After going easy for years on the fraudster Bernard Madoff, the Securities and Exchange Commission is now engaged in an all-out war against insider trading. After financial crisis comes regulatory frenzy—so it has been for some 300 years. Both the SEC and the Dodd-Frank Act are right on cue in this long-running political show.
Boom-bust cycles come with bubble laws, to use a term from Larry Ribstein of the University of Illinois College of Law, one of the legal scholars who looked at the historic trend. What causes securities regulation? Professor Stuart Banner of UCLA Law faculty has a succinct answer: “In a nutshell, crashes.
The 1720 South Sea Bubble in Britain gave rise to the Bubble Act. The 1792 crash in New York resulted in the first significant securities regulation in America. The 1929 crash led to the1930s securities laws. After the bursting of the late 1990s technology-driven stock bubble came the Sarbanes-Oxley Act of 2002. And the collapse of the twin credit and property bubbles heralded the passage of Dodd-Frank this year.
Enforcement of existing laws follows a similar cyclical pattern. Amitai Aviram of the University of Illinois College of Law shows that SEC enforcement actions tend to move in opposite direction to the stock market. Fraud is often perceived as the cause of a slump because it offers a vivid, concrete and easy-to-understand explanation, argues Professor Aviram. This creates political pressure on regulators to make special efforts after market downturns.
But isn’t insider trading a real problem, whatever the political motivation of regulators and legislators? Not necessarily. Donald Boudreaux of George Mason University has made a powerful case that insider trading is good for markets and investors. The trades provide information and cause markets to adjust quicker to underlying corporate realities, keeping prices honest.
Moreover, the line between trades that are criminal and those that are not is vague and impossible to police. “Parsing the difference between legal and illegal insider trading is futile—and a disservice to all investors,” Professor Boudreaux wrote in a Wall Street Journal piece.
The real problem is the fraudulent schemes that will be hatched by future Madoffs in the next boom. By then, regulators will be back to their complaisant mode. The current onslaught on a wide range of trading may be politically expedient, but it is at best a diversion from what should be the top regulatory priority in financial markets, namely fighting lies and fraudulent claims. At worst, regulators are criminalizing activity that is potentially beneficial. The main effect may be to reduce information flow to shareholders.
Meanwhile, various federal bureaucracies have just began the process of making arcane rules to implement thousands of pages of additional regulation. Richard Epstein recently pointed out that the two laws passed this year, ObamaCare and Dodd-Frank, are so massive as to throw administrative rulemaking into disarray.
It’s all another burden on the economy and on honest folk. Professor Ribstein argues that laws made in unusual circumstances discourage proper consideration of what can be achieved and at what cost.
Centuries of experience suggest none of this will stop the next Madoff. He knows how to work the regulatory state.