Legalize Insider Trading
2009-10-31 · Guest: Don Boudreaux (Professor of Economics at George Mason University) · 59:59
Legal and economic arguments for legalizing insider trading
This episode of The Bob Zadek Show features host Bob Zadek and economics professor Don Boudreaux discussing the legal and economic arguments for legalizing insider trading. They argue that insider trading leads to more accurate stock prices, which benefits the general public and helps allocate capital more efficiently. The conversation covers the history of insider trading laws, the role of the SEC in criminalizing the practice without explicit congressional approval, and the case of whistleblower Ray Dirks.
Topics: insider trading, SEC Rule 10b-5, market efficiency, stock market, criminal law, Alexander Hamilton, Ray Dirks, corporate fraud, economics, George Mason, Milton Friedman, Martha Stewart, Enron, fiduciary duty
Speakers: Bob Zadek — Host Don Boudreaux — Professor of Economics at George Mason University
Introduction to Insider Trading [06:11]
Bob Zadek: Welcome to the Bob Zadek Show, Sundays at noon on 910 AM, more stimulating talk. No surprise, but I’m your host, Bob Zadek. And have we got a show for you. Oh my god, I can’t stand it, I’m so excited. We have a topic that I love, we have a guest that I love. I’m so excited I’m going to be out of my nut today. Thanks for joining me. And write down this number: 800-345-5639. 800-345-KNEW. You’ll want to join the discussion today.
Today’s topic is insider trading. What is insider trading? Insider trading is a crime in the United States and much of the civilized world. It’s a crime you may not care about just yet, but you will care about it in about 45 seconds. Insider trading describes the crime where somebody who works for a publicly traded corporation acquires material non-public information about that company and uses that to buy or sell the stock.
Why are we talking about insider trading? Well, it’s been in the news a great deal these days. A company called Galleon—the president of Galleon has just been indicted on an alleged $2 billion insider trading scam. And we’re going to be discussing whether insider trading should be a crime. It should not. In fact, to use Milton Friedman’s words, we don’t have enough insider trading. You’re going to learn all about insider trading and you’re going to learn why you care.
I am honored to have as my guest, Donald Boudreaux. Donald is a professor at George Mason University in Fairfax, Virginia, and has been chair of the economics department from 2001 until August of 2009. Don writes a blog called Cafe Hayek. It is must-reading. Write this down: www.cafehayek.com. It is must-reading. If you listen to this show, if you care about our issues, subscribing to Cafe Hayek is a must. Don, welcome to the show.
Don Boudreaux: My pleasure to be here.
Bob Zadek: Don, thanks so much for joining me. It is really an honor. I have read your blog for the past year. I don’t miss a day. I love what you do. Thanks so much for taking the effort to write the blog and to send it out to us folks who care.
Don Boudreaux: Oh, thank you. It’s a lot of fun.
Alexander Hamilton: The First Insider Trader [10:19]
Bob Zadek: Welcome back everyone. This is Bob Zadek, host of the Bob Zadek Show, every Sunday at noon on 910 AM, more stimulating talk. 800-345-5639. 800-345-KNEW. My guest today is Don Boudreaux, professor of economics at George Mason University. Don, today’s topic is insider trading. You’ve written quite a bit on insider trading. I’m going to maybe during the course of the hour refer to some of your writing, which I love and you are right on. But I’m going to ask you, Don, as we start, a history question. Who was the first insider trader in American history?
Don Boudreaux: Oh heavens, I’m not sure I know. Probably George Washington or someone like that?
Bob Zadek: I’ll give you a hint.
Don Boudreaux: John Winthrop?
Bob Zadek: His picture is on the $10 bill.
Don Boudreaux: Alexander Hamilton.
Bob Zadek: Alexander Hamilton. Did you know he was the first insider trader?
Don Boudreaux: No, I did not.
