BrianGarst.com

Fox News reports on an aggressive insider trading crackdown:

…Monday’s raids targeted three hedge funds: Level Global Investors in New York, Diamondback Capital Management in Stamford, Conn., and an address that matched Loch Capital Management in Boston. Federal law enforcement agencies would not comment other than to confirm an investigation.

Investors can use the expert networks to glean details of what’s occurring within certain industries or particular companies. Someone interested in learning more about fast-food dining in China, for example, might connect with local store managers, suppliers or experts on dining in the region.

The expert networks connect the investor and the source, getting a fee from the investor and then paying the source, who could make $400 to $500 an hour, says Sanford Bragg, CEO of the consulting firm Integrity Research Associates, which connects investors with these research firms.

Hedge funds have been paying people to dig for hard-to-find numbers on companies for years.

Tammer Kamel, president of Iluka Consulting Group Ltd. in Toronto, recalls visiting a Hong Kong fund 10 years ago that wanted to better gauge future sales by a company with factories in China. Its solution: Pay Chinese farmers near a company warehouse to count trucks leaving the site.

For a possible investment in a casino, another fund paid people to stand outside the casino and count visitors walking in, Kamel says. Then the fund multiplied that number by average losses per visitor to get a better sense of the casino’s daily take.

“The managers were openly discussing technique,” Kamel said. “They clearly thought it was just smart data gathering.”

Of course it is smart data gathering! Moreover, it’s good for markets and the economy when someone does this research. How would it be better to allow businesses to prohibit people from determining if a business is cooking its books? It is madness to say that markets should have less information because some squish thinks it is “unfair.” Attempting to regulate the distribution of information is silliness in the extreme.

I’ll allow Don Bordreaux to explain better than I can the benefits of insider trading:

Time to stop telling horror stories. Federal agents are wasting their time slapping handcuffs on hedge fund traders like Raj Rajaratnam, the financier charged last week with trading on nonpublic information involving IBM, Google and other big companies. The reassuring truth: Insider trading is impossible to police and helpful to markets and investors. Parsing the difference between legal and illegal insider trading is futile—and a disservice to all investors. Far from being so injurious to the economy that its practice must be criminalized, insiders buying and selling stocks based on their knowledge play a critical role in keeping asset prices honest—in keeping prices from lying to the public about corporate realities.

Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets. The result is prices that lie.

And when prices lie, market participants are misled into behaving in ways that harm not only themselves but also the economy writ large.

…Suppose that unscrupulous management drives Acme Inc. to the verge of bankruptcy. Being unscrupulous, Acme’s managers succeed for a time in hiding its perilous financial condition from the public. During this lying time, Acme’s share price will be too high. Investors will buy Acme shares at prices that conceal the company’s imminent doom. Creditors will extend financing to Acme on terms that do not compensate those creditors for the true risks that they are unknowingly undertaking. Perhaps some of Acme’s employees will turn down good job offers at other firms in order to remain at what they are misled to believe is a financially solid Acme Inc.

Eventually, of course, those misled investors, creditors and workers will suffer financial losses. But the economy as a whole loses, too. Capital that would otherwise have been invested in firms more productive than Acme Inc. never gets to those firms. So compared with what would have happened had people not been misled by Acme’s deceitfully high share price, those better-run firms don’t enhance their efficiencies as much. They don’t expand their operations as much. They don’t create as many good jobs. Consumers don’t enjoy the increased outputs, improved product qualities and lower prices that would otherwise have resulted.

In short, overall economic efficiency is reduced.

It’s in the public interest, therefore, that prices adjust as quickly and as completely as possible to underlying economic realities—that prices adjust to convey to market participants as clearly as possible the true state of those realities.

economics