Insider Trading: What Would Rawls Do?

Insider trading has been a pervasive activity since the inception of the stock market. There are many competing viewpoints on the ethical implications of this behavior and how severely it violates justice and the social contract of modern finance to which market participants tacitly agree when they invest. An analysis of insider trading from the perception of several theories of justice, most notably the theory of justice as upheld by John Rawls, creates an understandable ethical framework to evaluate the behavior. However, from a conflict of rights perspective, there are a variety of differing cultural and philosophical aspects that affect the decision to engage in insider trading. Therefore, in order for a global stock market to succeed, a resolution of these opposing principles will be necessary for all participants to feel comfortable investing without fear of being treated unfairly.

I.               Professional Context of Insider Trading

The U.S. Securities and Exchange Commission (SEC) defines insider trading of securities as either legal or illegal: “Illegal insider trading refers generally to buying or selling a security, in breach of fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.”[i] Meanwhile, the SEC states that legal insider trading is the purchase and sale of stock in one’s own company that is reported directly to the SEC.[ii]  The question explored here is whether illegal insider trading is also unethical.

Recently, the SEC investigated a multitude of high-profile insider trading scandals and charged numerous participants. Those investigated include Rajat Gupta, a director of Goldman Sachs, Raj Rajaratnam and Jason Goldfarb from the Galleon Group; Donald Johnson from NASDAQ; Joseph Skowron and Yves Benhamou, who traded on inside information about a clinical drug trial; Matthew Kluger, Brett Bauer, and members of their trading ring, who misused merger and acquisition information from clients of Wilson Sonsini Goodrich & Rosati and reaped approximately $32 million in profits; and many more in this past year alone.[iii] In this respect, the SEC has made its position on insider trading clear and is on the lookout for seemingly small infractions despite a deficiency of resources.[iv]

In fact, insider trading is considered such a serious offense that Rajaratnam was sentenced to 11 years in prison and fined $10 million, representing one of the government’s highest profile charges of this type.[v] Rajaratnam had accumulated an estimated $72 million by illegally trading securities on non-public information obtained from Goldman Sachs and various other companies.[vi] Scandal has even struck the ever-ethical Warren Buffett: One of his employees, David Sokol, was cited for buying approximately $10 million of a company’s stock that Buffett’s Berkshire Hathaway later acquired at a tremendous premium.[vii] Jason Zweig of the Wall Street Journal contends, “If even Mr. Buffett can fail to appreciate a potential conflict of interest under his very nose, then ordinary investors need to realize just how pervasive and insidious conflicts of interest are throughout the financial world.”[viii]

Conflicts of interest are at the heart of why insider trading is unjust. In Zweig’s article, Max Bazerman from the Harvard School of Business states, “Even assuming that [Mr. Sokol] did nothing illegal, [his action] is typical of the kinds of conflicts of interest permitted by our financial system that undermine the integrity of markets.”[ix] Despite the potential for unjust behavior, a sample study of a thousand Wall Street analysts demonstrates the commonality of insider trading: “Two-thirds have accepted favors from the companies they follow…generally deny their integrity has been compromised…and are twice as likely to maintain their rating after an earnings shortfall by a company that provided them favors.”[x] This is no small issue, and most of the population is at risk of being treated unfairly in financial markets due to conflicts of interest.

II.             Distinct Ethical Issues

Insider trading in financial markets presents various ethical issues, including conflicting rights, differing cultural norms, and inequalities across market participants. Typically, insider trading is considered unfair because all market participants do not have an equal opportunity to exploit the information used to execute insider trades. These trades take advantage of favorable information to reap personal monetary gain through large sales or seek to avoid heavy losses from unfavorable information. Insider trading makes those who are not privy to such information feel powerless and no longer wish to participate, further interrupting the flow of financial markets.

However, some argue that insider trading makes markets more efficient and ensures stock prices are represented more accurately. Certainly there are conflicting rights at stake, such as insiders freely partaking in trading securities, all traders having equal information, and investors being safeguarded against their own naivety.[xi] This creates the dilemma of whose rights are more important and whether favoring certain rights can lead to consequences such as unethical action toward the disadvantaged party.[xii]

Is allowing insider trading always unethical, or can it be considered ethical under certain circumstances? The increasingly global economy creates a vast stage on which insider trading can affect a wider range of stakeholders than ever before. Given this fact, a common ground of acceptable behavior needs to be defined in order for everyone to feel safe investing in the market. The financial effects of insider trading can amount to hundreds of millions of dollars in high profile incidents, so it is not hard to sympathize with those who are unable to benefit from insider tips. Such circumstances highlight why insider trading is illegal and generally considered a violation of justice, even though there are competing philosophies that would suggest otherwise.