Bob Zadek: The story about Alexander Hamilton and insider trading is quite interesting. Alexander Hamilton was George Washington’s Secretary of the Treasury. He was the first Secretary of the Treasury. Hamilton was, of course, a big-government kind of guy, as we know. And as we also know from our study of American history, the states financed—they weren’t states then, they were colonies—they financed the American Revolution by issuing script, by issuing paper money, which the states were obligated on. And they were called Continentals. And the states, when the war ended, the states had all this debt, which they couldn’t afford to repay. They used the script to pay the militia, all the soldiers were carrying around this funny money, like Monopoly money. Wasn’t worth very much. It was trading for pennies on a dollar, although the word dollar hadn’t yet been invented. So all this funny money was circulating around, worth pennies on the dollar.
Hamilton has a plan. He wants the federal government to buy up and to honor and to pay off all of this state debt, so the states can start our country clean, free of debt. That would have been a windfall to the states who issued all the currency. There was a lot of opposition from the southern states, and there was a dinner among Jefferson, Madison, and Hamilton, called the Great Dinner Bargain, where in exchange for the northern states agreeing to let the nation’s capital be in the south, in what is now called DC, the southerners agreed to let Hamilton buy up all the script. Now, Hamilton told all of his buddies: “Go out and buy Continentals for pennies on a dollar. The federal government is going to guarantee it.” It sounds like today with the bailout. And all of his buddies in the northeast bought up all of this script for pennies on the dollar, and when Hamilton announced the federal government is going to guarantee it, they all cashed in the stuff for 100 cents on the dollar. And the first insider trader in American history, his picture’s on the $10 bill. With that, we start our show.
Don Boudreaux: Yeah, and his statue is in front of the Treasury building in Washington.
Bob Zadek: And he was an insider trader. It’s a cool story.
Don Boudreaux: Yeah, I didn’t know that story. Of course, the wrong in that story isn’t the insider trading, as we’ll probably explain, it was the bailout, as you accurately described it. But that’s a history that I’m not so familiar with, so we probably shouldn’t go down that road.
The Economic Rationale for Insider Trading [12:45]
Bob Zadek: That’s exactly right. Now, insider trading. So, insider trading is in the news a lot these days. Remember Martha Stewart? She was accused, but her crime was not insider trading because it’s too hard to convict anybody, it’s almost impossible. But she was accused, as they always are, of the cover-up. So this is a very vibrant body of law. Now, what is—now, so it’s part of American criminal law, securities dogma, that insider trading is against the law. Who cares? Why should we care if some insider has secret information and buys it or uses that to buy or sell a stock? Don, what is the rationale? Why does this country think it’s wrong for an insider to do that?
Don Boudreaux: Well, I think there are a variety of reasons, but the main reason is most people think it’s just unfair. They think of the stock market as something like a casino, and if the guy next to you at the casino has information you don’t have, well, that’s not a very fair game. And we all understand that. But the point of a stock market isn’t to make money for stock traders. The point of a stock market, the point of asset markets, of capital markets, is to make sure that capital goes to where it’s most productive as quickly as possible.
Bob Zadek: In the most efficient way imaginable.
Don Boudreaux: In the most efficient way imaginable. And for that to happen, assets, including share prices, have to be priced as accurately as possible, priced in a way that reflects as best as we know their true value. And one of the benefits of insider trading is that when insiders trade on their inside knowledge, it enables those prices to include that information. And that’s a good thing. That’s a good thing. So most people just think it’s unfair, but unfair and fair, those are words that have very vague meanings.
Bob Zadek: They have no meaning.
Don Boudreaux: Yeah, not in this context they certainly do not. But that’s why most people think it’s unfair.
The Legal History of Rule 10b-5 [14:22]
Don Boudreaux: And also, curiously, insider trading was not even illegal in the United States until about 1961. Congress has never—
Bob Zadek: Texas Gulf Sulphur?
