Opinion

Felix Salmon

How and whether to fight insider trading

Felix Salmon
Jun 3, 2013 23:17 UTC

Jim Surowiecki has an excellent column on insider trading this week. He claims — without hyperlinks it’s hard to judge this, but I do trust him — that the increase in insider-trading prosecutions isn’t just a reflection of increased prosecutorial zeal, but actually reflects a real uptick in insider trading itself.

Surowiecki sees three main reasons why this might be happening. The first is Reg FD, which made it unambiguously illegal to tip well-connected traders with inside information. The second is Sarbanes-Oxley, and the general “proliferation of consultants” which has both increased the number of places from which inside information can leak, and which has increased the amount of deniability that any leaker enjoys. Finally, there’s the fact that companies “have a much better real-time sense of how they are doing”, these days, which increases the amount of time that information has to remain secret before it is made public in quarterly earnings reports.

Surowiecki has a potential solution to these problems:

In a world where companies increasingly know about their business in real time, it makes no sense that public reporting mostly follows the old quarterly schedule. Companies sit on vital information until reporting day, at which point the market goes crazy. Because investors are kept in the dark, the value of inside information is artificially inflated… More consistent, if not real-time, data about revenue, new orders, and major investments would help investors make more informed decisions and, into the bargain, would diminish the value of insider information.

This makes a certain amount of sense to me. Indeed, it wouldn’t surprise me to learn that Google, or Amazon, could quite easily provide daily rather than quarterly financial statements, with the quarterly statements basically just being a reprise of information the company had already made public over the course of the quarter. Doing so would be quite Googley, actually.

But there are two reasons why most companies would never go down such a road. The first is just that they’re not technically capable of doing so. And the second is that most companies reflexively seek to keep control of their financial information. Reg FD has stopped them from picking and choosing who gets the information, but they can at least control what information they disclose, and when. Most of the time, they err on the side of disclosing less rather than more, since information is power and the company wants to keep power for itself rather than make it public.

In fact, companies don’t really care whether there’s insider trading going on in their stock. Indeed, as Surowiecki says, in the days before Reg FD they would actively encourage such trading, by dropping tidbits of information into favored analysts’ laps. So long as the information is going to come out anyway, the company should try to curry some favors from it somehow.

The point is that insider trading is a pretty victimless crime: the main damage it does is just to trust in the level playing field of the stock market, and that trust has been damaged much more greatly by various high-frequency algobots than it has by insider traders. If you’re a buy-and-hold investor, you won’t be hurt by insider trading; if anything, the broad knowledge of its existence will just make stocks that much cheaper for you to buy.

So why go to such great lengths to try to stamp it out? The SEC seems to be concentrating on insider-trading prosecutions almost to the exclusion of everything else, and it would cost corporate America billions of dollars to move to Surowiecki’s world of continuous data dissemination. I do understand that we should prosecute things which are illegal, and that there’s something deeply unfair about people making money from insider trading. But let’s not lose sight of the big picture. We’re already spending too much money and effort fighting insider trading, and, as Surowiecki shows, it’s a fight we’re losing anyway. My guess is we’d be better off if the SEC trained its considerable resources on fraud and real abuses of small investors, in the knowledge that there might be a bit more insider trading at the margin. It wouldn’t be an ideal world, but I think there would be more real benefits for the cost expended.

COMMENT

The sec is hunting tall poppies(Martha Stewart, Steve Cohen) because it looks good and plays well for obama.

As you have written they could do a lot for the American economy by cracking down on extortion otherwise known as patent trolling.

This would be efficient use of taxpayer funds so will never happen in America.

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Charlie Munger’s BYD conflicts

Felix Salmon
Apr 5, 2011 21:37 UTC

In April 2009, Marc Gunther wrote a glowing cover story for Fortune profiling hot Chinese automaker BYD, the recipient of hundreds of millions of dollars of Berkshire Hathaway’s money. The headline was “Warren Buffett takes charge” (charge, electric cars, geddit?), and two things were abundantly clear. The first is that Berkshire’s stake had catapulted BYD into the international spotlight and given the company invaluable credibility. And the second is that Charlie Munger was BYD’s biggest cheerleader, both before and after the stake was bought.

Buffett’s friend and longtime partner in Berkshire Hathaway, Charlie Munger, suggested early last year that they invest in BYD…

Buffett, who is 78, was intrigued by Munger’s description of the entrepreneur behind BYD, a man named Wang Chuan-Fu, whom he had met through a mutual friend. “This guy,” Munger tells Fortune, “is a combination of Thomas Edison and Jack Welch – something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it.”

