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A Contrarian View of Insider Trading

Written on:December 12, 2011
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Just as momentum is building inside Congress to enact new rules prohibiting insider trading among elected officials, an opposing Objectivist view (advocated by adherents of Ayn Rand) is being aired which contends that insider trading should be legalized.

The rationale? 

When a human being learns facts, they have to be put to use, otherwise, what’s the use of learning.   While some may call this a narrow definition, Alexander Cohen, the author of the article, “The Morality of Insider Trading,”

Alexander R. Cohen

notes that “It is not by mere knowledge that we live, but by knowledge that informs action. If one identifies an opportunity but does not act on it, one does not benefit from that knowledge; if one identifies a threat but ignores it, one might as well not have identified the threat at all. “ 

The article, published on the Atlas Society’s Business Rights Center web site, is provocative and consists of two parts: an instructive overview of the history of insider trading, including when it was legal in the later part of the 18th Century, until the SEC imposed more severe restrictions and modernized its definition of SEC Rule 10b-5 in 1961.  The second part presents the moral reasons why insider trading should be legalized.

While there was no single reason why the law re-considered its position to outlaw insider, it may be due to developments in the modern stock market, its technology, communications and importantly, the large monetary rewards available from leveraging privileged information.

Cohen notes that the legal rational of insider trading hinges on the use of material non-public information (MNPI).  This is defined as material information not available to the general public.  Information is “material” if there is “a substantial likelihood that a reasonable investor would consider it important in making investing decisions about the stock.”  When MNPI is used, it can take four forms: 

Cohen then applies the objectivist philosophy to assess the morality of insider trading.  “The essence of insider trading is acting on your knowledge of material nonpublic information.

And yet acting on your knowledge is exactly what you have to do, as a human being, in order to live.”  In an interview, Cohen said “the reason we have knowledge is to use it.  If knowledge is not applied, a person is acting against their own self-interests and is not recognizing reality.  When it comes to our minds, we have to use them and put them to work in the pursuit of values.” 

In the context of investing, Cohen takes this even further, saying that when an investor pursues knowledge related to the markets, it can be obtained in any way possible and must be used to secure a profit.  As Cohen quotes Ayn Rand, “Knowledge is a value one acts to gain and/or keep.” 

(In a related article, hedge fund billionaire Steven A. Cohen, no relation to Alexander Cohen, said earlier this year in a deposition that rules on insider trading are “very vague” and said sometimes it’s a “judgment call” about if a bit of information about a public company is inside information.)

 No Fraud Involved?

Cohen also contends that while SEC regulations classify insider trading as a type of fraud, it is not.  The reason? Fraud uses deceptive practices to obtain information or property that has value.  Insider trading relies on parties who have very different views about a stock’s prospects. 

And as for the use of MNPI, Cohen says “the party who did not have the MNPI had no right to it. Knowledge is a value; one has to gain it. “In this hard-knocks world, knowledge, however obtained, is power and knowledge must be acted upon in order to release its value. 

Taken to its objectivist conclusion, Cohen, formerly an adjunct assistant professor at the John Jay College of Criminal Justice, said “insider trading is not a violation of anyone’s rights because it is done in an anonymous marketplace where the trading parties do not have any obligation to tell other traders what they think or know.  They have no right to my knowledge, nor do I have any right to theirs.  This is what makes a trading marketplace.” 

In his article, Cohen wrote the following;

 “But because knowledge is a value one must make an effort to obtain, a right to have others make their knowledge available would be a claim on their effort—and a bigger claim the more they learned. It would be a demand that each of us serve everyone else—and, because we would have to offer up all our knowledge, it would doubly diminish the rewards of pursuing knowledge: not only would anything one learned create a duty to spend one’s time and energy passing that information on to anyone who wanted it, but having gained the knowledge would not give one opportunities others did not have—and therefore, in many cases, would not give one opportunities at all.”

“Thus there can be no right (except as a contractual matter) to be told what other private individuals have learned. There is only a right to seek knowledge—a right with which insider trading does not interfere, but which insider trading law burdens, by in some circumstances attaching to knowledge a restriction on one’s right to trade.”

His bottom line: “Insider trading, while in one respect morally questionable, is in another respect morally praiseworthy: as a general matter, one should seek knowledge and use it to guide one’s actions. The arguments for banning insider trading, and most of the arguments for morally condemning it, fail. Insider trading ought to be legal.”

Critics of Objectivism

Cohen’s staunch adherence to objectivism, however, also prods others to offer competing arguments.  Professor Julie Ragatz, Director of the Center for Ethics in Financial Services, and Assistant Professor of Ethics at the

Professor Julie Ragatz

American College, said the objectivist argument’s focus on self interest“is deeply problematic.” 

