In case you hadn’t noticed, we are in the midst of a crackdown. Or rather, another crackdown. The crime du jour is an old favourite: insider trading. For those who have lost track, accounting fraud is so 2001. Excessive CEO compensation went out of fashion right around the time The Sopranos went off the air. Ponzi schemes were pretty hot last year, but once they auctioned off Bernie Madoff’s monogrammed slippers (selling price: $6,000) you knew that trend was pretty much over. But insider trading? It is like denim — the patterns change but it never really goes away.
There are obvious benefits to these shows of regulatory force. Seeing hedge fund managers and lawyers in handcuffs not only produces a nice dopamine rush, it’s also meant to demonstrate the integrity of the capital markets. But the costs are frequently overlooked. Like most crackdowns, this one seems likely to deepen cynicism, erode confidence and lob more grenades at shell-shocked markets.
Judging by the daily media leaks and the slew of raids carried out on various financial offices in the past couple of weeks, American authorities are in the final stages of the most wide-ranging insider-trading sting in 30 years or more. Canada is not standing idly by, either. Toronto lawyer Stan Grmovsek was sentenced to more than three years in prison last January, and another Toronto lawyer, Mitchell Finkelstein is now facing a similar set of charges. The next big controversy is likely to focus on Taseko mines, whose stock plunged by 40% two weeks before its application for a mine in B.C. was rejected by Ottawa this fall.
Rest assured that this latest display of regulatory might will put an end to the scourge of leaky boardrooms and greedy traders once and for all. Just kidding.
Despite the periodic efforts of regulators to stamp it out, insider trading runs as rampant as ever, and that isn’t going to change. This is in part because it’s notoriously difficult to prove, but also because we have never definitely solved the fundamental puzzles at the heart of this supposed crime.
Sure, there are black-andwhite cases. When a lawyer steals data on impending takeover deals from his firm’s computer system and sells that information to brokers, it’s not hard to spot the bad guy. But insider trading cases are far more often defined in shades of grey. Who is an insider? What information is material? What’s the difference between an educated tip and an illegal leak? More than 50 years have passed since the SEC began prosecuting such cases, and fundamental questions of law remain murky at best.
Rather than concentrating on the most egregious abuses, hawkish U.S. regulators seem intent on expanding the definition of illegality.
Take, for example, the case of Mark Cuban. In 2008, the billionaire investor was told by the CEO of Mamma.com that the company planned a huge new stock issue, which would likely decimate the value of Cuban’s sizable stake in the company. Cuban didn’t like that idea and dumped his stock before the share issue could sink him. The SEC sued for insider trading, even though he wasn’t a company insider, didn’t seek the information and made no promise not to sell. One judge wisely threw the charges out, but the SEC recently got them reinstated on appeal.
Now there is word that the SEC is going after analysts for doing their jobs too well. Many researchers try to estimate how well a company like Apple or HP is doing by interviewing their suppliers. Want to know how many iPads are selling? Ask the guys who sell the glass screens. These so-called ‘channel checks’ are a staple of diligent analysis. They bring more information to the market and provide valuable insight for investors. It’s exactly the kind of footwork that we need more of, not less. But lately, any attempt to provide one investor with an edge over another is potentially indictable. That is the perversity of the crackdown mentality: when regulators start bringing down the hammer, everything begins to look like a nail.
Early indications are that the SEC raids are targeting a new area: so-called ‘expert networks’ in which former executives are paid to offer insights on the companies and industries they used to run. Maybe the SEC has stumbled upon a real ring of abuse, but it’s just as likely that they’ve simply discovered another shade of grey.
The public naturally wants to see corruption rooted out of the capital markets. But defining corruption, and distinguishing it from smart investing, requires a scalpel not a hammer. In our headlong rush to control the flow of information among investors, brokers and executives, we run the risk of making the system less transparent and more perilous.
The buzz from seeing rich guys get busted fades fast. The legal hangover will last a lot longer.