Coming from Munger, that meant a lot. Munger, the 85-year-old vice chairman of Berkshire Hathaway, is a curmudgeon who frowns on most investment ideas. “When I call Charlie with an idea,” Buffett tells me, “and he says, ‘That is really a dumb idea,’ that means we should put 100% of our net worth into it. If he says, ‘That is the dumbest thing I’ve ever heard,’ then you should put 50% of your net worth into it. Only if he says, ‘I’m going to have you committed,’ does it mean he really doesn’t like the idea.” …

In acquiring a stake in BYD, Buffett broke a couple of his own rules. “I don’t know a thing about cellphones or batteries,” he admits. “And I don’t know how cars work.” But, he adds, “Charlie Munger and Dave Sokol are smart guys, and they do understand it.”

Nowhere in the article was there any indication that Munger owned a large stake in BYD before bringing it to Buffett.* And all over the article is the idea that Buffett bought his stake in BYD precisely because Munger was such a strong proponent of the company and its CEO.

But now, in the wake of l’affaire Sokol, Munger’s changing his story:

Munger, 87, said his family invested with money manager Li Lu in BYD through a partnership that has a stake of about 3 percent and that he urged Sokol, then the leader of Berkshire’s energy business, to scout the business.

“I had Dave look at it, because I knew I couldn’t talk Warren into buying into the damn thing by myself,” Munger said…

Munger said his family holds a “little more” than half of the fund with the BYD investment, and that he didn’t participate in Berkshire’s discussions on its deal.

“I recused myself,” Munger said. “But there’s no question about it, that I caused Dave’s original interest.”

What seems clear here is that Munger wanted to “talk Warren into buying into the damn thing”; that he got Sokol to visit BYD with that very end in mind; that Buffett would never have bought his stake in BYD without Munger’s active participation; and that in the wake of Berkshire’s investment, Munger’s stake skyrocketed in value.

Munger’s recusal, on the other hand, seems pretty weak tea. As BYD’s chief cheerleader and Warren Buffett’s right-hand man, it’s pretty much impossible to see how he could effectively recuse himself from discussions: his input had already been made and clearly understood by the time that any formal investment decision took place.

Which brings me back to the question of why Munger feels the need to trade for his personal account in the first place. Why create an unnecessary opportunity for what seems in hindsight to have been a huge conflict of interest? And why was Munger’s personal stake in BYD never disclosed until Sokol blurted it out on CNBC Thursday? It certainly looks as though he felt that he had something to hide.

*Update: Fortune’s Gunther, in the comments, says that there was a sidebar in the print issue of the magazine which never made it online. And that sidebar said this:

Warren Buffet may be BYD’s most famous investor, but Li Lu, whose company LL Investment Partners owns 2% of BYD, has quite a story of his own. Born in China in 1966, Li Lu was raised by foster parents after his were forced into labor camps during the Cultural Revolution. As a 10-year-old, he barely survived an earthquake that killed 250,000 in the city of Tangshan. Then things got really interesting: Li Lu became a leader of the pro-democracy movement that organized protests in Tiananmen Square in 1989, appeared on China’s Twenty-One Most-Wanted List, and escaped to New York, where he was embraced by the human-rights community and earned three degrees from Columbia. After stints at Allen & Co. and DLJ, he met Charlie Munger through friends and started his own investment fund; Munger, the Berkshire vice chairman, is his largest investor. Li Lu, who is not allowed to travel freely in China, politely declined to be interviewed by Fortune. When asked about Li Lu’s story, BYD CEO Wang Chuan-Fu says: “That’s past history. Today, Mr. Li and I share the belief that the best way to help China move forward is to make BYD a world-class company.”

A close reading here would seem to show that Munger did have a stake in BYD, via LL Investment Partners — although it’s far from clear, and certainly there’s no indication when Munger invested. But this is even more subtle than Sokol’s passing mention to Buffett that he owned shares in Lubrizol.

Update 2: The WSJ’s Susan Pulliam had more detail in July 2010, saying that Munger invested some $50 million with Li Lu in early 2004, who rapidly invested a lot of that money in BYD. She continues:

In 2008, Mr. Munger persuaded Mr. Sokol to investigate BYD for Berkshire as well. Mr. Sokol went to China and when he returned, he and Mr. Munger convinced Mr. Buffett to load up on BYD.

There’s no mention of Munger recusing himself from that decision in any meaningful way; the WSJ now says that Berkshire policies bar “trading in shares of companies in which Berkshire might invest”, without publishing the memo, giving the exact language, or saying whether Munger is covered by it.

COMMENT

A pretty significant difference in the facts relating Munger’s investment in BYD is that he had invested in BYD “for years” before mentioning it as a potential acquisition for Berkshire and then recused himself from Berkshire’s consideration. At the time Munger invested in BYD, it likely wasn’t large enough to be a feasible investment for Berkshire Hathaway.

http://www.bloomberg.com/news/2011-04-05  /munger-says-he-told-buffett-of-byd-sta ke-stayed-out-of-berkshire-s-talks.html

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