitors? In a carelessly run office, a maintenance worker could hear all sorts of things. Should he be forbidden from acting upon his knowledge? How about relatives of executives? And how does the SEC go about deciding what is inside information? In the end, the decision must be arbitrary, as there is in fact no natural distinction to be made.

The law is intended to protect the average investor who does not know the kind of information company employees and executives know. The problem, however, is that the average investor is not a stupid sheep that stands by while a stock is falling, thinking: "Gee, I wonder what's going on." The average investor realizes that a sharp fall in price means that something is wrong and will avoid investing in that company or will sell off his current holdings. Hence, insider-trading laws actually keep investors from getting all of the information they can. That is not to say that Sam Waksal is a hero. He is guilty of many crimes, among them deceiving investors by lying about the reasons why the FDA rejected the drug. Insider-trading, however, should not be one of the things he gets sent to jail for.

Jonathan Berry is a sophomore in Ezra Stiles College

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