Don Boudreaux: Well, that’s right. And something called the Cady, Roberts memorandum from a man named William Cary, who John Kennedy appointed to be head of the Securities and Exchange Commission. Cary was a Columbia University professor of law, and it was his view that insider trading is bad. During the debates in the 1930s over the Securities Act and Securities Exchange Act in 1933 and 1934, there were some proposals to make insider trading illegal. Even that highly interventionist Congress under Franklin Roosevelt didn’t do it. But they did have a clause in the Securities Exchange Act of 1934, Clause 10b, that was against securities fraud.
Bob Zadek: Fraud. Fraud. And that’s an important distinction.
Don Boudreaux: Yeah, it was against fraud. And this guy William Cary had this theory, this law professor had this theory that he could use this Section 10b, that was a pretty broad prohibition of securities fraud, and turn it into, get it interpreted as, a prohibition on insider trading. So that’s how we got insider trading. Congress has never said insider trading is illegal. Congress is not the agency that came up with the prohibition on insider trading.
Bob Zadek: It was the SEC creating a new product.
Don Boudreaux: It was a bureaucrat at the SEC creating a new product. Now, having said that, that’s almost 50 years ago, and Congress certainly could have overturned it if it wanted to. It didn’t. The courts have pretty much accepted it. But it’s important to know that within my own lifetime, and within the lifetime of probably at least half of the people listening to your show right now, insider trading was perfectly legal in the United States. It only became illegal in the early 1960s.
Insider Non-Trading and the Unfairness of the Law [22:05]
Bob Zadek: Welcome back everyone. This is Bob Zadek, host of the Bob Zadek Show, every Sunday at noon on 910 AM, more stimulating talk. 800-345-5639. 800-345-KNEW. My guest today, and it is a profound honor, is Don Boudreaux, professor of economics at George Mason University and chair of the economics department for eight years from 2001 to August 2009. Today’s topic is insider trading. I suspect that many out there in my audience have bought or have sold securities. I suspect they have done their very best to analyze their decision or to follow competent advice. If you have bought or sold securities, how do you feel about somebody who is buying or selling as you are, but they have access to information at the time they make their decision that you don’t have? Is that good, bad, neither? Should that be a crime? Should they be allowed to sell? Is that good for you or is that bad for you? If you feel they are taking advantage of you, I’d love to hear from you. If you feel they’re not taking advantage of you and that’s perfectly fine, I’d love to hear from you as well. How do you feel about people having an edge over you as you buy and sell securities? My guest is, as I said, Don Boudreaux. Don has written—writes a blog called Cafe Hayek at www.cafehayek.com. And Don has written extensively on insider trading. One of his articles was, quote, “Learning to Love Insider Trading.” Don, welcome back.
Don Boudreaux: My pleasure. Glad to be here.
Bob Zadek: Don, you know, you make an interesting point in your article, “Learning to Love Insider Trading.” You make what I found to be a deliciously fascinating point about insider non-trading, which of course is not yet against the law because we don’t have electrodes plugged into people’s brains yet. So tell us about insider non-trading and how that is insider trading, but it’s perfectly allowed.
Don Boudreaux: Yeah, well, technically, according to the logic of the Securities and Exchange Commission, it should be illegal, but you know, there are various ways—you can actively trade. You can actually go out and buy a stock or sell a stock. But you can also change your mind about buying or selling. You could plan to have bought a stock and choose not to. You can plan to have sold a stock and choose not to. That’s non-trading.
Bob Zadek: Based upon inside information.
Don Boudreaux: And so, yeah, so let’s say you work for a company and you were planning to buy 100 more shares of this company’s stock, and you discover that the company’s in worse financial—you have inside information that the company’s in worse financial shape than most people believe, right? Well, you then cancel your plans to buy that stock. And you profit from that because you otherwise would have bought stock that would have declined, but by having this inside information, you were saved from making a bad investment. And that’s a good thing for you. And so the only trades that can even conceivably be prosecuted are active trades. But let’s face it, there are a lot of non-active trades. People change their minds all the time about whether or not to buy or not to buy or to sell or not to sell stocks. And inside information can affect those decisions no less than it affects decisions to actively buy or sell a stock.
