Wall St. And Business Wednesdays: (7/9/2003) E-Letter To Larry Elder Re: "Legalize Insider Trading"

I was pleasantly surprised to read your recent two-part interview with Professor Henry Manne. While many Blacks disagree and even dislike you because of your libertarian and conservative views, I thought your interview and ability to handle the topic of insider trading was the best recent evidence of your value to the Black electorate. With so many Black Americans financially illiterate I do not think we have the luxury of ostracizing or mocking opinion leaders giving attention to the subject of finance and economics, simply because of their political ideologies. I am pleased to know that we have a Brother who is interested in the financial markets and is willing to use his influence to further educate the public regarding their impact, mechanics and nuances.

While I am intrigued by Professor Manne's thesis - which you support - that we should legalize insider trading, I do not believe that it is as good an idea as you argue. I sent your interview to two of my friends and colleagues with expertise on financial markets to get their opinion of the subject. One is a business economist, Reuven Brenner, who as you may know has appeared on the cover of Forbes magazine and, in the view of many economists, including 1999 Nobel Prize winner Robert Mundell, is the best in the world. The other is a professional investor, Stephen Shipman, CFA and portfolio manager for Bjurman, Barry and Associates - a firm specializing in the management of investment portfolios for corporate pension and profit sharing plans, jointly trusteed and union pension plans, states and municipalities, foundations, endowment funds, and individuals.

Their respective opinions on the subject of insider trading dovetail with my view that what you and Professor Manne propose is a much better idea in theory than in practice. First, here is what Reuven Brenner had to offer in the way of an opinion after reading your complete interview:


Professor Manne does not discuss the details of how legalizing insider trading could work nor what the ramifications would be. Take this example: There are people working in a lab, who stumble upon something. They do not say anything about what they have discovered to the rest of the people working in the company, but they buy call-options (1) on the stock of the company. Or, say a secretary handling mail opens an envelope that indicates that the FDA did not approve a drug that her company has been working on and she shorts (2) the stock, before telling anyone else in the company. These effects in a world of legalized insider trading could destroy trust and collaboration within companies.

We have to remember that both God and Devil are in such details. I have yet to see Professor Manne or anyone else work out all of the details on how this could work.

Professor Manne says, yes, insider trading should be permitted. Fine, but then you have to consider the chain reaction. Compensations would become very different: people would expect lower wages in companies that are expecting to do innovations, and higher wages in more "traditional" companies with less emphasis on innovation. In those firms where innovation is expected you would have to be mindful of how this would affect the company's operations and culture. Now, perhaps, as an adaptation, companies would offer some complicated internal contracts and have to make other arrangements within, to monitor employee activity. But then why is that new situation in a world of legalized insider trading any better than what exists now, where the practice is illegal? Would we really be better off with every company having its own police force? And couldn't these internal police be bribed? And so on and so on...

My opinion does not mean that I think that today's insider trading law is perfectly enforced - or even that it can be. The problem is that today nobody bothers to define what "insider trading" is exactly, and so the enforcement becomes a political game. Nothing and nobody is perfect. But that does not mean that we should abandon things just because of the lack of perfection.

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I share much of Reuven Brenner's concerns as it relates to the impact your idea would have on business activity. To me, the most important part of his opinion relates to this portion of your interview:

Elder: You say that use of insider trading by CEOs would be a desirable form of incentive compensation. Explain that.

Manne: I didn't limit that to CEOs, but one of the problems has long been how to compensate really entrepreneurial kinds of people in large bureaucratic companies. If you just give them salary, they won't have any incentive to go out and really take any risks or try anything new. But insider trading gives you all the correct incentives for that.

While I certainly agree that the bureaucratic structure of firms stifles "entrepreneurial kinds of people", as Professor Manne states, and limits innovations, I do not think that encouraging insider trading is the remedy [I think a carefully constructed salary scheme is a much better method. In his book, History-The Human Gamble Reuven Brenner suggests that a policy firms can adopt to promote the "entrepreneurial trait" is "...a hierarchical structure that provides fewer positions as one advances in a profession, and significant discrepancies between wage rates for individuals with similar education...." He explains that such a structure would, "provide incentive to the lower-paid employees to gamble more frequently on novel ideas (since in this case some of these employees' expectations will at times be frustrated)"].

On this point I totally agree with the logic of the ruling in the most famous insider trading case to come before the Supreme Court, Dirks v. SEC, wherein Justice Powell wrote in a footnote (bold, italics and underline is mine), "In holding that breaches of...duty to shareholders violated the Securities Exchange Act, the Cady, Roberts Commission recognized, and we agree, that "[a] significant purpose of the Exchange Act was to eliminate the idea that use of inside information for personal advantage was a normal emolument of corporate office." Once insider trading is legalized you make the "use of inside information for personal advantage a normal emolument of corporate office". And then you have, in my view, changed the nature of the firm.

When insider trading is legalized an environment is created throughout the firm where there is greater financial reward to be earned by employees from trading on inside information than from innovating or doing their jobs. Also you should not dismiss another important factor. The majority of businesses are able to raise capital and obtain inelastic pricing or higher profit margins due to their enduring uniqueness. The external market for information regarding innovations and internal company activities - if insider trading were legalized - would lead to not only employees seeking to trade on inside information for their personal gain, but also those employees sharing such information with traders, speculators and investors as well, who might have relationships with competing firms. Firms could more easily lose their "enduring uniqueness", which would hinder the ability of entrepreneurs and companies to raise capital (or capital would become more expensive) in a world of legalized insider trading. What would stop a mutual fund manager from purchasing a tip or inside information from say, a Sprint employee and then selling it an AT&T vice-president - all while everyone involved makes trades on the information? The end of a prohibition on insider trading could easily be used to justify industrial espionage. Do we now make that legal as well?

