A Typology of Profit-Driven Crimes

Appendix II: The Curious Case of Insider Trading

The typology of profit-driven crime not only aids classification, but it can also be useful in questioning whether or not something really should be a crime at all. Take, for example, insider trading.

Insider trading was first conceived as an offence involving officers of corporations about to merge who took advantage of that knowledge to speculate to their own profit. It was then extended beyond its original mandate to embrace employees of law firms planning mergers and acquisitions, merchant banks involved in financing them, reporters for financial newspapers who got leaks, and even janitors who picked up discarded memos in the trash. If any of them used such information to anticipate stock price movements for their own gain, they were guilty of insider trading.[25]

In most countries for most of their history, insider trading, if it was subject to any penalties at all, was regarded as a civil offence. It was at the end of the 1970s, with the weakening of the general decriminalization sentiment that had been prevalent in the previous two decades, that the modern pattern of criminalization began.

The driving force seems to have been a big shift in the nature of stock market activity. Beginning in the late 1970s, and accelerating for the next decade, mergers and acquisitions began setting the tone. What would happen is that a corporate raider, backed by an investment banker who floated the necessary junk bonds, would launch hostile takeover bids for cash-rich corporations, then use whatever could be looted from the prize – the contents of the treasury, the proceeds from selling off profitable divisions, or whatever could be squeezed from the blue and white collar workers in layoffs and pay cuts – to pay off the high-interest loans used for the takeover. The target company might try to resist by buying up its own shares, simultaneously taking them off the market and driving up the price, and therefore the acquisition cost, of those left. They might be aided by greenmailers, who caught wind of the takeover attempt, cornered some stock, then offered it to the targeted company at a huge markup. If the defensive strategy failed, the top executives could usually arrange a golden parachute. It was in this hot-house atmosphere that insider trading ceased to be a term used by financial industry insiders and became part of the public lexicon.

The way it worked, takeover arbitrageurs would take positions in anticipation of takeover announcements and then sell once the market rose. Apart from the frequency with which the "arbs" themselves turned out to be the source of rumours about pending takeovers to rig the market, the key to their success was how well they anticipated actual takeovers. And that often required a little help from friends inside – inside the investment banking houses that financed the bids, the law firms that drew up the documents, the printing houses that produced tender-offer brochures, and once even a psychiatrist who coaxed the information out of an executive’s wife during therapy. The executive’s wife aside, friends who provided the tips usually got a cut of the profit. With suitable information the arb would do two things – buy the stock of the takeover target because it was bound to rise, and short the stock of the bidding company because, loaded with extra debt, its shares were likely to fall.[26]It was precisely this kind of activity that led to the great insider trading scandals that shook Wall Street in the mid 1980s. Yet for all the storm and fury, it remains unclear just why insider trading should be a crime. 

To begin with, once insider trading ceased to be confined to officers of corporations actually involved, it became unclear just where the frontiers between "inside information" and the normal search by potential investors for data on which to base a stock purchase really fell. (If all investors have the same information, there will be virtually no differences in expectations and therefore virtually no trades – at which point the markets become both thin and inefficient.) Simultaneously the core issue ceased to be breach-of-fiduciary-duty, and became simply obtaining profit, that other people thought should rightfully be theirs, from correctly guessing stock price movements. This tendency to seek an ever-expanding mandate while blurring the central moral issues seems a danger inherent in all attempts to use the criminal code for purposes of economic regulation.

However, even if the offence of insider trading were redefined to accord better with its original mandate, its logic could still be open to question. Insider trading is not a predatory crime – it does not involve the forced transfer of property. It is not a market-based crime – the object of the exchange, securities, is perfectly legal. It is not even clearly a commercial crime – to trade on privileged information to capture the profits from market movements that take place for independent reasons is quite different from rigging the market to make it move in a particular direction. With insider trading there is no victim in the classical sense. What is at issue is not a contest between predator and victim over forcibly or fraudulently redistributed wealth, but a quarrel between two sets of investors over distribution of profit. In the past (and in the bulk of instances also in the present) most such disputes were (are) left to the civil courts. With stock markets as with race tracks, it should never be forgotten that insider tips can provide an advantage but, unless combined with painting the tape or doping the horse, can never guarantee the results.

On balance, it is difficult to avoid the impression that insider trading was criminalized, much the way anti-trust actions were before it, for reasons that are more ideological than economic. Anti-trust law criminalized conspiracy in restraint of trade not to guarantee competition – there are far better ways to do that – but because certain business practices threatened the political legitimacy of the free-market system by giving the impression that it was biased in favour of "big business."[27]Similarly, the reason for criminalizing insider trading seems to have been to reassure would-be investors that the stock market does not unfairly favour some at the expense of others.


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