In professional sports, teams are required to announce in advance of games the status of injured players. When Tom Brady went down with an early season injury in 2008, the New England Patriots became a decidedly weaker team. Betting on the team’s performance changed direction. Insiders who knew the nature and severity of the injury before it became public could have made a fortune betting on outcomes and point spreads.
The same potential applies to business and markets. Mergers, government investigations, management changes, projections of earningsall of these changes can impact stock performance. Inside knowledge gives an investor tremendous advantages in stock trading. With the ability to liquidate holdings, deal in futures, and buy on margin, any advantage in timing over other investors can mean less risk and higher potential gains.
If stock trading were simply a game played in smoky back rooms, one might argue that the government should have no role. The player would assume his (or her) own risk. However, most working Americans have some exposure to the markets, through mutual funds, 401-k plans, college savings plans or other pooled arrangements.
While economists may speak of the importance of the government minimizing its interference in free markets, there are two functions the government must play. First, the government must guarantee the integrity of money. The government seeks to stabilize the value of currency against forces like inflation and counterfeiting. It is essential that values assumed under a contract signed today also apply when the contract is executed.
The second role of government is to assure the integrity of the transaction. Adherence to contract law by both parties in a transaction is critical. It is also critical that both parties have access to the same knowledge affecting the transaction whether they choose to do the research or to consider all the facts. If I know that the car I am selling was immersed for three days during a storm, it would be unethical for me to sell it to a buyer who did not have this information.
The most critical reason to enforce insider trading laws is to decrease deliberate manipulation of markets. In John Grisham’s recent novel, The Appeal, the evil businessman’s company was successfully sued, and it’s market price was plummeting. Having inside knowledge (because of his own illegal activities) that the suit would be overturned, he bought large numbers of shares in the company. His goal was to make a fortune when the stock market value rebounded. All his gains would be at the expense of people who thought they were taking reasonable market risk.
Insider trading laws are at the very heart of the confidence that allows investing to make sense for every worker.