Editor's Note: Luigi Zingales is Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business and author of the forthcoming book A Capitalism for the People.
By Luigi Zingales, Project Syndicate
Imagine that you are an elected member of the United States House of Representatives in the middle of the debate on the health-care reform act that was passed in 2010. In a House committee meeting, you learn before anyone else that a proposed public-insurance option - a program that would compete with private insurance - will not be included. This information will have a large impact on health-care companies’ stock prices. Can you trade these companies’ shares before it is made public?
Morally, it is difficult to separate this example from traditional cases of corporate insider trading. Yet no law prohibits the practice. The U.S. Congress - the legislative branch of the country’s government - effectively exempts itself from the normal rules of insider trading. Congress and the U.S. Supreme Court are the only federal agencies whose employees may, without restrictions, trade stocks based on non-public information. All other U.S. government employees who traded on privileged information of the type described above would be acting illegally.
Not only can members of Congress legally trade on confidential information; they do, despite the potential cost to their reputations. The U.S. television program 60 Minutes recently reported that several current members of Congress allegedly used confidential information that they acquired on the job for personal gain. While the nexus between the privileged information and the trading is difficult to prove (as it is in most insider trading cases), the timing is highly suspicious.
But it is difficult to challenge this congressional “privilege” in the U.S., in part because insider trading is an ambiguous concept under U.S. law, with no statutory definitions of the terms “insider,” “inside information,” or “insider trading.”
In contrast, the European Union has tried to define these terms in directives aimed at prohibiting the practice. According to a directive issued in 1989, “An insider is one who, due to his relationship to the company as manager, director, employee, or major shareholder, possesses inside information (material non-public facts) and knowingly uses such inside information to acquire or dispose of securities to which the information relates for his own account or another.”
But this definition, while forthright, leaves a large loophole for legislators. For example, it creates the possibility that, say, British MPs could legally trade shares on information acquired in the course of normal business, because they do not qualify as “insiders.”
In 2004, a paper published in the Journal of Financial and Quantitative Analysis showed that U.S. senators who traded stocks beat the market by 12% per year. Since even the best hedge-fund managers find it hard to achieve comparable results, we must conclude that these senators either are better than hedge-fund managers, or that they benefit from privileged information.
Even more worrying than insider trading by elected representatives is the political-intelligence industry that now flourishes in Washington, Brussels, and other major global capitals. In the U.S., former U.S. congressmen and their staffers collect privileged information and sell it to hedge-fund managers, raking in $100 million annually.
A proposal to ban insider trading by U.S. congressmen has languished in Congress since 2006. But it appears that the 60 Minutes program generated some attention; within four days of the broadcast, the number of cosponsors of the proposal increased from nine to 57, and a session was called to discuss the legislation next month.
Yet the problem is not simply Congress’s exemption from insider-trading law. The real issue is that the U.S. Congress - like many countries’ legislatures - lives by rules that are very different from those imposed on ordinary citizens. In particular, the accounting, transparency, and fraud rules that govern businesses do not apply to elected representatives.
It is a problem that goes well beyond insider trading. If corporate executives lie during a conference call, they can be sued. Politicians, on the other hand, lie during electoral campaigns and once in office, with few or no consequences. If the U.S. government had been compelled to abide by the same accounting rules as the private sector does, it would have been forced to consolidate Fannie Mae and Freddie Mac - the giant government-backed mortgage companies at the heart of the recent financial crisis - and to report all contingent liabilities at market value.
Rather than just extending insider-trading law to the U.S. Congress (or to other legislatures), citizens should demand that all restrictions and reporting requirements imposed on the private sector apply automatically to elected representatives as well. This would make these legislatures more credible, and their laws more just.
The views expressed in this piece are solely those of Luigi Zingales.