Bob Zadek: But they can’t be criminalized because the government can’t prove that you intended to do something and you didn’t. So we have—
Don Boudreaux: Right, you can’t put electrodes in people’s heads. Yeah. And so this raises a fundamental unfairness about the law itself. People talk about insider trading being unfair. It’s unfair to the guy who actively trades on inside information and gets prosecuted and punished, because the gal who used her inside information to not trade can’t get punished. Of course, in my view, none of it should be illegal.
Fraud vs. Information Trading [26:06]
Don Boudreaux: And can I say a word about this fairness issue that you asked your listeners, you know, do you think it’s—would they think it’s unfair that someone has an inside advantage over them?
Bob Zadek: Of course you can. Go ahead.
Don Boudreaux: One way they should think about it is, yeah, it’s true, I understand. If some insider at, you know, XYZ Corporation has some information that you don’t have, sure, that person stands to make money on that stock with a better chance than you do. That’s true, right? But at a higher level, what you should want as a stock trader and certainly as just a participant in the economy, you should want that stock price to be as honest as possible, right? What’s not fair to you is if the insider, let’s say, has information that the company’s going down the tubes, and information that’s not public yet, right? And so not knowing this, you go out and you buy the stock, right? And then tomorrow that becomes public information, and then the stock price plummets, and you lose a lot of money because you bought stock that you wouldn’t have bought had you known the information. If the insiders had been allowed to trade on that, right, then you would have been saved from the unfairness of being misled by a stock price that turns out to have been too high.
Bob Zadek: Which is why Milton Friedman said, quote, “We need more insider trading, not less,” close quote.
Don Boudreaux: That’s right. That’s right. And Milton Friedman knew a thing or two about economics and free markets.
Bob Zadek: More than almost any other human being who ever lived.
Don Boudreaux: And also, now, we should keep in mind that no one is advocating that company executives engage in fraud. No one is advocating that company executives violate their fiduciary duties. And everyone, including myself and including Henry Manne, who’s a great inspiration to me—he was the theorist back in the 1960s who first started thinking along these lines—
Bob Zadek: Who wrote the seminal book on insider trading.
Don Boudreaux: Insider Trading and the Stock Market. That’s right. And we all—no one argues that companies should not be allowed—companies themselves should not be allowed to say what kind of information is and isn’t off-limits to inside traders. What I argue against is that it’s not the government’s place to criminalize insider trading. If a company does not itself say, “Look, people who work for us cannot trade on these types of information,” if a company doesn’t do that, the government shouldn’t do it. If the company does it, then the company should be allowed to sue people who violate its bylaws in court. Of course, that should happen. So it’s just not the government’s business to do it.
Void for Vagueness in Criminal Law [28:00]
Bob Zadek: And most importantly, and you made this point, Don, in your distinction between malum in se and malum prohibitum, which I’ll get into in a second. But there is a principle of criminal law. This is a crime. It is a crime invented by a bureaucrat, not by the legislature. And a basic tenet of criminal law is you have to know what the crime is, or else it’s patently unfair. And there is a principle called “void for vagueness.” If the crime—like, there used to be a crime called vagrancy, which you used to get homeless people off the streets and throw them in jail. Well, those criminal statutes were thrown out because nobody knew what it meant. What it meant was if you wore dirty clothes, you get locked up. So you have to—criminal law is important. You have to know you’re committing a crime, or else you lose all of the deterrent effect of it. And when you have a crime like insider trading, invented by a bureaucrat 50 years ago and becomes part of our dogma when nobody knows if they’re breaking the law, that’s a deterrent to market operation. It makes markets inefficient. And talk about unfairness, what could be more unfair than you have a bureaucracy on a random basis enforcing a law that nobody knows even what it means?