III.           Stakeholders

Primary stakeholders directly affected by insider trading include all market participants subject to losses who cannot achieve gains because they are not properly informed. Market participants include anyone who owns traded stock through financial instruments, including individuals stocks, portfolios, mutual funds, retirement plans, educational savings plans, etc., and all beneficiaries of such instruments. Primary stakeholders also include the individuals, small groups, or companies who benefit from inside information, such as those who execute trades with non-public information and those who could possibly benefit from knowing about more efficient market prices.

Secondary stakeholders do not necessarily own stock that is traded via inside information, but all other members who suffer losses withdraw from the market because they feel they have been subject to unfair conditions. In effect, the market becomes illiquid and even more competitive. Also, the institutions that facilitate trading, such as investment and commercial banks, may suffer a decline in business, with people choosing not to invest in a market in which they feel they cannot make money against the knowledge of inside traders. Without trust in the system, it appears likely that all participants lose. This is a major concept of social contract theory and the ethical concept of justice as it relates to insider trading.

IV.           Account of Justice Theory

The controversy over insider trading can be assessed from a justice theory perspective.  The concept of justice can mean something different to everyone, because it encompasses a plethora of viewpoints regarding what is fair, which human rights are most important, and how these rights should be judged. Justice can be considered a subset of deontology or Kantianism because it represents an obligation or duty to the protection of certain rights. Justice does not always deem consequentialist beliefs ethical, since consequences for a certain disadvantaged party may be so dire that the greater good violates human rights. The philosopher John Rawls calls this a “natural duty of justice.”[xiii] Rawls believes that utilitarianism is wrong because “the law or policy that maximizes aggregate welfare or overall social efficiency might also violate rights, trample on basic liberties, distribute wealth unfairly, or be otherwise unjust.”[xiv] According to James and Stuart Rachels, consequences are not all that matter and may allow for someone to be treated unfairly. Therefore, the rights at stake may not have been properly prioritized or may even be perverse considering the overall balance of happiness versus unhappiness.[xv]

Additionally, when considering financial markets, the concept of distributive justice is an important factor. In the recent Journal of Alternative Investments article “Risk Management and Risk Transfer: Distributive Justice in Finance,” author Robert Kolb describes distributive justice as “the moral justification of how the goods and ills, or costs and benefits, of a society are distributed across its members.”[xvi] Distributive justice contains a variety of theories. Egalitarian theories focus on a truly equal distribution of outcomes; desert theories focus on equity when one party may be more deserving than another due to the utilization of more resources; and libertarian theories deal with the “right to act in accordance with the right to accumulate wealth or garner other goods; whatever distribution of wealth results from those rightful actions is just.”[xvii] These are competing views of distributive justice and can determine whether or not insider trading is ethically permissible.

Justice theory works only in the setting of some sort of social contract, which aids in the ranking of rights as a mutually agreed upon aspect of society. British philosopher Thomas Hobbes describes a sort of harsh social contract theory based on physical preservation that enables humans to live together in peace and engage in civilized exchanges that benefit all through agreement and enforcement.[xviii] Rachels eloquently describes such a social contract theory: “Morality consists in the set of rules governing behavior, that rational people will accept on the condition that others accept them as well.”[xix] Abiding by this type of social contract not only preserves justice by punishing violators but also often produces a greater good for contractors than possible when independent agents act alone.[xx]  This type of general social contract brings a unique perspective to insider trading and the use of non-public information in financial markets, but it does not explain how to rectify the situation.

