It is impossible to read the business press in recent weeks without being impressed by the extent to which insider trading dominates the headlines. Last week Berkshire Hathaway executive David Sokol resigned after revealing that he had taken a large stake in Lubrizol prior to pushing for Berkshire Hathaway to acquire the company, a transaction that increased the value of his stake by $3 million. He invested only after Citigroup had identified them as a good acquisition target for Berkshire Hathaway.
The Wall Street Journal’s Holman Jenkins opined that “…Berkshire's shareholders aren't out a dime unless Mr. Sokol has somehow put out word that Lubrizol was in play, thus driving up the price—which he didn't.” Even if you believe that a previously uninterested party taking a $10 million stake in a company sends no signal and has no effect on the price of the stock, you would also have to assume that Mr. Sokol had no influence on the price offered for Lubrizol, which may be true. To be fair, even Mr. Jenkins saw a whiff of insider trading, a conflict “[t]o the normal business eye.” And this is a lot for Mr. Jenkins, who rarely objects to any behavior that makes the market more efficient. He largely assumes away any mixed motives in Mr. Sokol, and the editorial’s title clearly states his opinion that it did not bother Berkshire Hathaway CEO Warren Buffett: “St. Warren Casts Not the First Stone.”
But it bothers a lot of other people. It is true that insider trading increases the efficiency of the market by speeding up the incorporation of information into the share price. But what drives insider trading laws, and what bothers most people about it, is the issue of fairness. Trading on insider information is not a victimless crime. There is another party on the other side of that transaction, since the number of shares in the market is fixed. What are that person’s (or investment fund’s) rights?
My guess is that Sokol’s situation is not something that will result in any kind of criminal charge, though it may result in SEC sanctions. Raj Rajaratnam, on the other hand, is fighting for his future in a courtroom. If courtroom testimony and the confessions of others who have pled guilty are to be believed, Mr. Rajaratnam never hesitated to mine information for his Galleon Group by whatever means possible. The vortex surrounding his trades has sucked in people within his firm, traders with other firms, an IBM executive, even his own brother. As detailed in a recent Fortune article, the story is a real page turner.
The FDA is holding its collective breath after charges were filed last week against an employee accused of making millions trading on information to which he was privy. He allegedly used seven accounts in other people’s names. He had access to the system that tracks the approval process for drugs, trading against denials and buying shares ahead of approvals. Not that long ago, it was inside information about an FDA action that led Martha Stewart to dump ImClone shares to avoid a loss, and the subsequent investigation led to charges of lying to investigators, and a federal prison sentence.
Once Mr. Rajaratnam’s trial is over, we are likely to see one or more high profile trials aimed at ferreting out networks of “experts” that may be enabling insider trading on a massive scale. Firms hire “experts” as consultants who are then interviewed by hedge funds and other traders. These experts are often insiders at public companies. If they do not reveal private information, but just opine on industry conditions, this is generally not a problem. But there appears to be significant evidence that a number of these experts have stepped over the line.
So what is fair? If there is bad news, shareholders will be impacted eventually when it is revealed. This is just accelerated by the insider trade. However, the insider trader avoids the loss by trading out of it. It reminds people of what happened at Enron when management changed pension plan providers, preventing employees from selling their Enron stock while management was dumping its stock in large quantities. It helped adjust the stock price rapidly and efficiently. But was it fair?
When an insider buys shares on inside information, the insider is taking those shares from someone at a discounted price from their true value, which is unknown to the seller. I am guessing that David Sokol will hear from one or two of those folks who traded out of Lubrizol when he was buying in.
I am a believer in market efficiency, both as a description of what is generally true and something that is largely good, and to be preferred. But that does not make it the ultimate value that ought to control markets.
There is a moral problem in insider trading that is rooted in fairness. Immature markets are dominated by insider trading. But in mature markets, as long as there are people who care about fairness, you can expect to see insider trading prohibitions enforced.