SEC Attacks SAC Capital

The Securities and Exchange Commission is building a case against Steven Cohen and his firm SAC. What did SAC do wrong? According to the SEC, they insider-traded. What does that mean? Insider trading is when someone trades with knowledge they have but which others do not. The question is whether this should be a crime.

It’s telling, that if you trade based on proprietary knowledge, you are now charged with fraud. How do we get from trading to fraud? The above article offers no explanation. We have to look elsewhere, to someone who understood the issue.

George Orwell used thought control as a major theme in his novel 1984. He realized that if a dictator can control the language people use, then he controls the very thoughts that people can have. This theme was also prominent in Ayn Rand’s Anthem.

The average person does not understand the stock market, much less securities regulation. But he understands fraud. Fraudsters are very dangerous criminals, because they can hide unnoticed while abusing the trust of a large number of victims. Who wouldn’t want fraudsters to go to jail?

The key idea in fraud is deception. The fraudster lies to his victim, in order to get take victim’s money. Even if you think that insider trading is bad, can you really say with a straight face that it is an act of deception?

In the case of SAC, the article describes the two juiciest criminal cases so far. One is against Michael Steinberg. He allegedly traded Dell and Nvidia stock, based on tips from an analyst. Another is against Matthew Martoma. He allegedly got information from doctors involved in clinical drug trials to trade Elan and Wyeth.

This isn’t fraud. Why do so many people support outlawing it, then? I think it is because of what they think the purpose of the market is—what it should achieve above all else. Egalitarianism.

Many people today think that the market is (or should be) a random and chaotic casino. This view holds that it’s good for everyone when stock prices are rising, as they have been since 2009. And conversely, it’s bad for everyone when stock prices fall, as they did in 2008. Not coincidentally, this is one reason why people who should know better support the Fed. They think that a central bank can engineer a steady rise in stock prices.

The idea that someone might make money when others are not, well, that’s tantamount to a thief taking money from his victim!  It goes against what many people feel is the primary purpose of the stock market—the reason why it exists—to let everyone make money together.

It’s obvious, once this view is stated openly, that the whole premise is wrong. The stock market has an economic purpose. Like all valid economic purposes, it’s served when people are free to make and lose money, and thwarted when people are artificially barred from winning or losing. The purpose has been mostly lost, so let’s state it explicitly.

The stock market exists to allocate capital into the hands of those who are producing wealth. By its nature, this necessarily means de-allocating capital out of the hands of those who are destroying wealth.

This is no mere intellectual abstraction. When a wealth-producing company is starved for capital, no one wins. We are all made a little less wealthy. When a wealth destroying company is handed capital it doesn’t deserve, such a company destroys the wealth, and impoverishes everyone.

If insiders, outsiders, upsiders, or downsiders help allocate capital away from wealth-destroying, and towards wealth-producing, companies, they deserve their profits and we should all thank them. We should not envy them their gains or seek to punish them.

Everyone has a rational self-interest in proper capital allocation. Especially those who eat, surf the Internet, or fly in airplanes. And especially those who hope to live long enough for life-extending technology, space travel, and 3D holographic TV.