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Should Insider Trading Be Legalized?


The Galleon charges may be just another headline.

Insider trading is back, big time.

On Friday, federal prosecutors and the SEC charged Raj Rajaratnam, the founder of New York hedge fund the Galleon Group, with insider trading in the stocks of several companies, including Advanced Micro Devices (AMD), Google (GOOG), and Akamai (AKAM). Prosecutors say he earned about $20 million in the process. Six others were also charged in the scheme.

This isn't your garden variety insider trading case. It involved an extensive, coordinated investigation by officials from both the FBI and the SEC, complete with government wiretaps. It suggests a level of aggression by law enforcement against insider traders not seen in decades.

It's a high-profile case with a $7 billion hedge fund and a perp walk. But most insider trading cases are brought solely by the SEC without the muscle of the US Attorney's office and the FBI behind it. The SEC can be commended for its efforts in the Rajaratnam case, but it won't answer the question of whether or not the agency is still the toothless cougar many believe it to be.

"The SEC has always been a relatively small agency with a relatively small budget," says Thomas Gorman, a securities attorney for Porter Wright Morris & Arthur and a former counsel in the SEC's enforcement division. And this is the agency with a mandate to ferret out and enforce cases of insider trading (among other financial misdeeds), which Gorman says is "difficult to detect and even more difficult to prosecute."

(For more on insider trading and how members of Congress -- and their staff members -- are exempt from insider trading laws, CLICK HERE)

Direct evidence of insider trading, like the wiretapped conversations obtained against Rajaratnam, is extremely rare. As two SEC officials pointed out at a symposium some time ago, "there are no smoking guns or physical evidence that can be scientifically linked to a perpetrator," they said. "Unless the insider trader confesses his knowledge in some admissible form, evidence is almost entirely circumstantial."

Moreover, the SEC has just about 1,100 people responsible for ferreting out and enforcing violations among this country's more than 12,000 publicly traded companies, 10,000 investment advisers managing more than $38 trillion in assets, nearly 1,000 fund complexes, 6,000 broker-dealers with 172,000 branches, and the close to $44 trillion worth of trading conducted each year on America's stock and option exchanges.

Seems like an impossible task. In that case, why not just legalize insider trading?

Amazingly enough, there are some who endorse this very idea.

Nobel Prize-winning economist Milton Friedman said, "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that."

Dean emeritus Henry Manne of the George Mason University School of Law and the author of Insider Trading and the Stock Market, said in a radio interview that insider trading "helps to move the price of a share to its 'correct level'" and trades made using privileged information provide an "actual reflection of what's going on" with a particular stock.

And Donald Boudreaux, of the Future of Freedom Foundation wrote, "Perhaps the greatest benefit of insider trading is that it causes equity prices to disclose all relevant information as quickly as possible."

Gorman disagrees.

"I don't believe it would be appropriate to legalize insider trading," he says. "Putting information into the marketplace improves price discovery, but that information should be made public all at once so it gets absorbed into a stock's price immediately, rather than in dribs and drabs."
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