Don Boudreaux: Yes, that’s a really good point. And you know, that’s just a whole other thing that’s wrong with this insider trading thing. Crimes—to criminalize something, that is a powerful action exercised by government. And in the Anglo-American tradition, we recognize that that is an action that has been abused quite often. And so in our tradition, we tend to be, and we should be even more, demanding of the government when it criminalizes something, that the thing that’s criminalized is unambiguously bad, really harmful to society, and that the government specifies very clearly what it is that’s wrong. And the Rule 10b-5, which is the section of the law that’s used to criminalize insider trading, is incredibly vague. It’s astonishingly vague. It’s very difficult to define, it’s very difficult to enforce. And so the old principle of void for vagueness would I think apply here and should eliminate at least the criminality part of insider trading.
Synthetic Insider Trading: Viagra and Cialis [35:14]
Bob Zadek: Welcome back everyone. This is Bob Zadek, host of the Bob Zadek Show on 910 AM, more stimulating talk. I’m joined by Don Boudreaux, professor of economics, former chair of the department of economics at George Mason University in Fairfax, Virginia. Today’s topic is insider trading. As American as apple pie, let’s decriminalize, let’s encourage this perfectly natural behavior that is healthy for the markets. If any of you out there buy or sell stocks, and if you have an opinion about whether somebody should be allowed to buy or sell the securities that you are participating in, and if they have information you don’t have, is that fair—I hate that word—unfair, good or bad? How do you feel about somebody being in the same marketplace as you are with more information? Do you support insider trading prohibitions or not? Love to hear from you, so would Don. Welcome back, Don.
Don Boudreaux: Good to be here.
Bob Zadek: Don, you know, there’s an interesting aspect of insider trading that I read about that really piqued my interest. And that was, let’s assume you are employed by a drug company. And let’s say—and I forget which drug company is which—but let’s assume there’s one drug company, I forget which one it was, that sort of introduced Viagra into the marketplace. And Viagra was a big hit, of course. And now you work for the drug company that is about to introduce Cialis, which I hear second-hand is a better product. And so you determine once Cialis is introduced into the marketplace, Viagra’s fortunes will decline. So you know insider trading is prohibited, so you don’t use the information to buy stock in your company, which is going to introduce Cialis, but you do it—you short the company that sells Viagra because they’re going to suffer. So you do synthetic insider trading. Now, that’s not illegal, I don’t think.
Don Boudreaux: Well, I don’t really know the answer to that question because, you know, Section 10b-5 is so vague that perhaps some bureaucrat can decide, “Hey, let’s try to do that.” It’s not trading—you’re using inside information—I don’t know the legal answer to that, but again, that’s part of the problem.
Bob Zadek: Well, exactly. It’s exactly why I raised the question, because you can’t have—society is not benefited by a criminal law that nobody—it’s not really a criminal law, but it’s treated as such because there are fines and punishment. You can’t have a body of law that is so vague that’s subject solely to the arbitrary and capricious whim of a bureaucrat. The SEC, not even a law enforcement body, but rather a bureaucratic body, the SEC will decide who to beat up and who not to beat up based upon a somewhat random interpretation of the statute. How can that benefit society? The answer is, of course, that it cannot.
Politicized Enforcement and Martha Stewart [38:34]
Don Boudreaux: Yeah, and let’s face it, another point that’s a little more general here. It’s ludicrous to believe that these kinds of prohibitions are not going to be politicized, they’re not going to be used for political ends. That’s just the nature of what bureaucracies do. And so, unless you have an offense that is widely agreed upon to be bad and harmful to society, then that offense has no business being prohibited by the bureaucracy, because the bureaucracy is going to play to the tune called by its political masters. That’s what bureaucracies do.
