By Larry Zicklin
From the RAND Corpopration
Thursday, January 17, 2008 12:00 AM
Just a few years ago, insider trading was considered "dirty." It was the province of marginal players working on the fringe of the capital markets. The traders were both limited in number and in buying power, and therefore too unimportant to have any lasting effects on stock prices or the integrity of the financial system.
But today insider trading has proliferated and gone global. Rather than a handful of rogue players in New York or Los Angeles, many professional investors who manage large global pools of capital are trading on inside information in both the equity and derivative markets.
Why the explosive growth of insider trading? Because the rewards are great and the possibility of being caught and punished are almost non-existent. Try proving that an investment partnership executing thousands of trades per month had inside information in one particular trade. You will be shown brokerage reports recommending the stock, charts demonstrating the stock's favorable technical position, rumors in obscure blogs, and other partnership holdings within the same industry that would demonstrate the managers' favorable opinion of the particular business.
Instead of the rogues who once purchased thousands of shares, we see millions of shares or their equivalent options being purchased in the weeks before favorably priced transactions take place, according to academic studies. Viral V. Acharya and Tim Johnson of the London Business School point to the significant evidence of insider trading existing in the credit default swap (CDS) market.
CDS are a form of insurance against credit defaults, and it would only be logical for banking institutions to try to protect themselves against defaults by trading CDS of the same companies they are financing. CDS thus become a sensitive indicator when debt securities are likely to be downgraded during periods of stress or in a going private transaction. Who better than the lenders would have insight to buy protection at opportune times?
In the recent disclosures of options backdating, executives assigned past prices to option grants that were supposed to reflect current markets. This is like betting on the roulette wheel after the number is known. Similarly, substantial price or volume increases in the period prior to deal announcements are never a matter of random events. Such increases are the consequence of deals being known to hundreds of people who trade on information before public announcements are made.
Take the case of a company that recently sold itself in a widely publicized deal. After the public announcement, I noticed that the both the stock price and the options volume had substantially increased in the weeks prior to the public announcement. I contacted a director who told me that it was the company's belief that almost 1,000 people -- including bankers, lawyers, and accountants -- knew of the probability of the sale prior to its actual occurrence.
While most of the people with advanced knowledge of the sale must have signed some form of confidentiality agreement, it didn't seem to stop them from either trading on material non-public information or making that information available to others who traded on it. As a result of transactions like this, insider trading is now about as common as running a yellow light.
In the long run, this acceptance of investor misbehavior will be highly destructive to the financial markets. In a big bull market such as we recently enjoyed, the effects are minimal because shareholders are enjoying the dizzying success of record stock prices. Under present conditions, profits are more difficult to achieve and frustrated investors can regard insider trading as living proof that the markets are rigged.
Honest individuals or institutional investment managers will eventually ask themselves why they should participate in a manipulated game. They will then withdraw some or all of their funds from our system, and try to find other forms of investment or competitive markets where the "game" is better supervised.
For honest professional investment managers the situation is even worse. Their performance records will not be as good as their unsavory competitors who traffic in non-public information. The honest managers are doomed to lose assets to the dishonorable players who will be able to take advantage of their size to buy even more tainted information and subsequently improve their investment performance.
We will then experience the modern day Wall Street version of Gresham's Law. Instead of bad money driving out good, dishonest investment managers will drive out the honest ones as they debase the financial markets. As Gresham once said, "good and bad coin cannot circulate together."
The Securities and Exchange Commission has been largely ineffective at policing insider trading, occasionally nabbing a "small fry" while permitting large pools of capital to enjoy the fruits of their illicit activities.
The quality of the U.S. markets is a key part of the capital raising system. We should be committing the necessary resources to quickly clean them up. In an economy of our size, these costs are not material and would be more than justified by the advantages to be gained by having an honest market structure that would be the envy of competitors around the world.
At the same time that we purge the system, we should encourage publicly held corporations to disclose material events as rapidly as possible, thereby eliminating the time advantage given to chosen insiders. We should also aggressively prosecute those who violate the law and force them to pay substantial penalties, while also returning any ill-gotten gains. If we are relentless in our pursuit, these examples would make front page headlines and discourage others who might be thinking of degrading our markets.
Time is of the essence. Without a committed state and federal effort to address this crisis, the financial system is certain to suffer in ways we probably don't fully understand but will ultimately live to regret. Avoiding the serious problems of insider trading is a difficult task. Extricating the system from these problems once they become even more commonplace will prove to be impossible.
Larry Zicklin is a clinical professor of business ethics at Stern School Business at New York University and vice chairman of the LRN-RAND Center on Corporate Ethics, Law and Governance at the RAND Corporation, a nonprofit research organization.