Should insider trading really be considered a crime?
Without a doubt, the conviction of Michael Steinberg on four counts of securities fraud and one count of conspiracy marks a significant victory for the United States attorney's office in its campaign against insider trading.
Steinberg is the highest-ranking employee of SAC Capital to be convicted of insider trading. He is—or was—reportedly personally close to SAC Capital's founder, Steve Cohen.
But it's worth asking: what exactly did Steinberg do wrong?
We know that a jury found he was guilty of violating securities laws. One of his subordinates, a Swede named Jon Horvath, testified that he believed Steinberg wanted him to "cultivate sources of non-public information"—although he admitted that Steinberg never directly asked him to break the law.
But even if we agree with the jury on the facts, it's worth asking the deeper question: Why is this a crime?
In many ways, Steinberg's is a pretty typical insider trading case. He was accused of trading the stock of Dell and Nvidia after obtaining information about their quarterly earnings of prior to their release to the public. Horvath supposedly passed the earnings information on to Steinberg, after having obtained it from a group of hedge fund analysts who apparently got it from someone inside the company.
Which makes this a very good case to investigate what we're doing when we criminalize insider trading. There's no need for fancy legal theories here. This is a case of getting confidential corporate information and using it to trade. And it's very hard to figure out exactly what harm has been done.
(Read more: Why insider trading should be legal)
Who was the victim here? In some cases involving tips about confidential information, a case can plausibly be made that the victim is the company whose confidential information is leaked. Leaks of merger negotiations, for example, might harm the companies involved by undermining the deal before it is ready to be announced to the company.
But it's hard to see how Steinberg's acquisition of Dell's earnings a day early hurt the company in any way. His trading may or may not have moved the stock price a bit but the actual release of the earnings moved it more.
Does Dell have an intellectual property right in its earnings? We don't really recognize all corporate secrets or corporate information as protected intellectual property, much less property whose unauthorized use gives rise to criminal sanctions. There are certain categories—trade secrets, trademarks, copyrights—that are protected. But earnings aren't trade secrets. Dell released them the very next day.
So were the shareholders the victims? Not one shareholder of Dell or Nvidia was made worse off by Steinberg's trades, much less by his acquisition of the information.
What about the people who bought the shares of Dell on the day Steinberg was selling? Again, they would have been in exactly the same position regardless of whether Steinberg traded or not. Arguably, they were able to buy at a slightly better price because Steinberg's trades would have pushed the stock slightly in the direction the stock actually moved when the earnings became public.
You'll sometimes hear it said that the people on the other side of Steinberg's trades were harmed because they wouldn't have bought the shares if they had the same information he had. But that's precisely the wrong test. The question isn't what would they have done if they also had inside information. It's what would they have done if Steinberg hadn't had his information? The answer is: exactly what they did anyway. Steinberg's possession of inside information didn't affect them one bit.
That's hard for people to grasp so let's run through a couple of scenarios.
Let's say Dell is going to announce disappointing earnings and no one has the information. Steinberg holds his shares and Mr. Retail Investor buys some the day before earnings. That the "no leaks, no insider trading" situation. Mr. RI suffers a loss of, say, $5 a share when the news comes out.
Now lets say Steinberg gets a hold of the earnings report but doesn't trade. Mr. RI buys some the day before earnings and suffers a loss of $5 a share when the news comes out. That's "yes leaks, no insider trading" situation. The outcome for the uninformed investor is exactly the same.
In the third situation, Steinberg gets hold of the earnings report and trades. Mr. RI buys some and suffers a loss of $5 a share when the news comes out. Actually, if Steinberg sold enough to move the market, perhaps Mr. RI's loss is a little less because the price would be lower when he bought. In any case, there's no plausible way Mr. RI is worse off because of the insider trading. The loss is the same or perhaps a bit less.
What's really going on, I think, is something simpler, more primitive. In some way that is difficult to articulate, trading based on confidential corporate information seems unfair. Somewhere in our gut, this seems wrong. Morally repulsive. We don't think that someone should be able to make a lot of money through something so unfair. So we've banned it.
In other words, our ban on insider trading isn't really about protecting investors or making markets function better. It's about expressing a moral view, much like we do with Blue Laws that ban the sale of alcohol on Sundays.
There's nothing necessarily wrong with encoding morality into securities laws. But should Steinberg really be facing a possible sentence of 85 years for violating our moral sentiments?