On 8 January 2013, Rajat Gupta, former head of McKinsey & Co, will go to jail for two years and pay a fine of $5 million after being convicted for insider trading. His basic crime was not that he made money from insider information, but that he passed information on to Raj Rajaratnam, who was convicted earlier in October 2011, and began his 11-year prison sentence the following month.
Only one part of the two sentences – the financial penalties – makes any sense, for insider trading is actually an esoteric, victimless crime. No one should be going to jail for making money – or not losing money – merely on the basis of access to information.
Let us first understand that insider trading really is, and why there are no victims in this crime.
Using a commonsense meaning of the term insider, it means anyone working for a company, or an associate or a vendor or even an analyst with access to non-publicly available information on a company that could, theoretically, impact the stock price one way or the other.
When an insider trades on the information he or she has, the assumption is that the other party to the deal – the one who buys or sells shares to him or her – is an innocent who does not have the same privileged access to information.
This is very dubious logic for the following reasons.
First, the insider himself may or may not make a profit or avoid a loss, since the stock market does not move on the basis of a single piece of information. Many factors go into the making of a price, including market sentiment, demand and supply of stock, industry and economic trends, and stock-specific developments. There is no one-to-one correlation between insider info and an insider’s gains or losses.
Second, the insider may have an advantage in terms of information, but markets always have two parties to the deal: buyers and sellers. If an insider buys a share with the benefit of inside info, one can say that the sellers are disadvantaged, but all unwitting buyers – the ones who were not insiders on the day an insider bought the shares – would also have benefited. So the balance of losses and gains from inside information are not that skewed. Insider info also benefits some categories of investors, especially in these days of algorithmic trading and technicals-driven trading, where a spike in shares tends to draw more investors into a stock.
He said in his judgment: “While insider trading may work a huge unfairness on innocent investors, Congress has never treated it as a fraud on investors, the Securities Exchange Commission has explicitly opposed any such legislation, and the Supreme Court has rejected any attempt to extend coverage of the securities fraud laws on such a theory…”.
So if loss to investors, or fraud, in not the basic reason for convicting Rajat Gupta, what is? Says Judge Rakoff: “The heart of Mr Gupta’s offenses here, it bears repeating, is his egregious breach of trust. Mr Rajaratnam’s gain, though a product of that breach, is not even part of the legal theory under which the government here proceeded, which would have held Gupta guilty even if Rajaratnam had not made a cent.”
(Rajaratnan was convicted last October for buying and selling Goldman Sachs shares based on information provided by Rajat Gupta, who was on the investment banker’s board.)
The judge is effectively saying that Gupta’s real crime was that he disclosed what was discussed on Goldman Sachs’ board to outsiders – which was his breach of trust.
If this is the case, it should be Goldman Sachs suing Gupta, and not the Securities and Exchange Commission or Uncle Sam.
The judge says as much: “In the eye of the law, Gupta’s crime was to breach his fiduciary duty of confidentiality to Goldman Sachs; or to put it another way, Goldman Sachs, not the marketplace, was the victim of Gupta’s crimes as charged. Yet the (sentencing) guidelines assess his punishment almost exclusively on the basis of how much money his accomplice gained by trading on the information. At best, this is a very rough surrogate for the harm to Goldman Sachs.” (As an aside, we may add that Goldman Sachs did not lose anything by this).
The larger point is this: given the fact that the market always reacts to trading trends and volumes, is insider trading all bad? When an insider trades and sends prices up (or down), the market takes note. If an important bit of news is going to impact the stock, is it better for the market and investors to wait for a formal announcement on the same, or is it better to figure out something is afoot based on the hidden signals of the insider traders?
The central argument for punishing insider traders is information asymmetry – one man has info which other don’t. If we use this logic, we should ban all branded products. For example, a generic drug is sold at one price, while a branded product made from the same active pharmaceutical ingredient is priced several times higher. But this is legal.
A Tiruppur-made hosiery product is rebranded by an international textile label and sold at several times the basic market price. The consumer pays more because he does not know that the same manufacturer makes the vest sold for Rs 100 in Tiruppur as the one sold by, say, Tommy Hilfiger, for two-and-a-half times the price. The margin comes from information asymmetry – the same way it does for insider traders.
As we noted earlier in the Raj Rajaratnam case, the case for hard treatment of insider trades is based on flaky premises. This writer does not believe that Rajaratnam deserves 11 years in prison for his insider trades, just as he don’t agree that Gupta deserves his two years in jail.
No comments:
Post a Comment