Busting Insider Trading: As Pointless as Prohibition

By Henry Manne

The much-hyped modern insider-trading prosecutions and their results are reminiscent of nothing so much as Prohibition-era government attacks on bootleggers. There is about as much chance of stopping trading on undisclosed financial information as there ever was of stopping the consumption of booze. There is simply too much money sloshing around the world's stock exchanges waiting for an "edge." Information is more mercurial than mercury and will seep into some crevice in the system no matter how many channels are closed.

Preet Bharara, the federal prosecutor in Manhattan who has racked up 80 insider-trading convictions, is no Eliot Ness —relentless pursuer of violators of the 18th Amendment prohibiting the manufacture, sale, transport, import or export of alcoholic beverages. But the similarities of the two men's situations are apparent, and the futility of their tasks identical. Ness and his fellow Bureau of Investigation agents convicted hundreds of Prohibition-era functionaries with no discernible effect on the amount of alcohol consumed. And so it is with Mr. Bharara's scores of insider-trading convictions, but
the similarities go further.

The legal alcoholic-beverage industry before Prohibition began in 1920 was made up of thousands of small mom-and-pop saloons, taverns, bars, liquor stores, brewers, distillers and distributors. They operated just as any other normal American industry at that time. But after their trade became illegal, most of the law-abiding folks working in this industry chose other, less risky and more reputable professions. Yet drinking alcohol did not stop. The consumption of hard liquors went up, not down, after 1920, supplied by gangsters and moonshiners and sold in speakeasies that sprung up across America.

The modern effort to stop trading on undisclosed financial information, though it has distant origins in the Securities Exchange Act of 1934, really dates from the early 1980s, about the time corporate takeovers became a widespread financial device. Insiders of the sort once thought to be "real" insiders—top executives, directors and large shareholders—could always be easily identified and targeted. As a result they have largely disappeared from the ranks of those being targeted for prosecution. But highly valuable "inside" information did not disappear. A new cast of characters was needed to replace the obvious suspects.

This challenge was in time neatly met by hedge funds and "expert" advisers. These new channels for distributing information—both licit and illicit—proved to be efficient devices for getting valuable information integrated into stock prices, a process otherwise greatly impeded by regulation, not least the rules against insider trading.

Under Prohibition, as now, prosecutors were always striving to land a big name. For Eliot Ness it was Al Capone, and for Preet Bharara it appears to be Steven A. Cohen, the billionaire founder of SAC Capital Advisors, now called Point72 Asset Management. Last November, the firm pleaded guilty to insider trading and agreed to pay a record $1.2 billion penalty. In February, a jury found Mathew Martoma, a former SAC portfolio manager, guilty of insider trading. But he wasn't the ultimate prize. As a witness for the prosecution said under cross-examination during the trial, the FBI told him that they "are really after a man named Steven A. Cohen."

For Mr. Bharara this pursuit hasn't been easy, even with wire taps and informants. The FBI finally got Capone on a tax-evasion charge, the 1920s equivalent of today's always-available RICO and mail-fraud charges. But Mr. Cohen remains personally free of criminal taint. Prohibition-era prosecutors often had to make do with whoever was available for easy convictions, namely speakeasy managers and patrons, workaday gangsters and moonshiners. Eventually this massive criminalization of a generally benign activity—and the ensuing corruption—became too scandalous even for the pious moralists who fueled the drive for Prohibition. In 1933, to joyous popular approval, the 18th Amendment was repealed.

Perhaps the same will happen with insider trading, but we are not there quite yet. The imagination of wealth seekers in using valuable information in the stock market will always outpace the ability of regulators to cope. The payoffs are too big and too accessible and the number of willing players too great for the practice to be significantly inhibited by scores of convictions. But political reputations can still be made by convincing investors that these prosecutions are in their interest and will significantly alter the market's behavior.

The case for outlawing insider trading is even weaker than it was with alcohol. The latter did in many cases inflict real damage—to careers, family relationships, livers. Insider trading not only does no harm, it can have significant social and economic benefits including a more accurate pricing of stocks.

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