For most observers the question is not whether members of Congress should be allowed to inside trade, but rather whether current law already makes such trading illegal. Larry Ribstein and Todd Henderson, however, have staked out a contrarian position on the foundational question. Go read the whole Politico op-ed, but here's the three main arguments:
... trading allows information to get into the market, as Henry Manne argued in defense of allowing CEOs to trade, and, and therefore helps move prices to their correct level. Though congressmen will not, and should not, hold press conferences to reveal everything they know, they can still communicate the information by trading. This helps efficiently allocate capital to its most productive uses — and avoids trades being made at erroneous prices.
Allowing politicians to trade on the same basis as the general public also gives them a financial stake in the regulations they pass. Though members of Congress theoretically could invest without insider trading, in fact given their pervasive knowledge, a prohibition would seriously deter them from being investors.
Allowing trading helps members of Congressmembers see their work from an investor’s — rather— rather than just politician’s — perspective. Politician-investors have an incentive to help the market as a whole — rather than just engineering wealth transfers between interest groups.
Paying politicians for performance is a good idea — and trading profits are a powerful tool for doing so.
It's interesting that they invoke the name of Henry Manne. As I noted in my article Insider Trading Inside the Beltway: Manne is widely acknowledged to be not just the leading critic of insider trading regulation, but also the champion of affirmatively permitting corporate insiders to trade on the basis of material nonpublic information. Yet, Manne also advocated “a strong condemnation of [insider trading’ by government officials.” See generally Henry G. Manne, Insider Trading and the Stock Market (1966).
As for Ribstein and Henderson's claim that "Paying politicians for performance is a good idea — and trading profits are a powerful tool for doing so," Manne famously argued that allowing corporate insiders to trade on the basis of material nonpublic information was an effective means of compensating entrepreneurs in large corporations. His argument was premised on the differing roles within the corporation of managers and entrepreneurs. The former simply operate the firm according to predetermined guidelines, while the latter develop new valuable information. Entrepreneurs are inherently more difficult to compensate than mere managers. As to the latter, because the service is known and easy to monitor, the manager’s “service can be purchased like any commodity in the marketplace.” In contrast, an entrepreneur’s compensation must not only compensate him for the value of his services but also incentivize him to continue producing valuable information. Because it is rarely possible to ascertain information's value to the firm in advance, however, predetermined compensation, such as salary, is inappropriate for entrepreneurs. Instead, claimed Manne, insider trading is an effective way to compensate entrepreneurs for innovations. Because the increase in the price of the security following public disclosure provides a relatively accurate measure of the value of the innovation to the firm, insider trading allows the entrepreneur to recover some substantial portion of the value of his discovery.
The validity of this argument vis-à-vis corporate insiders is sharply contested. Even Manne himself, however, recognized that “it has no substantial application to government” employees and officials. This is so because the compensation argument rests on the need to incent entrepreneurs to produce information. Members of Congress, however, “are peculiarly in a position to receive valuable market information, not create it.” The information on whose basis Members of Congress thus are likely to trade “would not ordinarily reflect entrepreneurial developments for which they are responsible.” Accordingly, there is no socially valuable activity on their part to be incentivized.
To the contrary, “the ability of elected officials to profit on the basis of material nonpublic information creates perverse incentives for these officials, and introduces innumerable distortions and the potential for immeasurable harm in a legal system in which public trust and confidence is critical.”
Curiously, Ribstein used to somewhat similarly argue that:
Congress’s insider trading is bad because it gives our lawmakers the wrong incentives. Do we really want to give Congress more reasons to hurt and help particular firms?
In fact, Congress’s trading is worse than trading by corporate insiders, which at least might be rationalized as a way to let employees cash in on their productive efforts. It’s far worse than the usual trading on non-public information by outsiders without any breach of duty, which may encourage socially productive investigation and monitoring ....
He was right back then. Not so much now.
Congressional insider trading thus is undesirable, in the first instance, because it creates incentives for members and staffers to steal proprietary information for personal gain. The massive increase in federal involvement in financial markets and corporate governance as a result of the financial crisis of 2008 has made opportunities to steal such information even more widely available to government officials. Second, it gives members and staffers incentives to game the legislative process so as to maximize personal trading profits. Third, inside information can be utilized as a pay-off device. Fourth, it gives members and staffers incentives to help or hurt firms, which distorts market competition.
It's also just unfair. “No citation is needed to assert that [giving Members of Congress the opportunity to earn abnormally high returns by virtue of their service as elected officials] strikes many people as unfair.” Matthew Barbabella et al., Insider Trading in Congress: The Need for Regulation, available at http://ssrn.com/abstract=1318682. The difficulty with such a confident pronouncement is that while there is a widely shared belief that insider trading is inherently sleazy, converting that impression into a coherent policy basis for developing specific legal rules has proven quite difficult. As Jonathan Macey complains, “scholarship that decries insider trading as ‘unfair’ completely lacks reasoned argument. Often those who brand insider trading as unfair do not even attempt to explain what insider trading is, much less why it is unfair.” Jonathan R. Macey, Ethics, Economics, and Insider Trading: Ayn Rand Meets the Theory of the Firm, 11 Harv. J.L. & Pub. Pol’y 785, 787 (1988).
In the present context, however, we may be able to some meat on the bones of a fairness argument. Congress routinely imposes rules on the public and the executive branch that it does not impose upon itself. Until recently, “one of the most notorious of these congressional exemptions” arose out of Congress exempting ‘itself from federal anti-discrimination and other workforce protection laws.” Cheryl D. Block, Congress and Accounting Scandals: Is the Pot Calling the Kettle Black?, 82 Neb. L. Rev. 365, 374 (2003). In arguing in favor of the Congressional Accountability Act of 1995, which ended that practice, Senator Grassley contended that;
I hold a strong belief that we, in Congress, are merely representatives of the people. We are not better than the people we represent and we are not, by definition and determination, different from the people we represent. We are, as representative government intends, the people themselves.
It is simply not fair, or good governance, for the Congress of the United States to enact laws for the American people, while exempting itself from compliance…. This is a democracy, and therefore, we make laws for the people, and we, too, must follow these laws.
Grassley began this line of argument by quoting Madison in Federalist No. 57:
[Members of Congress] can make no law which will not have its full operation on themselves and their friends, as well as on the great mass of society. This has always been deemed one of the strongest bonds by which human policy can connect the rulers and the people together. It creates between them that communion of interests and sympathy of sentiments of which few governments have furnished examples, but without which every government degenerates into tyranny. … If this spirit shall ever be so far debased as to tolerate a law not obligatory on the legislature as well as on the people, the people will be prepared to tolerate anything but liberty.
As the Supreme Court has noted, Thomas Jefferson likewise believed that “legislators ought not to stand above the law they create but ought generally to the bound by it as are ordinary persons.” Gravel v. U.S., 408 U.S. 606, 615 (1972).
The present exemption of Congress from the insider trading laws violates these basic principles of good government. Accordingly, even if we cannot state a universal definition of fairness in the insider trading context, the loophole through which Congressional insider trading escapes those penalties validly may be called unfair because it breaks the “bonds” of which Madison spoke. Given the harsh and Draconian penalties Congress has seen fit to impose on those who commit insider trading, moreover, the exemption of Congress from those penalties is particularly egregious.
