Insider Trading

Question: Why is Martha Stewart's insider trading only bad because it is prohibited? I thought that capitalism needed a free and open market with multiple buyers and sellers or else the market function itself would be in danger; buyers and sellers could not trust it. Insider trading destroys that market function and seems therefore bad in itself.

Answer: First, Martha Stewart was not convicted of insider trading. She was convicted of lying to federal law-enforcement agents. However, the underlying reason for her prosecution was an accusation of insider trading.

The whole episode was a disgraceful abuse of governmental authority.

Now, here is an Objectivist view of insider trading laws:

It is considered "insider trading" when a person with access to internal information of a firm uses that information to profit in the marketplace before the information is made public.

Does insider trading interfere with the free market? In the broad sense, what traders and arbitrageurs do is act on private information to make money in a public market. It is a truism of financial economics that if two parties are trading solely for the sake of profit, then each of them acts on the assumption that he knows something the other one does not. In fact, the act of trading reveals that there is private information that someone thinks bears on the trade.

(Now, in actual markets, people trade for many reasons besides expected profit maximization in the traded asset. They sell for liquidity, or to pay out retirement savings, or to make a big purchase like buying a home, for example. So some trades would take place even in the absence of private information.)

In the broad sense, then the market exists to allow people with private knowledge to trade. The idea that there must be a "level playing field" in the financial marketplace, or "equal opportunity" for the ignorant, irrational, or mis-informed, contradicts the purpose of the market. Truthful information is expensive to obtain; as no one has the right to the fruits of another's labor, no one has the right to demand the product of one person's research and judgment for free. In this sense, insider trader laws are unjust. In acting on the best information she could learn, Martha Stewart was simply acting as a rational trader. If our laws truly reflected respect for laissez-faire capitalism, traders like Stewart could never be prosecuted.

Martha Stewart was not, however, alleged to be the "insider" in her case.

The insider was Sam Waksal, the CEO of Imclone Systems. Because Imclone is a publicly traded joint-stock company, the legal obligations of Waksal were quite different from those of Stewart. Even under laissez-faire, an employee would have fiduciary and contractual responsibilities to his firm. Under laissez-faire, those responsibilities would probably not be defined by statute, but would depend on the contracts of the particular firms. But since joint-stock investors count on the ability to trade their securities easily, they would have good reason to endorse something like the information-publishing requirements that the SEC and corporation law currently place on public corporations. There would probably be uniform contracts for corporations. The owners of Imclone would have had every right to sue Waksal for violation of contract and failure to fulfill his fiduciary obligations.

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