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Mark Cuban, the SEC, and Questioning the Illegality of Insider Trading

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Yesterday, a US federal appeals court ordered billionaire Mark Cuban to face a civil fraud lawsuit accusing him of insider trading, namely, an SEC accusation that, in June, 2004, Cuban sold his 6.3% stake in Internet search engine after learning the company was going to dilute its shares with a stock offering. By selling before the information had been made public, Cuban allegedly avoided over $750,000 in losses.

The Fifth Circuit Court of Appeals said the decision by a federal district court in Dallas that dismissed the SEC's case against Cuban was wrong, and sent the case back for further proceedings.

Reuters reports that "Cuban said he will seek a rehearing before the entire Fifth Circuit and continue to seek sanctions against the SEC, which he said has demonstrated 'bad faith in bringing this utterly meritless case.'"

On the flip side of the coin, SEC spokesman John Nester said: "We are pleased with the court's decision and look forward to presenting our case."

Just as there are two sides to every trade, there are two sides to every argument.

While insider trading is generally accepted as inherently wrong, some attest that it is not only not wrong, but that it is actually beneficial to the workings of financial markets.

Doug Bandow, who worked as special assistant to President Ronald Reagan and is now a senior fellow at the Cato Institute, wrote an article in Barron's this past May on the subject.

"Few people ever ask the most basic question: Why is insider trading a crime?" he wondered.

Bandow continued:

"The law bizarrely affects only one-half of the trading equation. People make money by not trading as well as trading. But it is virtually impossible to prove that someone chose not to buy or sell stock because of a legally improper tip. So hundreds, maybe thousands, of people get away with insider "not trading" every year. Yet it isn't obvious that the operation of the financial markets is impaired in any way."

As for the benefits of insider trading, Bandow had this to say:

"Insider-trading laws deny markets important information. The recent financial crisis was caused in large part by inadequate information. People didn't know the true value of mortgage-backed securities, leading to a financial house of cards that crashed down on federal agencies, investment houses, commercial banks and average investors.

"The distinction between public and non-public information is legally decisive but economically unimportant. Perversely, the insider-trading laws seek to prevent people from trading on the most accurate and up-to-date information. The law seeks to force everyone to make today's decisions based on yesterday's data. It's a genuinely stupid thing to do."

He concluded that, "Acting on new information moves the market toward the right or 'honest' price, as economist Donald J. Boudreaux puts it. Prosecuting people for insider trading slows the price-adjustment process. That means the price shock when the relevant news hits the market will be more abrupt and the losses will be greater for some people."

This, of course, got me thinking. So, I emailed an associate of mine for his take on the issue, and here's what he wrote back:

"It's clear what the rules are, and sometimes rules are about perception. Is it fair that Raj Rajaratnam and Martha Stewart get arrested while others get away with it? No. Is it fair that someone gets busted for DUI while the 15 other cars they are following were also being driven by impaired drivers and got away with it? No. But what should we do, make drunk driving legal? If we were serious about stopping drunk driving we could set up government checkpoints all over the roads. Auto manufacturers could be required to produce thumb ID and breathalyzer testing ignition equipment. Does anyone want that? No. At any rate, railing against insider trading laws is like railing against pink awnings on a burning building."

Another wrote:

"Markets are fundamentally based on trust - without it people just can't trade. So if you know that other people have access to information you don't, or even if you don't know but just suspect, you don't trade. Any market would unravel quickly if it became legal to trade on inside information. It may be 'inefficient' in regard to making true price discovery take longer, but that's an argument for greater transparency in accounting and reporting, not for insider trading."

Then, I chatted with independent trader Jeff Macke--never one to shy away from a good argument.

He said:

"Insider trading, as an enforceable law-breaking activity, is BS. Doing stock research is, by definition, all about trying to understand a company better than other investors or traders. "How's the quarter look?" "How's demand from your corporate buyers?" All valuable questions that research uncovers."

Ah, so there we enter the gray area of research and uncovering information that others are not privy to.

"So are stock tips, it's just the information there is generally wrong," Macke said. "Consider the size of, say, the MBA community just from the Stanford network. I can count, off the top of my head, 12 different people from my class that I could have lunch or drinks with from whom I could gather inside information simply through being a friend. "Hey, you seem down. How about another round? Is everything okay at work, I mean, with you being the CFO of Amazon/ CEO of eBay/ partner at Goldman and all?" Is that illegal? I'm just being a buddy."

The debate can--and will--undoubtedly continue. But, here's something to ponder in light of the fact that insider trading is illegal at the present time and Mark Cuban is worth $2.4 billion:

Did he really need to risk an SEC enforcement action over .003125% of his assets?
POSITION:  No positions in stocks mentioned.