Bob Zadek: Martha Stewart. What great headlines that was for the SEC and for Congress to put Martha Stewart in the public dock. And of course, she ended up going to jail, not because of insider trading—it’s too hard to prove—but rather for lying to a federal investigator because they couldn’t prove insider trading anyway, and she just exercised really bad judgment. There’s a perfect example of using a vague statute just to headline grab. And you made a very important point earlier in the first segment where you indicated that this was never a case of the legislature deliberating, if they ever do, deliberating and deciding this should be criminalized, but rather this was an invention of a bureaucrat. And I describe it as the SEC simply inventing a new product for it to work on, which is insider trading. And they became the enforcers of this bureaucratically created body of quasi-criminal law. It’s just—it’s so wrong. And it’s anti-free market, anti-capitalistic, and it causes stocks, Don, as you pointed out, to not have their real value. It causes phony stock prices.
How Prohibitions Harm the Public: The Enron Example [40:12]
Don Boudreaux: Yeah, which is—if you want to use the word unfair, I think that is unfair then to the general public who are now who are trading, buying stocks, selling stocks, many of which are not priced as accurately as they would be priced if insider trading were legal.
Bob Zadek: So we out there, we who buy and sell securities, are harmed. We are harmed by insider trading statutes because we don’t get to buy investments at their true value. These values are artificial. They don’t reflect the best information available.
Don Boudreaux: Sure. I mean, imagine someone—suppose you had bought Enron stock, say, in the summer of 2000 or January of 2001. You bought a stock that went kerplunk just a year later. And if insiders had been allowed to trade, they knew what was going on at Enron, they would have sold that stock short and you would have either not bought the stock or you would have bought it at a lot lower price, and so you wouldn’t have been harmed as much.
Bob Zadek: So there were thousands of—sorry, go on.
Don Boudreaux: Well, so it’s likely insider trading prohibitions scared a lot of insiders at Enron off, or people who knew this information, scared them off from making those kinds of trades, which would have been in everyone’s benefit except, of course, you know, the bad guys at Enron.
Insider Trading in Real Estate [41:56]
Bob Zadek: And what’s so utterly hypocritical from a free-market sense is insider trading is allowed in every other activity except stocks. So that, let’s assume that you knew that Disney was going to be building a theme park in Orlando. And you had that and you didn’t use the information to buy Disney stock, but rather to buy up all the land in Orlando, which was then orange groves. You would have made a fortune on the basis of inside information, but outside the purview of the SEC. So as a society, we don’t care about it, we’re happy to reward the diligent, people who get information. But only in this tiny subset, the stock market, we decide there’s something heinous about that.
Don Boudreaux: Yeah, and again, this was the invention of some law professor at Columbia. It was his fancy idea and he wanted to engineer society to look a little bit more like he thought it should look. And he lucked out, as it were. He got his idea implemented, and now we all take it as if it’s something handed down from God.
Bob Zadek: It’s interesting that you say that, because how fast a theory of an SEC employee becomes etched in the fabric of the country, so that now we take it sort of as a given without any thought whatsoever that there’s something inherently wrong with insider trading. Instead, there’s something inherently right with it. But how easy it is for a very, very unsound principle, a principle that is anti-capitalistic, to become part of the culture of our country. It’s astonishing to me.
Don Boudreaux: People don’t think of it. I’ve gotten so many hostile emails in response to my Wall Street Journal article, and probably the most common thing that people strike in those emails is they say, “Well, boy, if we get rid of insider trading, that’s going to ruin the capital markets. There’ll be no more stock markets.” And then I write back to them and say, “Well, no, that can’t be right because this wasn’t even illegal until 1961. We had stock markets before 1961. There were no catastrophes of the kind you predict before 1961, and there wouldn’t be those catastrophes now.” But people pick up on—the culture has accepted this William Cary, he was the SEC chairman who invented this, they picked up on his fears and now it’s become an article of faith.
George Mason and Gunston Hall [49:45]
Bob Zadek: Welcome back everyone. This is Bob Zadek, host of the Bob Zadek Show on 910 AM, more stimulating talk. I’m joined by Don Boudreaux, professor of economics, former chair of the department of economics at George Mason University in Fairfax, Virginia. We are talking about insider trading. As American as apple pie, let’s decriminalize, let’s encourage this perfectly natural behavior that is healthy for the markets. If any of you out there buy or sell stocks, and if you have an opinion about whether somebody should be allowed to buy or sell the securities that you are participating in, and if they have information you don’t have, is that fair—I hate that word—unfair, good or bad? How do you feel about somebody being in the same marketplace as you are with more information? Do you support insider trading prohibitions or not? Love to hear from you, so would Don. Welcome back, Don.