Again, under your proposal the market for trafficking in inside information becomes greater than the market to conduct business - certainly in the eyes of employees with unbridled ambition. Hence, companies might have more of an incentive to devote resources to focus more on monitoring employees and the flow of internal information than they would on improving their business development.

At that point what business are they really in - the business of record, or the police business? Perhaps you might argue that companies having their own formidable police force is no different than whole nations which have an army, navy, air force and marines, and even, an intelligence arm.

Having said all of that I am certainly sympathetic to your argument that the current system does not work too well because enforcement is selective and because there is no real working definition of insider trading that is universally accepted in the marketplace. But then, I must ask: what are you really proposing to legalize?

If insider trading hasn't been properly defined then you are not really proposing the legalization of a single measurable practice but rather, you are actually calling for the legalization of an almost infinite range of practices. The definition of what "market-moving" or "material non-public" information is, naturally varies over time, and across different industries.

Another problem that I see in how the initiative is described in your interview, and particularly in that excerpt that I have referred to above, is that once insider trading is legalized there is no longer any real distinction between an insider who is a corporate officer, with a clear fiduciary responsibility to shareholders and one who is a low-level employee, even a part-time employee, all of whom operate inside the firm, in a position to access information of company affairs. The day insider trading was legalized you would have such "insiders" as the company janitor and receptionist in a position to trade on information. Even employees from the local temp service could be considered as "insiders". But wouldn't the securities laws have to be changed to compel these non-traditional insiders to disclose their stock market trades of company shares? How do you suppose we are to learn of and follow the trading of these lower level insiders, who frequently change jobs on a weekly, even monthly basis? Would market analysts, investors and traders have to follow the daily company log of employees? Would they have to stay in touch with every corporate human resources office to determine when an employee was hired and fired or considered part or full-time? I don't see how your proposal would handle this problem.

Certainly the system is imperfect but I am not sold that legalizing insider trading solves more problems than it creates new ones. I think the most important improvement that can come in the short-term under the current imperfect system where insider trading is illegal would be in the area of disclosure. On that point, here is what Bjurman, Barry and Associates portfolio manager Stephen Shipman had to say in response to your idea and interview:

Having reviewed the article, and understanding their perspective as ideologues, I find myself in near complete agreement with Larry Elder and Henry Manne on this issue. But as a market practitioner there are a couple of points, though, that I should make to clarify some aspects of the article. 1) Information about insider trades is helpful to the marketplace and is something that I personally monitor because I suspect most managers are greedy bastards out to enrich themselves more than their shareholders. What's important is disclosure. The only good thing about the new Sarbanes-Oxely law (3) that I can see (and use) is the new requirement to publish insider transactions within two days of the event. Before, it could be three to six months, depending upon the games played. In today's Internet world, I think all managers who transact shares should post them at the end of the trading day on the 'net! Perhaps even on an SEC site. 2) Insider trading convictions are difficult because Congress has historically refused to define it in legislation. What does that tell you? Defining 'material non public information' is very difficult because peoples' interpretation of 'material' is varied. What I think is material to Microscoft may be much different than my partner's view. Well, if Congress can't identify it, what makes us think that some bureaucrat can?

My seventeen years of experience in the investment business tells me that nothing is more important than disclosure ! If we participants have that, we have almost everything we need in order to make prudent judgments. With the web, why not disclose more and more gray area info and let the market decide? I suspect that if we just had Warren Buffett's daily telephone log we could make better decisions...or lead him to regulatory scrutiny for being in possession of 'material non public information.'


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Mr. Elder, although we disagree on this issue, I am above all grateful that a Black opinion leader such as yourself has deemed the subject of what goes on in capital markets to be an important one.

I look forward to reading more of your attention to Wall Street as well as your usual political musing.



Sincerely,

Cedric Muhammad
Publisher
BlackElectorate.com
http://www.blackelectorate.com/



Footnotes:

(1): Holding an option gives you the right to buy or sell a specific investment at a set price within a preset time period. But there's no obligation to exercise the option, and actually buy or sell, before it expires. A call option is the right to buy a stock at a certain price for a certain period of time. In this example the lab employees are buying the call options expecting the price of the stock to go up. If all goes well, at a certain point after the stock price rises they will exercise the option to actually buy shares of the stock at the lower option price, and then sell those shares at the higher price, earning a profit.

(2): A person sells short when they borrow shares they do not own from their broker, order them sold and pocket the money. Then the person waits for the price of the stock to drop. If it does, the person buys the shares at the lower price, turns them over to their broker (plus interest and commission) and keeps the difference.

(3): Sarbanes-Oxley refers to legislation passed that establishes a new accounting oversight board. Here, you can read Senator Paul Sarbanes' remarks from last year regarding it:

http://sarbanes.senate.gov/pages/press/070802_pub_co_accting_reform_act_bnk.html

Cedric Muhammad

Wednesday, July 21, 2004