Insider trading, behavioral ethics and effective “inner controls”

Late last week the U.S. Securities and Exchange Commission announced that it had reached a settlement with a hedge fund involving the largest penalty ever imposed for insider trading. But it is a fair bet that even this record breaking fine will do little to deter future insider trading, because of the unique compliance challenges raised by this area of the law.

One challenge is that insider trading can be enormously difficult to detect.   This is particularly so where the individual misusing the information is neither an insider herself nor tied to one in an obvious way. Insider trading is sometimes described as a “perfect crime” and, sad to say, in many instances it doubtless proves to be just that. (Part of the way we know this is that “numerous academic studies [have] …. [u]ncover[ed] indicators like spikes in a stock’s trading volume just before key information, such as quarterly earnings, is made public…” which suggest that there is a fair bit of insider trading going on –  yet the number of actual prosecutions in this area is relatively low. )

The other challenge  (which is germane to the behavioral ethics aspect of this blog) is that the opportunity for insider trading may fail to trigger the sorts of “inner controls” – meaning an individual’s moral restraints – that the prospect of committing various other crimes typically does.  Part of the reason for this is that while in most instances (at least under U.S. law) insider trading involves a breach of fiduciary duty – i.e., improper disclosure of a corporate secret –  often the individual benefitting from that transgression is several steps removed from the original wrongdoing (due to the information being passed along or “tipped”).  Per several behavioral ethics experiments, “distance” between the wrongful act itself and the beneficiary of the transgression increases the likelihood of wrongdoing, and in insider trading that distance can be significant indeed.

A related problem is that the specific victims of insider trading – typically anonymous market participants – are not evident to would-be violators. Per  other behavioral research, this second type of distance also tends to diminish internal moral restraints.  Moreover, this sense that insider trading is harmless is, in my view, exacerbated by the arguments of some commentators that such conduct should actually be lawful, to make markets more efficient.

Can any of this be remedied?  I’ll leave the detection issue to those others, but on the behavioral ethics side I think it is imperative that these two types of distance be addressed by, among other things, imagining what things would be like if insider trading was not in fact a crime. Using this sort of “what if?” approach – as we did earlier with conflicts of interest generally  – one can envision a world in which businesses are reluctant to engage in transactions that require confidentiality to be successful, which would hurt productivity in many ways.  This thought experiment also suggests that individuals and organizations would be reluctant to invest in capital markets that they fear may be rigged by insiders, which, in turn, substantially raises the cost of equity to businesses.

Like “conflict of interest world,” insider trading world “is a place of needlessly diminished lives, resources and opportunities.” In my view, effective deterrence in this area requires greater recognition of these harms so that they can fully inform the operation of our inner controls.

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