This Insider Trading is Legal

Last Updated Jul 18, 2011 5:12 PM EDT

Consider two investors.

Investor A is extraordinarily well-connected, and counts among his friends some of the most powerful and knowledgeable insiders in both the corporate and financial worlds. He leverages these relationships masterfully, prying from them (and sometimes paying them for) insider information about deals that are about to go down, earnings that are about to be announced; getting as someone put it, "tomorrow's information today." Investor A uses that information to rack up tremendous gains for the fund he manages, garnering a track record that's to be envied, enriching himself and his investors along the way.

Investor B is also extraordinarily well-connected, with access to a veritable motherlode of information that often has the potential to not only move the price of one or two individual stocks, but entire markets. Like Investor A, he also trades on this information -- not via a fund, but in his own personal account. And like Investor A, he uses the information he has access to very well, outperforming the market by some six percent per year over a 17 year period.

Investor A, as you might have guessed, is Raj Rajaratnam, who managed what was once one of the world's largest hedge funds before being convicted of 14 counts of securities fraud. He is scheduled to be sentenced next week, and faces up to 25 years in jail.

Investor B? He (or she) is a member of the U.S. House of Representatives who, unlike Rajaratnam, faces no legal repercussions for personally profiting from non-public information.

The stellar track record of these House members comes courtesy of a new study -- entitled "Abnormal Returns from the Common Stock Investments of Members of the U.S. House of Representatives" -- which appears in the current edition of Business and Politics. The authors of the study (professors Alan Ziobrowski, James Boyd, Ping Cheng, and Brigitte Ziobrowski) combed through years' worth of stock trading information disclosed by House members, and found that from 1985 through 2001 House members demonstrated an uncanny ability to earn market-topping returns that are "economically large and statistically significant."

This new study is a follow-up to their similar analysis of the returns earned by members of the U.S. Senate, in which they found that members of the world's greatest deliberative body were able to outperform the stock market by roughly 10 percent per year.

So why are our elected officials permitted to profit on the non-public information they posses? The authors of the study note that divestiture -- which would require a politician to sell any stocks that he might posses information on -- is ruled out because a Representative's work might touch upon such a broad swath of industries the they'd effectively be shut out of the stock market entirely. And recusing themselves from votes which might impact their holdings is ruled out because doing so has a negative impact on the Representatives' ability to represent their constituents.

Absent those, it was decided that sunlight is the best disinfectant, and thus its members are simply required to disclose their stock purchases and sales in an annual Financial Disclosure Report, which is what the professors used for their study.

But either the sunlight isn't strong enough, or its disinfecting abilities are muted, because it's clear that simply having to disclose their stock trades has not been particularly effective in preventing our politicians from finding a way to personally profit from the information they're privy to.

(Such trading isn't limited to our elected officials. An investigation led by the Wall Street Journal's Jason Zweig last year found that in 2008 and 2009 72 Congressional aides made trades in companies that their employers' oversaw.)

Perhaps most damning in the current study is the evidence the professors unearthed which indicates that at some level, these politicians know that what they're doing is wrong. They discovered that there is a negative correlation between tenure and returns: The highest returns tended to be earned by the least-tenured politicians. In other words, the more they have to lose -- in terms of career and reputation -- the less likely the politicians were to try to profit on their position (at least, ahem, in the stock market).

Solving this problem is both simple and easy: require all federally elected officials to place their investments in a blind trust, as the President does. Don't want to give up your day-trading? Then don't run for office. But obviously the political class has little motivation to take up the cause of depriving themselves and their colleagues of this profitable perk. So, like so many of these little open secrets (i.e. the British tabloid scandal) it's likely that nothing will be done until someone gets extraordinarily greedy (or stupid, which is often greed's sidekick) and ends up focusing the public's attention and outrage on behavior that would be clearly and unequivocally illegal in the private sector. If nothing else, it gives you a reason to look forward to stupid and greedy behavior.

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  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.

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