05/13/2011 04:44 pm ET | Updated Jul 13, 2011

Tell Me Why I Should Care About Ending Insider Trading

As a retail investor, I'm told that I should be happy about the Rajaratnam conviction on various charges related to insider trading activity. The prosecutor in the case tells the world that this behavior "cheats the ordinary investor." I'm also told that the insider trading crackdown which we are now seeing 'levels the playing field' between professional and 'ordinary' investors. "In scoring their biggest insider-trading victory in a generation, regulators have a message for a nation of nervous individual investors: When it comes to information about stocks, the playing field is getting a little more level."

I don't follow this logic and am concerned that this crackdown is misguided and perhaps counterproductive. Never having had any position in any of the stocks in which Mr. Rajaratnam was trading, I don't see how he cheated me. Even for those who did have such positions, I don't see how they were cheated. If they sold their shares in market transactions, they did so voluntarily without any prompting or misrepresentation from him. If they didn't sell their shares, there was no harm at all.

Most fundamentally, why is a level playing field economically important or even desirable? Trading in stocks is by definition a zero sum game where one trader's gain reflects another's loss or foregone gain, but has no effect on the aggregate capital stock or output of society. The person who sold their shares to a buyer in possession of inside information went to the market to sell their shares for some independent reason, and in any event, is not out of pocket at all. At worst, they lost the opportunity for a gain resulting from disclosure of the inside information, and even that may not have amounted to a realized gain for them; the stock may have fallen back to its prior level by the time they sold it. Insider trading has simply never caused anyone to lose their investment in a company; no company has ever been pushed into bankruptcy from such trading.

Some observers, such as the WSJ's Mr. Cheng in the second linked article above, mention a need to bolster public confidence in the market, but I'm not convinced that investors care all that much about disparities in information. In my own case, and, I think that of other investors, the issue is much more whether the company in which I am investing is being run into the ground by crooked or incompetent management or has extremely favorable or unfavorable marketplace prospects. These considerations are what drive my own investment outcome -- not whether someone else is making "unfair" profits in the same security in which I have a position.

Yet, the insider trading crackdown does nothing to cause any company to develop, sell or produce better products or services. It also does nothing to improve the quality of management -- either in terms of weeding out Enron or Worldcom-style dishonesty or Bear Stearns, Citigroup or Lehman-style horrid decision-making. Throngs of investors actually lost tens of billions of dollars when their investments in such companies were totally or virtually wiped out. I doubt that it was much consolation to them that they were treated "equitably" compared with other investors who incurred similar losses. Insider trading had nothing to do with the demise of such companies.

To actually benefit retail investors, and the economy as a whole, we need governmental efforts which focus on causing companies to be better run and avoid the sort of debacles which have plunged our economy into recession twice during the last ten years. Among other things, this means improved corporate governance, so that we get the right people into management and onto the boards of directors which oversee them, and provide the right incentives to avoid horrible decisions which impose social costs.

The Dodd-Frank law and SEC regulations under it, are at least a start in this regard insofar as they facilitate proxy access for minority shareholders, and address management compensation, but still say nothing about what officers and directors are supposed to do and not do about fundamental matters of business policy. Until such matters are front and center, stopping insider trading will be nothing but an economic sideshow.