Don Boudreaux: Good to be here.
Bob Zadek: Of course, the namesake of your university, George Mason, is one of my great heroes, the father of the Bill of Rights.
Don Boudreaux: He was a great man.
Bob Zadek: He wouldn’t endorse—he couldn’t endorse the Constitution. He was a drafter of the Constitution but wouldn’t sign it, wouldn’t support it because it lacked the Bill of Rights, which he felt was essential. He was a great man. He probably is, in the opinion of most folks, a second-tier founder. He’s not well-known, but he was a great patriot and an interesting fellow.
Don Boudreaux: Yeah, I think one reason he is considered a second-tier founder and is not well-known is because of his steadfast refusal to approve of the Constitution without a Bill of Rights. He attended the Constitutional Convention in Philadelphia and he was one of its most frequent speakers.
Bob Zadek: He was actually the second most frequent speaker, according to James Madison.
Don Boudreaux: I can believe it. And he left, really at Madison’s wish, because they wanted to get a unanimous approval of all the people in attendance. So George Mason was also very gracious. Although he opposed it, he left so they could say we had unanimous approval. Came back to Virginia, and then when it came to Virginia to be ratified, he opposed ratification in Virginia because it did not yet contain a Bill of Rights. And that cost him his friendship with George Washington.
Bob Zadek: He was a neighbor of George Washington and they became estranged when he wouldn’t support the Constitution.
Don Boudreaux: Yeah, they were almost next-door neighbors. By the way, if you come to Northern Virginia, go see Gunston Hall, which is George Mason’s home. It’s just north of Mount Vernon and it’s beautiful, as is Mount Vernon, but it’s a beautiful place.
The Heroism of Ray Dirks [50:55]
Bob Zadek: On the subject of insider trading, there’s a fascinating insider trading story involving Ray Dirks and Equity Funding. Don, you know that story?
Don Boudreaux: I do not.
Bob Zadek: Ray Dirks—Ray Dirks was a hardworking stockbroker in the 1970s. It’s a fascinating story, Don. He gets a call one day from a guy named Secrest. Secrest worked for a high-flying company called Equity Funding, a life insurance company whose stock was going through the roof. Secrest was really angry because he got shorted on his Christmas bonus. And he was very angry at his company. So he called Ray Dirks, who he knew to be a hardworking broker. And he says, “Hey Ray, let me tell you something. This company that I work for, Equity Funding, it’s a fraud. They have insurance policy writing parties on the weekends when the employees come in and they write phony policies just to satisfy the regulators and to satisfy the auditors. It’s all a house of cards. The stock is going through the roof, but it’s all phony and you gotta get the word out.” And he says it involves the Mafia, involves sex and drugs and rock and roll and all this stuff.
So Dirks gets all worked up and starts to do some investigation. And he discovers it’s a fraud. He calls the Wall Street Journal. They say, “Well, it’s a publicly traded company, it’s all hearsay, we don’t want to go public yet.” Dirks says, “Okay.” Dirks does some more digging. He goes to the SEC—shades of Madoff. The SEC won’t move. They say, “No, no, no, it’s a big company, it sounds like it’s just a rumor, disgruntled employee, we’re not going to look into it.” Shades of Madoff. He then tells all of his institutional clients: “Sell Equity Funding. It’s all a fraud.” He makes not a dime. All of his clients sell Equity Funding. Equity Funding blows up. The president goes to jail for like eight years. The whole house of cards comes crumbling down.
