Insider Trading Charges Criticized as Ill-Defined and Harmful to Markets

Published May 31, 2016

Federal charges filed in late January against a “criminal club” of investors who made money trading on insider information has raised the issue of what, exactly, is insider trading and whether it should be a crime.

The announcement followed by three months the sentencing of Galleon Group founder Raj Rajaratnam to 11 years in federal prison after his conviction on insider trading charges. This is the longest prison sentence for insider trading in U.S. history.

“Today you sentence a man who is the modern face of illegal insider trading,” Assistant U.S. Attorney Reed Brodsky told U.S. District Judge Richard Holwell. “He is arguably the most egregious insider trader to face sentencing in a courthouse in the United States.”

Moving Stock Prices

Prosecutors alleged Rajaratnam moved so much money in his multibillion-dollar funds that they could trace price changes in certain stocks to his trades.

In the January announcement, Federal Bureau of Investigation officials said they had arrested four people and unsealed charges against three others. The accused allegedly were “a circle of friends who essentially formed a criminal club” in which “everyone scratched everyone else’s back” by providing information to each other, according to Manhattan U.S. Attorney Preet Bharara. They were charged with securities fraud and conspiracy to commit securities fraud.

Some economists say they oppose such prosecutions. They argue insider trading is so poorly defined that no one can definitively say what it is. They also argue trading on insider information may in fact be beneficial to markets.

‘Purposely Vague Law’

“The insider trading law is purposely vague. The problem with a vague law, when you come down to the nuts and bolts of justice, is that it gives prosecutors a lot of leeway to fashion charges out of events that likely are legal,” said William Anderson, assistant professor of economics at Frostburg State University. “It allows prosecutors to be able to do whatever they want. Any time you give prosecutors carte blanche, you’re asking for trouble.”

Anderson added, “Members of Congress make a lot of money on insider trading—they allow themselves to do it—and then beat their chests about other people doing it.”

Abuse of Justice

Prosecutors are also abusing justice in these insider trading cases, said Anderson.

“A criminal trial should be this: A law was broken. Is the person on trial the one who broke it? In these federal cases, we’re asking jurors to determine, first, if a law was broken, and, second, what the law is. Juries are not set up to do that. You’re asking them to determine whether a law was broken in the first place. That question should never come before a jury, yet it’s done all the time. What we’re dealing with is something that is immoral.”

Though he is an economist by trade, Anderson’s avocation is watchdog of police and prosecutors, for which three members of the 2006 Duke University lacrosse team may be thankful. The players were falsely accused of a racially motivated rape. During months when major news organizations reported without question the allegations of prosecutor Michael Nifong, Anderson stood nearly alone in writing dozens of articles on his blog charging Nifong with prosecutorial misconduct.

Anderson’s writings drew attention to inconsistencies and probable falsehoods from prosecutors and police, and eventually he was proven correct. The rape accusation was shown to be false, the charges were dropped, and in 2007 Nifong was disbarred for withholding exculpatory evidence and lying to a judge about it. The rape accuser, Crystal Mangum, last year was charged with first-degree murder in connection with the stabbing death of her boyfriend.

Economist and Heartland Institute board member Jim Johnston says there are pragmatic reasons to oppose insider-trading prosecutions.

Impairing Efficiency

“To my way of thinking, restrictions on insider trading only get in the way of distributing information about a company,” Johnston said. “That impairs market efficiency. But in the final analysis, restrictions on insider trading do not work. Word always leaks out.”

Robert Wenzel, editor and publisher of the Web site, also objects to making insider trading a crime.

“The entire idea of investing is based on the idea that you have better information than is reflected in the market price. Why else would you invest?” he said. “The more aggressive investors are at seeking out information about an investment, the more efficient the market is going to be. To crack down on this is absurd. It results in preventing valuable information from reaching the market.”

Steve Stanek ([email protected]) is a research fellow at The Heartland Institute and managing editor of FIRE Policy News.