Insider trading: where's the crime?

THE GOVERNMENT would have us believe that insider trading is the white-collar equivalent of murder. Former U.S. Attorney Rudolph Giuliani sent a number of insider traders to prison; his successor, Benito Romano, is attempting to nail the big enchilada, Michael Milken, and last August won a guilty plea (for one count of mail fraud) from Goldman Sachs's Robert Freeman. Moreover, Drexel Burnham has gone under, in large part as a result of its plea-bargained settlement-which cost the firm $650 million and much of its autonomy-of the insider-trading and other charges against it.

Unfortunately, this misguided crusade seems only likely to intensify. In late 1988 Congress passed legislation doubling the maximum jail term, to ten years, and increasing by ten times, to $1 million, the allowable fine for insider traders, as well as authorizing the SEC to reward informers. The legislation was intended, in the words of Representative Matthew Rinaldo (R., N.J.), to "send a clear signal to Wall Street and Main Street that insider trading will not be tolerated." Proposals to further stiffen penalties are now before Congress, and Richard Breeden, chosen by President Bush to head the SEC, wants even more power. In March he told the Senate Banking Committee that Drexel's fall was evidence of the SEC'S need for additional authority.

What is there about insider trading that warrants a decade in jail and a $1-million fine? And what justifies paying people to spy on their co-workers? Rinaldo argues that "insider trading hurts our markets, hurts our economy, and hurts our people."

Rinaldo's view is shared by a majority of his colleagues, but neither they nor the enforcers at the SEC have offered any evidence to back it up. The politically popular tough approach to insider trading is based on envious feelings, not economic facts. Most insider deals neither wrong individuals nor destabilize markets. The government jails insider traders as a matter of polities, not justice.

The typical insider transaction occurs when someone learns of an impending merger and buys stock in the target company. If the deal goes through, prices rise, and he makes money. What's wrong with. that? Most people who trade stocks feel no compunction about using a "hot tip" from a friend or broker. Some tips just turn out to be better than others.

In some cases, to be sure, an insider trade might violate a firm's fiduciary responsibility. For example, if employees of an investment-banking firm involved in a merger leak news of the impending takeover, a raider will have to pay more for his shares. But the proper remedy is a civil suit for damages, not a criminal indictment by the government.

CONSIDER the case of Michael Milken, who has been pegged as white-collar public enemy number one, charged with 98 counts of insider trading, securities fraud, and racketeering. He had to put up $700 million worth of property as a guarantee against potential forfeitures under RICO; Assistant U.S. Attorney John Carroll, in asking that bond be set at $250 million, compared Milken to former Philippine dictator Ferdinand Marcos.

Yet most of the charges against Milken shouldn't be treated as criminal. For instance, Milken is accused of "parking" stocks with Ivan Boesky that is, selling them to Boesky while agreeing to repurchase them at a set price in the future. Why is this a crime? In the 1980 case involving the Fischbach Company, the alleged parking arrangement allowed industrialist Victor Posner, a Drexel client, to evade a "standstill" agreement with Fischbach not to buy more of its stock. Posner may have violated a private contract and therefore should have been civilly liable; Milken, however, did nothing that warrants an indictment.

Similarly, Milken is charged with manipulating prices to drive down the price of the stock of COMB Companies, which had retained Drexel to manage a convertible offering. If the allegations are true, then in this case Milken caused Drexel to breach its fiduciary responsibility to a client. But COMB should then have sued Milken and Drexel, rather than the U.S. Attorney filing a criminal charge.

Finally, there are the ubiquitous counts of insider trading. Milken allegedly arranged insider deals using his knowledge of a proposed merger between Phillips Petroleum and the Diamond Shamrock Corporation, a leveraged buyout of Storer Communications Inc., and several other transactions. If Milken violated Drexel's internal rules, he deserved to be fired; if his activities cost Drexel's clients money, he should be forced to repay them. But in neither case did his actions constitute "crimes" in the traditional sense.

The case against Freeman was even harder to justify. He used his high level contacts to learn that there was trouble with a 1986 LBO involving Beatrice in which he and Goldman Sachs had invested heavily. What was wrong, for instance, with his calling Henry Kravis, head of Kohlberg Kravis Roberts, which was bidding for Beatrice, to assess the status of the deal? Perhaps Kravis shouldn't have taken the call, but it's hard to see that Freeman did anything morally wrong in making the call. Even most insider-trading cases involving egregious misconduct don't belong in criminal courts. Dennis Levine's exchange of proprietary information from his work at Drexel Burnham for suitcases of cash from Ivan Boesky was outrageous, and it did hurt Drexel and Drexel's clients. Levine and Boesky were therefore rightly liable for civil damages. But the only conceivable criminal case against them should have been one akin to industrial espionage, and even that would be difficult to justify since Levine misused information that he was given, rather than stole secrets he was not lawfully privy to.

And few insider traders are as culpable as Levine and Boesky. Take former Wall Street Journal reporter R. Foster Winans, who wrote what was essentially a gossip column on the stock market. The day before his column, "Heard on the Street," appeared, he would disclose its contents, garnered legally as part of his research, to a broker friend who sometimes traded on the information. Winns violated the newspaper's code of ethics and was properly fired, but he had no fiduciary responsibility to the firms involved and the Journal could have legally traded on the information. Nevertheless, he was convicted and imprisoned.

Equally bizarre were unconnected charges against a Business Week editor and a sales representative of Business Week's printer who traded on information contained in soon-to-be released issues of the magazine. The information was public and about to be widely disseminated; those who read the magazine before it went to press obviously had an advantage, but not much more of an advantage than subscribers who lived in areas with better mail service.

Indeed, the SEC has tried, so far unsuccessfully, to extend its rules to anyone who trades on non-public information, including those who innocently overhear a conversation. One football coach who traded on information he overheard from oil-company executives at a game was taken to court by the SEC. He won, but only after an expensive fight.

Of course, there is a lot of talk about maintaining the "integrity of the marketplace" and a "level playing field." But no number of prosecutions will equalize the positions of an arbiter in New York and a retiree in Peoria. Nor should we want to stamp out all "inside information," for that would entail stopping anyone who knows anything about the market from buying or selling stocks. Such a policy would be not only manifestly idiotic, but also economically disastrous, because we all have an interest in share prices reaching their true level as quickly as possible. Otherwise millions of people would constantly be making incorrect-and correspondingly costly-investment decisions.

Allowing people to make millions using private information may seem unfair. But that's no reason to jail insider traders and to pay informers. The purpose of the criminal law should not be to assuage envy. Congress should decriminalize insider trading.