The Continuing Impact of Insider Trading Prosecutions

We have spent a considerable amount of time writing about insider trading issues and cases in the past. In doing so, we have consistently commended law enforcement efforts to come down hard on the perpetrators of such crimes. However, it is also true that we typically tend, despite the recent problems in the market, to tilt toward the 'hands off' end of the spectrum when it comes to increased regulation. The question could be asked whether these are not incongruous positions to hold. In fact, we believe that they are perfectly compatible. From a posting in late 2009:

The stock market is too often an insider's only club in what should be the most populist of markets. Realistically, cases like this (a hedge fund-related insider trading prosecution) are more than likely just the tip of the iceberg, a fact that prosecutors and regulators should remember before patting themselves too generously on their respective backs. However, it is a start, and could also serve as a model for financial regulation. Instead of putting further systems in place to regulate the financial markets, more cases like this could be just the fix for unfair play, creating a disincentive to cheat, and ultimately an equal playing field for all.

Since the 2009 case referenced above, law enforcement officials have uncovered and prosecuted a string of record-sized insider trading cases involving traders, bankers and more recently even law firms. This is incredibly positive for the morale of the market and is evidence that the system is working. Securities regulators are becoming more sophisticated at discovering wrongdoing, and are incredibly efficient at prosecuting it. Of course it is important in a society built on the rule of law to punish people who do wrong. However, these successful prosecutions arguably provide a even bigger benefit with regards to the morale of market participants.

When the public perceives that anyone not on the inside (to paraphrase Gordon Gekko) is on the outside, it hurts the integrity of the markets and dulls their ability to be used as tools for financing public companies. When investors are, on the other hand, witness to the downfall of those who abuse their positions and knowledge, the sense that everyone is on an (at least more) even footing is restored. That such prosecutions have a prophylactic effect on other potential wrongdoers perpetuates this sense among the investing public.

Very little regulation was put into place in the wake of recent trading scandals. Despite this, empirical evidence would suggest that officials are becoming much better at catching individuals who attempt to game the system. The continuance of this trend will help to ensure that investors stay honest, having much the same impact as regulation at a much lower cost.