Rawls promulgated Kantian contractarianism in his own way as the “basic principle of impartial deliberation – for example, that each person take into account the needs of others ‘as free and equal beings.’”[xxi] Rawls also states that a social contract will provide justice even though most people are self-interested as long as the “original position” ensures that each party can negotiate from a point of equal power.[xxii] Rawls was a strong proponent of morality through impartiality, and his “veil of ignorance” was the solution to self-interest, allowing contractors to protect their own interests by considering those of others, not knowing on which side of the agreement they may eventually end up.[xxiii] Trevino and Nelson point out that Rawls believes “rational people who use the veil of ignorance principle will be more likely to develop ethical rules that do not advantage or disadvantage any particular group.”[xxiv] In addition, “humans are fundamentally risk averse and wary of being worst off; such neutral people would arrive at fair principles that grant all individuals equal rights to basic liberties and equality of opportunity that benefit the least advantaged in society.”[xxv] Someone operating under the veil of ignorance will not know if they are going to be the most disadvantaged, which highlights one important feature of Rawls’ theory as an offshoot of Kantian ethics: Justice is brought about by rational beings and “[their] conception of ethical principles as determined by constraints on principles chosen by rational agents.”[xxvi] Rawls’ view of contract theory and justice fits nicely with modern finance theory and seems acceptable by a wide range of moral agents because of its similarity to western beliefs, such as Christianity and the Declaration of Independence, which proclaims that “all men are created equal.”[xxvii]

V.             Application of Justice Theory to Insider Trading

If most individuals who enter the global financial market agree to a social contract in which fairness and distributive justice are key features, the contract and conflicting values must be managed and handled appropriately in order for the market to work properly. Hersh Shefrin and Meir Statman state that fairness in financial markets means “all parties have equal access to information relevant to asset valuation but are entitled to nothing more.”[xxviii] This definition certainly implies that the use of inside information is unfair, but this is not the whole story. Several factors and conflicting rights affect justice in financial markets, such as informational efficiency and asymmetries, freedom from coercion, and freedom from one’s own ignorance, among others.[xxix]

Shefrin and Statman contend that legalizing insider trading may actually increase the efficiency of stock market prices and that there is an “efficiency/fairness frontier” in which “choices…involve reductions in efficiency to increase fairness” and vice versa.[xxx] One conflict of rights in financial markets is the right to true informational efficiency versus the right to equal information for all traders. However, informational efficiency is fulfilled by disclosure. Further, Shefrin and Statman argue that if insider trading is legalized, novice traders will no longer be under the false impression that it is rare because it is illegal, making them more able to protect themselves. However, the authors remind us that if insider trading is legalized, many individuals will choose not to participate, thereby creating adverse effects such as illiquidity. Investing will no longer be “a fair game of skill, [where] winners and losers are expected…trading on inside information is unfair because it conveys a non-skill based advantage to the trader.”[xxxi]

However, those who possess insider tips and wish to trade based on that information might feel they have a right to be exempt from the coercion of disclosure that facilitates equal information.[xxxii] Nevertheless, the social contract of market investing holds certain rights above others, and the right to equal information is first priority for many participants. In the United States, the widely accepted “fiduciary duty” rule under the Insider Trading Sanction Act of 1984 and the Insider Trading and Securities Fraud Act of 1988 states that inside information must be disclosed or heavy penalties will be administered.[xxxiii]

According to Kolb, distributive justice becomes an issue in this context because of the risk associated with investing in financial instruments.[xxxiv]  Kolb describes investing as bearing a “socially useful risk” separate from risks that only affect the deciding party and “that such behavior may impose costs on others is a morally relevant factor.”[xxxv] Kolb’s outlook on risks in financial markets somewhat coincides with Hobbes’ theory of justice: “Of those who bear socially useful risk, few accept those risks to promote the benefit of society.”[xxxvi] The transfer of such risks needs to be managed according to distributive justice, since most investors determine the riskiness of their own portfolios in a fair market.[xxxvii] Kolb claims that when risk transfer involves informational asymmetries, deceit, or unequal positions of power, ethical dilemmas result.[xxxviii] Insider trading is an example of an informational asymmetry in which risks can be transferred from a knowledgeable party to an unknowledgeable party, subjecting the unknowledgeable to a degree of risk that would not normally be acceptable. Kolb contends that “when we transfer, manage, or avoid risk, we seldom pause to ask what has happened to the risk that we have escaped.…Transferred risk does not truly disappear, but remains to harm others.”[xxxix]

Insider trading is a violation of justice in the context of modern finance theory. The assumptions of this theory are that “investors are rational, are risk averse, possess homogenous expectations regarding the distribution of future investment returns…and are utility maximizing with utility being a positive function of expected return and a negative function of risk.”[xl] Although investors realize that everyone is generally risk averse and profit maximizing, involuntarily bearing risk as a result of insider trading can cause people to withdraw from the market to avoid being treated unfairly,[xli] which puts limits on the basic assumptions of modern finance theory. Additionally, modern finance theory is violated because expectations of returns have been disturbed, and “informational asymmetry gives rise… to discussions [that] usually focus on the returns the insider can garner by exploiting the inside information.”[xlii] Given this perspective, neither the libertarian nor the egalitarian concepts of justice suit the finance industry, but desert theories stating that hard-working analysts deserve their profits do match the social contract of the stock market.[xliii]