What happens to Dirks? He should be a hero. There should be a statue in his honor. SEC goes after him for sharing inside material non-public information and censures him. They censure him for blowing the whistle. He didn’t make a dime. He merely told his clients that which any broker should do: “I have information, I’ve done my work, I’ve investigated, sell.” He gets censured. He fights his censure even though a censure is a very low level of criticism by the SEC. They censure him. He says, “No way.” He fights it up to the US Supreme Court. Who defends him in the US Supreme Court? Ronald Reagan’s Solicitor General takes on their own SEC and says, “No, this guy should not be censured.” And in the Supreme Court, the Supreme Court said Ray Dirks did nothing wrong, remove the censure. And ten years after his censure, his insider trading censure is removed. It’s a great story and it shows how out of control this vague body of law is. It’s great reading, Don, the Ray Dirks Equity Funding scandal.
Don Boudreaux: Yeah, I hadn’t heard that story. I’m going to look it up as soon as we’re off the phone. But it’s just par for the course. Here’s a guy who got inside information and passed it along to clients, and he saved his clients from untold amounts of misery and loss because of what he got. That’s exactly what should happen. He saved other people from buying that stock at prices too high, because when his clients sold, of course, the price fell. He helped—I don’t know the story at all, but I am sure that his actions helped to expose the fraud in that company earlier than it would otherwise have been exposed.
Bob Zadek: It did, it did. Don, you’re exactly right. Because once the stock plummeted from 30 to 15, it hits everybody’s radar screen. The SEC says, “What’s going on? How come the stock took a nosedive?” And they then investigate after the signal from the drop in the stock price. And that’s what blew the whistle. Then the Wall Street Journal publishes the story because now it’s all over the trade press. So it was Dirks who did exactly the right thing. He was a hardworking broker, never made a dime. And the SEC, who sat on the story and didn’t act, nor did the auditors act, Dirks gets censured. So this shows how random the quote “crime” is and how arbitrary the enforcement is. And if anything cries for repeal, it’s when you have a criminal law that is randomly enforced, void for vagueness, and anti-marketplace. We can’t have it exist. It’s a great story.
Don Boudreaux: That is a great story. And so here you have the agency that holds itself out as being the great protector of investors and the great guard against fraud, not doing its job. And then you have a supposedly wrongful action, namely getting inside information to be traded on, doing the anti-fraud work, and then the SEC going after that guy. It makes my blood boil. It’s just so wrong.
The SEC’s Intellectual Bankruptcy [56:13]
Bob Zadek: And if you want to hear the intellectual bankruptcy of the SEC, I’m going to sort of as we wind down the hour, there was an Associate Deputy Attorney General in 2006 named Ron Tempas. And he testifies before Congress on insider trading. And he calls—Don, this is going to make your blood boil—he says insider trading is, quote, “a variation of corporate fraud,” and he says, and I’m going to quote him, “smacks of secret backroom exchanges between insiders every small investor fears,” close quote. Oh my god, class warfare. The outsiders against the insiders. It shows how bankrupt the whole concept is.
Don Boudreaux: Yeah, I mean, he misses the whole point. In fact, insider trading helps expose backroom deals. That’s what it does. But you know, most people don’t take the time to think clearly about these issues. Frankly, most people don’t know enough economics, unfortunately, to think clearly about such an issue. But they like to moralize, and they like to do the class warfare kind of thing. And that’s true especially for people with political power, people in high office, because they have a platform for moralizing and speechifying, and that’s what they do. But unfortunately, very little of that has any relation to reality.
Bob Zadek: Don, thank you so much for joining me this hour. This is Bob Zadek, host of the Bob Zadek Show. It was my distinct honor to have Don Boudreaux join me to talk about insider trading. If you favor insider trading, you better write your congressman, decriminalize the statute. If you think insider trading is wrong, then write your congressman and get Hamilton off the $10 bill. We can’t have it both ways. Thank you so much for listening. I’ll be back next Sunday. Bob Zadek, host of the Bob Zadek Show on 910 AM, more stimulating talk. Thanks so much for joining me.