The WSJ today reports that:
The government has secured 56 guilty pleas or convictions out of 63 people charged with insider trading since late 2009.
Many of the cases brought in this latest anti-insider trading crusade have involved hedge fund traders and other market analysts, with a special focus on so-called expert networks. The Economist explained how these networks work and what impact the legal crusade is having:
Expert networks are matchmakers that link clients with experts. A hedge fund that trades pharmaceutical stocks, for example, might use an expert network to find a doctor who can explain how a new cancer drug works. The network would set up a phone call and pay the doctor handsomely.
Such networks have recently caught the eye of American regulators, who fret that investors may be using them to ferret out illegal inside information. ... [As a result,] some hedge funds are suspending their use of such networks, for fear of falling foul of the law. Others are making their traders jump through legal hoops before allowing them to speak to an expert. A few are abandoning networks altogether, and finding their own experts.
I am not one of those who thinks insider trading out to be legalized. To the contrary, I have defended a prohibition of insider trading--if not the precise prohibition established by current law--as a necessary way of protecting corporate property rights in information. See Insider Trading Regulation: The Path Dependent Choice between Property Rights and Securities Fraud. Southern Methodist University Law Review, Vol. 52, Pp. 1589-1651, 1999. Available at SSRN: http://ssrn.com/abstract=208272.
The current emphasis on attacking hedge funds and expert networks, however, strikes me as having the potential to chill legitimate market analysis.
In the seminal Supreme Court case of Dirks v. SEC, Justice Lewis Powell explained that overly zealous enforcement of insider trading bans can have a highly detrimental effect on market efficiency:
Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market. [Footnote 17] It is commonplace for analysts to "ferret out and analyze information," 21 S.E.C. Docket at 1406, and this often is done by meeting with and questioning corporate officers and others who are insiders. And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation's securities. The analyst's judgment in this respect is made available in market letters or otherwise to clients of the firm. It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation's stockholders or the public generally.
[Footnote 17] The SEC expressly recognized that
"[t]he value to the entire market of [analysts'] efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by [their] initiatives to ferret out and analyze information, and thus the analyst's work redounds to the benefit of all investors."
21 S.E.C. Docket at 1406. ...
Notice that Powell expressly endorsed allowing market analysts to "meet[] with and question[] corporate officers and others who are insiders ...."
Facilitating such meetings is precisely what expert networks do. To be sure, that doesn't give the networks a license to facilitate tipping by insiders. But I still wonder whether the current crusade is overdoing it and thereby chilling legitimate market analysis. If so, the crusade may do more damage to market efficiency than any of the alleged insider trading activity.