While some content that insider trading information is merely an information imbalance between different traders, Ragatz said “it comes down to the fact that people in possession of insider information were given access to this information for ends other than the pursuit of their own material benefit.”

In the case United States v. O’Hagan, Ragatz said the Supreme Court stated that liability attaches if the “misappropriator” fails to disclose to his principal the use of confidential information, while having a duty of loyalty or confidentiality. This raises the issue about people who are trusted inside organizations and whether they should be allowed to pursue their own self-interests or those of the organization.  From a practical perspective, they cannot do both because it is morally wrong, she said.

When people held in a position of trust by members of an organization, misuse information for their own gain, without the knowledge of the organization, it is wrong because it undermines the trust necessary for organizations to flourish and thrive.

“Using insider information seems unfair not because someone has more information, but on account of how they came possess that information and the ends to which that information was intended to be used. 

“Behavior such as this offends because it is a rank promotion of self interest at the expense of the goods achieved by cooperation. Perhaps this would not bother Mr. Cohen, but it is possible to condemn his insider as a ‘free-rider’ who benefits from the gains of cooperation (flourishing organizations and increased value) while doing her best to undermine them,” Ragatz said.

Damage Control in Washington

While Cohen’s objectivist argument addresses the morality of insider trading, Congress is moving to restrict or ban the practice.  In response to a CBS “60 Minutes” investigative story that aired Nov. 14, 2011 about Congressional insider trading, including trades which the story said involved former House Speaker Nancy Pelosi, current House Speaker John Boehner and others. 

As a result of the report, Congress has proposed legislation that would seek to bar trading on legislative information obtained by lawmakers, staff members and an emerging category of “political intelligence firms.” 

One reason for the exceptionally accelerated legislative track is that Congress’ positive public approval rating has fallen to 9%.  Given this reality, the legislation may be a form of self-preservation, as well as a political form of self-dealing.

While this objectivist approach runs counter to prevailing public opinion and legislative momentum, insider trading is an old, accepted practice.  Charges of “front-running” customer orders by floor members and traders in the futures and stock markets were common before the advent of electronic trading. 

A main reason why electronic trading languished for over a decade was that it would eliminate or restrict front-running, which was once considered an inalienable right of being an exchange member.  Electronic trading only came to pass after the rise of institutional trading increased trading volatility and made it too expensive for under-capitalized floor traders to fill these orders without taking inordinate risk.  When the front-running advantage, as well as other beneficial membership perks, was reduced, the futures and stock exchanges went public, so their member-owners could cash out. 

The difference between front-running and insider trading is one of organization and regulation.  Stock and futures exchanges were self-regulated, and policed their own members.  Years before the Las Vegas slogan emerged, futures and stock exchange members knew that what happened on their respective trading floors stayed on their trading floors.  In only the most egregious circumstances were outside regulators (the SEC or CFTC) ever involved. 

Congress “Shocked” at Insider Trading

Just as Captain Renault in the 1942 film, “Casablanca”, famously tells Rick, the nightclub owner, that ”I’m shocked, shocked, to find that gambling is going on in here!” Congress is now shocked that insider trading is going on in its hallowed halls.  But it certainly must have been an open secret, especially since Sen. Charles Grassley (R-Iowa) in the 60 Minutes interview that it was “something we ought to look into.” 

He also said he was “chagrinned” by the CBS insider trading report, and since he passed legislation in the mid-1990s overturning decades of exemptions that Congress enjoyed from laws which applied to the general public.  Grassley said he was not aware of the stock trading possibility. and would conduct an investigation of the matter.  That’s an odd omission since the bull market of the 1990s certainly captured every investor’s attention.

While the positions of Cohen, Grassley and a bi-partisan group of Democrats and Republicans present very different opinions about insider trading, it’s clear that the practice exists because certain people greatly benefit from it.  How, when, and if insider trading laws are enforced depends on who they are and the extent of their actions. 

Cohen’s proposal would remove the barriers and make enforcement unnecessary.  It would advance the cause of the Objectivists, however esoteric. 

Alternately, Rep. Spencer Bachus’ (R-Ala.) proposal would call for an as-yet unseen high level of regulatory enforcement in an age when the Justice Department has not aggressively pursued the thousands of people who caused the largest financial fraud in U.S. history.  Those people may never be prosecuted or penalized, and will be free to enjoy their rewards.  But all agree that morality has been denigrated by the practice.  But since there is no price tag on morality, it becomes a willing victim.

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