Decisively, insider trading is unjust under Rawls’ veil of ignorance, because those who have inside information should choose not to use it based on the uncertainty of which position they will ultimately hold; therefore, by not exercising their advantageous position, they will protect their own interests as well as the interests of those who would potentially be subject to a violation of distributive justice. It is postulated that under the veil, many market participants share this same view and will abide by the social contract of modern finance theory in order for justice to predominate. Also, inside traders will attempt to avoid finding themselves at the mercy of someone else with inside information. According to Rawls’ theory of justice, insider trading is largely unethical; however, there are no guarantees and no absolutes in evaluating ethical decisions from a justice theory perspective.

VI.           Cognitive Barriers

There are a number of cognitive barriers that may be involved in the decision to engage in insider trading. First, some investors or groups may be subject to the “illusion of superiority,” believing that they are at least as ethical, if not more so, than anyone else; no one wants to believe or admit that they are not as honest or impartial as they ought to be.[xliv] Also, inside traders may believe they have a moral justification for their behavior if they are proponents of libertarian justice theories, are helping their respective companies, or believe in the efficiency of markets to the extent that insider trading is not an issue.[xlv]  Likewise, individuals from certain cultures may find insider trading to be less problematic than those in the U.S.  Moreover, inside traders may distort the consequences of their behavior by considering that there are millions of investors in the stock market, and the financial gain they achieve is not that significant in comparison to the amount of assets on the market or other ill-gotten gains achieved through crimes and misconducts. Correspondingly, reward systems of the finance industry have been skewed toward exorbitantly high short-term profits, thus encouraging insider trading and other similar behavior.[xlvi]

Cultural differences can also influence the realization of justice in financial markets. Statman discusses these effects in “The Cultures of Insider Trading,” a 2009 article published in the Journal of Business Ethics. He states, “Culture is a body of values, beliefs, and attitudes shared by members of society, and it matters in economics and finance.”[xlvii] Statman has determined that in some cultures where collectivist tendencies are high, such as China, insider trading is deemed appropriate because it is acceptable to treat others unfairly based upon professional, familial, and friendly relationships, even though insider trading is just as illegal in China as it is in the U.S.[xlviii] Insider trading in China is relatively common, and the differences in perception are further exemplified by Statman’s discoveries that insider trading is “widespread” and “ingrained;” additionally, “many people do not trade shares [in China] unless they have inside information. We simply have no choice in such an environment.”[xlix] China also does not implement harsh punishment for insider trading the way that the SEC does in the U.S.[l]

Such cultural differences make sense, but they pose a threat to international perceptions of stability since the stock market is becoming a global entity. Therefore, there is a conflict between cultural proclivities and distributive justice in the sense that insider trading and equal information are mutually exclusive, and the entire international market will be at odds with such competing mindsets. Eventually, one of these positions must prevail, and for a large portion of the public to invest in the market, some sort of regulatory justice must dictate trading behavior and separate it from other cultural norms, which is a daunting and possibly unreasonable task.

Additionally, should individuals be expected to abide by concepts of distributive justice in relation to family and friends? Even in the U.S., examples of insider trading involving family members have surfaced. Spencer D. Mindlin of Goldman Sachs has recently been charged with insider trading for communicating inside information on exchange-traded funds to his own father. There is debate as to whether these particular actions constitute illegal or unethical activity;[li] given such circumstances, it is difficult to determine the ethical implications of justice.

VII.         Conclusion

As previously mentioned, insider trading is a violation of distributive justice in relation to the right of equal information for all traders. According to the theory of John Rawls, traders should avoid engaging in insider trading in order to protect their own interests as well as the interests of others. Since the stock market is becoming an increasingly international entity, inside traders need to consider the consequences of their actions, because more often than not, they will also be subject to the decisions of others. When considering ethical decision-making using a theory of justice, the ends do not justify the means no matter how large or small the affected parties. This is a very significant concept to consider, although several different theories, philosophies

BY: SARA WENZEL

EDITOR: ANGELA LUTZ