Economist Portrait of Insider Trading Judge Trivializes Contradictions
By Staff News & Analysis - June 14, 2012

The very model of a modern major judge … When the judge in the Rajat Gupta case has the gavel, the law itself is on trial … The financial crisis has placed the muddled state of corporate law in America under intense scrutiny. Jed Rakoff, the judge in the current insider-trading case against Rajat Gupta, a former managing director of McKinsey, has emerged as an important player in this process. The 68-year-old judge is technically on "senior status" in the federal district court, meaning he can elect to work reduced hours. But there is nothing half-hearted about Mr Rakoff's approach. He is a powerful presence in a courtroom, and even more so in a string of recent opinions that underscore the contradictions in American regulation. – Economist Magazine

Dominant Social Theme: Insider trading is confusing, but certainly worth clarifying. And always worth prosecuting.

Free-Market Analysis: This is another one of those Economist articles that reads better if you don't read it more than once. It points up once more the issues we've discussed regarding insider trading, its hopelessness as a legal doctrine and the general unfairness of prosecuting those who "profit from undisclosed information."

If you take the time to analyze the article, and know something about the US securities business, the ludicrousness of prosecuting insider trading is only further illustrated. On the other hand, we don't want to be too hard on the article as it does provide us with a nugget of important information.

While the Securities and Exchange Commission has always refrained from being too specific about insider trading – in order to provide itself with maximum prosecutorial leverage, this article offers up a terse and pithy definition courtesy of Rakoff himself. Here's how the article describes the way Rakoff arrives at his definition:

In response to a tricky legal issue raised on a Friday, he requested that briefs from the opposing counsels be brought to his chambers on Saturday, and he delivered an opinion when the court reopened on a Monday. As the case began, opposing lawyers were required to submit by midnight definitions of insider trading, a notoriously murky area of law.

Mr Rakoff's response came the next day. It was brief, clear and encompassing: insider trading is the intentional disclosure of material information in anticipation that it will be used for a trade in exchange for "at least some modest benefit". Whether this definition withstands the scrutiny of other courts may determine the case's legacy, regardless of the verdict.

What we see here is a judge presiding over a high-profile case without an accepted definition of the crime with which the defendant is being charged. It doesn't seem to strike the Economist as odd that Judge Rakoff had to "require" lawyers to submit definitions of insider trading.

Rakoff is apparently making up definitions on the fly. For purposes of THIS trial anyway, he's decided that, "Insider trading is the intentional disclosure of material information in anticipation that it will be used for a trade in exchange for 'at least some modest benefit'."

So what is material information? Here, from Investopia: "Material information, about certain aspects of a company, that has not yet been made public but that will have at least a small impact on the company's share price once released."

So we can see that insider trading focuses on sensitive company information known only to a few. To trade on this information is to receive an unfair advantage.

The larger question then becomes why is it necessary to incarcerate those who profit from such an advantage? The Wall Street Journal answered this question late last year in an article entitled, "Why Exactly Is Insider Trading Illegal?" …

It seems that every time you get a wave of insider-trading prosecutions, inevitably a rash of opinion pieces follow asking the following question: why, exactly, is insider-trading illegal? The textbook answer is straightforward: anything else would lead to a tilted playing field, one in which Wall Streeters, corporate insiders and others with friends in high places profit most on the trades, and others struggle to keep up. Such a scenario would likely lead to a drop in confidence among average investors, and, presumably a crippling exodus from the markets.

Is this concern warranted? We would argue that most people at this point know that securities markets are subject to overwhelming manipulation. For instance, a large percentage of securities trades are exercised by computers – and these computer-aided transactions are apparently responsible for destabilizing securities markets via "flash" crashes.

Additionally, massive, state-oriented entities like the Federal Reserve are in directly buying both private and public securities instruments. Meanwhile, there is apparently a "plunge protection" team operating out of the White House (or somewhere).

Yes, US stock markets, in particular, are subject to massive manipulation – and the public knows it. According to statistics from the Investment Company Institute, some 46.4% of "American households" were invested in domestic stocks in 2011, down from a high of 53% a decade earlier."

Of course, many of these households are invested in stocks via 401Ks and pensions. Who knows how many would actually be invested in stocks if they had any choice in the matter? Probably a lot less.

In a previous article, "The Hopelessness of Insider Trading Prosecutions," we commented on the many ways that markets were unfair to the small investor so treasured by the elites that have actually organized the modern stock market. We pointed out that "unfair" advantages were obtained in numerous ways, as follows:

What about the Wall Street firms themselves that have the wealth and savvy to buy top-of-the-line computers and hire the best minds to run them? What about companies that write proprietary software or operate systems that utilize artificial intelligence?

All of the above constitutes forms of insider information that gives people access to insights that others do not have. Some of this information is a good deal more powerful than run-of-the-mill public-company "insider info."

The Economist concludes its fulsome portrait of Judge Rakoff as follows:

Much has been made of Mr Rakoff's funny side. He wrote a parody of Gilbert and Sullivan's Major-General song from "The Pirates of Penzance" that ran in the Wall Street Journal and is now featured on his Wikipedia page:

I laugh at all my judge's jokes, and listen to his endless spiel. I never pay the slightest heed to his reversals on appeal. And even in those moments when it looks like he has gone berserk, I smile and say, "More coffee, Judge?"—a perfect district judge's clerk.

It is no doubt good politics to couch things in 19th-century rhymes. But to read Mr Rakoff's opinions is to see that his affinity for the absurdity of another era is rooted in what he sees today.

While Rakoff may indeed be a humorous and clever barrister, there is nothing funny about the lives that insider trading prosecutions have ruined, and will continue to ruin. In fact, it is difficult to avoid the conclusion that it is simply a dominant social theme – a judicial promotion advanced by a power elite that wants to rule the world and seeks to deprive individuals of various (simplistic) methodologies of profit.

Anyone can benefit from insider information but not anyone can afford a supercomputer. They may both provide – with fair certainty – a market advantage but only one advantage will be prosecuted.

Logically speaking, prosecuting insider trading while not prosecuting other forms of "unfair" advantage makes no sense. Of course, if one began to analyze – as we have from time to time – the full panoply of securities industry rules and regulations, one would soon discover that very few of them can stand up to even the briefest scrutiny.

After Thoughts

There's nothing funny about the current system. Markets and competition should decide what strategies are utilized in the marketplace – not complex and contradictory regulation.

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