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Preet Bharara’s Arms Race Theory of Insider Trading

Lurking just below Peter Lattman’s report of the broad federal dragnet apparently underway against insider trading, you can faintly make out the outlines of a new theory of criminalizing insider trading.

NYSE trader
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NYSE trader

Lattman, who covered the legal beat and later private equity at the Wall Street Journal before moving over to the New York Times, provides an especially informative report on the campaign, which is being led U.S. Attorney Preet Bharara.

“Illegal insider trading is rampant and may even be on the rise,” Lattman quotes Bharara as saying in a speech last month. “Disturbingly, many of the people who are going to such lengths to obtain inside information for a trading advantage are already among the most advantaged, privileged and wealthy insiders in modern finance. But for them, material nonpublic information is akin to a performance-enhancing drug that provides the illegal ‘edge’ to outpace their rivals and make even more money.”

The idea that insider trading is a “performance-enhancing drug” could merely be an attempt to ramp-up public anger at insider-trading by analogizing it to the drug-scandals in professional and Olympic sports.

But I think something more is at work. It appears to me that Bharara is presenting a novel theory of insider trading to support its criminalization and enforcement by federal authorities.

By way of background, the biggest hidden scandal about insider trading has always been the weakness of the case for federal enforcement, especially federal criminal enforcement. It’s not even clear why it should be banned at all.

Insider trading actually does not actually impose serious costs on outside investors. The impression that there is not a level playing field may make some investors reluctant to trade—but sensible investors probably shouldn’t be trading much anyway. Certainly, our public policy shouldn’t be directed to encouraging trading. Arguably, long term investors may be aided by insider trading because it may make markets operate more efficiently.

The strongest argument against insider trading actually has nothing at all to do with the stock market or protecting ordinary investors. It’s that insider traders are engaged in a type of intellectual property theft, profiting on information that is the private property of a company.

“I think insider trading is theft of information and is punished for precisely the same reasons that we punish other forms of theft of property,” writes Stephen Bainbridge, UCLA law professor and author of “The Law and Economics of Insider Trading.”

Note, however, that this theory would greatly constrain the kind of insider trades that would be barred. Cases like the ones that the SEC and federal prosecutors now seem to be building—against the business of consultants providing information about their former employees—would turn on contractual matters like whether the consultants are violating confidentiality agreements. State law, particularly state civil law, seems the appropriate way of addressing these concerns.

Getting back to Bharara, the new theory that is being marshaled against insider trading seems to be based on the idea that the pursuit of non-public information is resulting in an inefficient informational arms race. That’s the strongest case against the use of performance enhancing drugs in sports—that it creates an “arms race” atmosphere where players who wouldn’t otherwise use drugs feel pressured to begin using them to keep up with the enhanced players. In the end, if everyone ends up using performance enhancing drugs, no one winds up with an “unfair” advantage but lots of time and resources are wasted on the drugs.

In hedge fund investing, the analogy could be the use of these outside consultants that allegedly provide hedge funds with non-public information. Each fund manager has an incentive to seek the non-public information to gain a trading edge. But if everyone uses them, there’s no real advantage to their use. The time and resources spent acquiring the non-public information is simply wasted.

Bharara’s campaign against insider trading may be an attempt to end the informational arms race. That won’t make the playing field level—but it will make it so that naturally skilled traders are able to trade without inefficiently expending money to seek out non-public information. Which sort of makes you wonder if some of the top hedge fund managers—say, SAC Capital’s Steve Cohen—aren’t quietly cheering on the latest enforcement actions.

There is an irony here. The widespread use of non-public information by hedge fund managers may make the expenditures on consultants useless—but they should also make the market more efficient. As more people trade on better information, ordinary investors gain a relative benefit while highly informed fund managers relatively suffer. So the latest federal dragnet may be protecting elites and hurting ordinary investors.

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