“Is It or Isn’t It Inside Information?”

Sydney M. Williams

Thought of the Day

“Is It or Isn’t It Inside Information?”

December 21, 2011

Trading on material inside information is a criminal act. If investor A is told by a company’s CEO that the dividend will be cut at the next board meeting and then sells his stock to Investor B who is not in possession of that information, he, and the CEO have committed a criminal act and should be punished. If investor A contributes $10,000 to the campaign kitty of the House Finance Committee chairman who then lets on that a certain bank is in jeopardy, the investor is in possession of material inside information. If he acts on the data, he is guilty (or should be – I am not a lawyer) of violating insider trading laws, and so should be the one offering the information. However, should investor A travel to Washington to listen to members of Congress express their views as to the likelihood of the passage of a particular piece of legislation and then, after analysis of the companies that may be affected and using her judgment, buys shares from investor B, she should not be deemed to be in possession of material inside information. At least that is my opinion. The laws are murky.

Determining what is material non-public information has always been difficult, and is especially so in a day when information swoops across the country from internet portal to blog in seconds. An article in Tuesday’s Wall Street Journal (“Inside Capital, Investor Access Yields Rich Tips”) did little to clarify the landscape.

Investing successfully is about gaining an edge. It combines gathering information, analyzing the data and exercising judgment. It requires hard work, diligence and an instinct for investment. Like every other enterprise in life, it is an industry in which a few people excel, but most do not. It is an industry that attracts both the intelligent and the devious. People who do well tend to do very well. In a political environment increasingly dominated by those who prefer equality of outcomes to acknowledgement of the success of the exceptional, the working assumption of many in Washington appears to be that success can only be achieved through unfair advantage.

This search for fairness has inculcated our society for many years. In 1961, Kurt Vonnegut wrote a short story, “Harrison Bergeron.” The story begins:

“The year was 2081, and everybody was finally equal. They weren’t only equal

before God and the law. They were equal every which way. Nobody was smarter

than anybody else. Nobody was stronger or quicker than anybody else. All this

equality was due to the 211th, 212th and 213th Amendments to the Constitution,

and to the unceasing vigilance of agents of the United States Handicapper General”.

Fourteen year old Harrison Bergeron is removed from his family. Because of his exceptional talents he must be fitted with handicaps. However, he escapes, declares himself emperor and is shot by the Handicapper General, Diana Moon Glampers. All of this happens on TV, which his mother Hazel is watching. She tells her husband George that something sad happened on TV, but she cannot remember what it was. George tells her to forget sad things.

Our society appears to be drifting in such a direction. Elementary schools have become reluctant to single out gifted or otherwise talented children. Paul Bennett, the Canadian author of The Grammar School, wrote about John Taylor Gatto and his recent book, Weapons of Mass Instruction: “The underlying message is crystal clear; public schools have become agents of compulsory schooling strangely akin to sausage ‘factories’ for both students and teachers.” Routinely all children are rewarded for participating in sports. Exceptional talent is rarely singled out.

This odyssey for fairness based on equality has permeated our government. While regulators and the Justice Department need to be vigilant in searching for those who violate insider trading laws, they must also be cognizant that there is a significant grey area – that they do not confuse exceptional research with inside information. The desire to level the playing field can become absurd. Is it unfair that those of us on the East Coast have a three hour advantage over those on the West Coast when it comes to reading the Wall Street Journal? Is it wrong that some investors have more assets than others, so therefore garner more attention from brokers? Is it fair that members of Congress can trade on information that would send a mere mortal to prison? Should those who are smarter, work harder and more nimble be penalized with handicaps ala Harrison Bergeron?

Analysts are hired to search out information that can provide an edge. They must read prospectuses, 10Ks, annual reports and research notes. They must visit managements and manufacturing facilities; they do store checks, roam through warehouse, speaking to everyone possible. It takes judgment and an ability to assess the data and to form conclusions. If done successfully, the analyst or portfolio manager will do well. And the success may well be in part due to being in possession of information not generally known, not because someone whispered in an ear that a plant is to be opened or legislation passed, but because of extraordinary effort.

This is a topical subject. Confidence in our markets has been waning. There is a school of thought that says the whole system is rigged. People watched government bail out banks three years ago. Some of that money was used to reward traders who had fostered the credit implosion, none of whom have been imprisoned. On the other side, there are those who are convinced that regulation is strangling initiative, including fundamental research. It is critical that government gets this right – lock up the bad guys, but recognize that there are differences in people – some are just better investors. Is it, or is it not material inside information?