Business November 2011

Capitol Gains

Are members of Congress guilty of insider trading—and does it matter?
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Joseph Darrow

In 1995, when Alan Ziobrowski was an associate professor of finance at Lander University, in South Carolina, he found himself at home one night watching “one of those 60 Minutes–type shows.” That evening’s story caught his interest: Gregory Boller, a professor of marketing at the University of Memphis, had found some striking coincidences in which members of Congress, between 1990 and 1995, bought or sold stock in companies that could be affected by ongoing government activity.

According to Boller’s study, which Mother Jones also covered, Senator Lloyd Bentsen (D–Texas) had bought stock in a dairy processor and sold it 10 months later, days before the Justice Department began investigating the company for rigging bids to sell milk in public schools. Senator Bob Dole (R–Kansas) had purchased stock in Automatic Data Processing four days before President George H. W. Bush signed a law with new rules for military data processing. Representative Newt Gingrich (R–Georgia) bought Boeing stock just before he helped kill amendments that would have cut funding for the International Space Station—an outcome that helped Boeing secure a contract.

It all sounded very damning. And yet to Ziobrowski, Boller’s work didn’t seem completely fair. The examples were cherry-picked and could, in fact, have been mere coincidences. How many times, for example, had congressmen sold Lockheed Martin or AT&T right before passing laws that benefited the companies? To know whether members of Congress were turning insider knowledge into personal financial gain, you needed to look at all their trades—those made by the small fry as well as the presidential contenders, the losers as well as the winners. The real question, he thought, was whether a portfolio made up of stocks held by members of Congress would significantly outpace the market.

To find the answer, Ziobrowski recruited three other professors, including his wife, Brigitte, who oversaw the tedious process of actually turning the entries on the opaque disclosure forms into usable data. While the House forms were available in libraries, getting the records from Senate offices proved especially difficult. “We finally had to buy many of them at 20 cents a page,” Ziobrowski told me. And even after they got the forms, “it took years to go through and track all of those transactions,” Ziobrowski says.

Their results were necessarily approximate. Some members left office before selling shares; others would sell some, but not all, of their stock. “And then there are others who just don’t bother to tell you when they sell,” Ziobrowski told me. “You’ll see the portfolio change, but you don’t know why. There’s no watchdog, there’s no one who audits to check that they’re accurate.”

Even so, the professors eventually had a data set comprising all known senatorial transactions between 1993 and 1998. And what they found shocked Ziobrowski.

“Most of the time, you do studies like this, and you end up concluding that there are no abnormal returns. Call us naive, but the part that bothered me most about Boller’s work is that it suggests that they’re doing something sneaky, but it didn’t actually show that they were doing anything sneaky.” He chuckled. “None of us were betting our tenure on the results of this study.”

But when they’d completed their analysis, it looked like they—and at least a few members of Congress—had hit the jackpot. Their analysis of the Senate returns over the six-year period, published in the Journal of Financial and Quantitative Analysis in 2004, showed that the Senate portfolio outperformed the market by approximately 12 percent a year. In April of this year, the team published a follow-up analysis of the House in Business and Politics, which showed that House members on average outperformed the market by a smaller but still impressive figure—roughly 6 percent a year.

These numbers are bigger than they sound. If you took $100 and invested it at 6 percent over a 40-year career, when you retired, that $100 would have increased almost tenfold … while if your portfolio averaged a steady 12 percent, your original $100 would have turned into more than $8,000. If you’ve looked at your 401(k) recently, you know most people don’t get such returns. And that was just the extra profits they made, over and above the 20 percent annual return that even a blind monkey with a dartboard and an E*Trade account was making back in the late 1990s. A study of corporate insiders, who presumably have lots of information about their firm’s performance, showed that their purchases earned abnormal returns of only about 6 percent a year. Senators seemed to be the greatest stock pickers since Warren Buffett.

But of course, Warren Buffett spends most of his days locked in his office in Omaha, pondering his investments. Senators had to get their stock deals done between rubber-chicken dinners and grip-and-grins at the state fair. Which made it hard to escape the conclusion that they were doing something a little worse than sneaky.

Or were they? A few years ago, after the Center for Responsive Politics made congressional disclosure forms available in an easily searchable data set, two graduate students in Harvard’s political-science department decided to revisit the question for the new millennium. Andrew Eggers and Jens Hainmueller, now assistant professors at the London School of Economics and MIT, respectively, had become interested in the emerging literature on whether politicians benefit financially from holding office, and they were just finishing their first paper, which used probate data to look at that question in the United Kingdom. (Answer: yes, at least if they were Tories in the House of Commons between 1950 and 1970.)

They eagerly attacked the U.S. data. Both of them got a big surprise. Their data, which covered 2004 through 2008, didn’t show Congress outperforming the market by 12 percent. In fact, they didn’t show it outperforming the market at all. For the five years they studied, Congress actually underperformed the market by 2 to 3 percent annually. On average, Congress did worse than an index fund, and about as well as your average stock-picking granny. If Congress was indeed trading on inside information in the late 1990s, it seemed to have stopped.

But, if all the data are right, why would congressional stock-picking have changed so much? That’s “the one fact that we cannot 100 percent nail down,” says Hainmueller ruefully, especially since Ziobrowski et al. haven’t released their painfully assembled data set. One of the papers could be wrong, of course, but it’s hard to adjudicate that when one group hasn’t released its data and the other’s paper hasn’t yet been published in a peer-reviewed journal—and anyway, neither group is openly disputing the other’s results. Still, Eggers and Hainmueller’s difficulty in explaining the difference may make it harder for them to get their own results published.

One possibility is that insider trading has gotten harder. As a risk-arbitrage trader at Goldman Sachs, former Treasury Secretary Robert Rubin made a living exploiting persistent anomalies between, say, the stock price of a company that was being acquired, and the price that the buyer was offering; now hedge funds are in a technological arms race to gain advantages that last for only milliseconds. Meanwhile, a booming political-intelligence industry scrutinizes Congress like a flock of half-starved vultures. Congressional information advantages may not persist long enough to let members profit from them.

Or perhaps uncovering the behavior changed it. This is the theory that Ziobrowski endorsed when I spoke with him, and it’s quite plausible.

Eggers and Hainmueller also emphasize that the earlier results were driven in large part by a few very heavy traders. To be sure, those traders might have been lucky—and indeed, when you go back and look at the original evidence that sparked Ziobrowski’s research, it’s not quite as lurid as it may first have appeared. Bob Dole’s suspicious trade turns out to have occurred well after Congress had passed the new law that benefited data-processing firms. And while Newt Gingrich may have helped save a program that eventually benefited Boeing, that happened before the contract had been awarded—and since Democrats controlled the House of Representatives, he could hardly count on being able to steer the Space Station business to Boeing.

On the other hand, some of the other trades—such as Bentsen’s dairy deals—still look pretty bad. Perhaps the Senate’s outsized results were driven by a few bad apples who, thankfully, didn’t spoil the rest. When they left Congress, or reformed under the threat of exposure, the excess profits went away.

It’s also possible that congressional insiders could have simply stopped reporting potentially dubious transactions once they knew people were paying attention. According to Ziobrowski, the forms still aren’t audited, and they’re woefully inadequate—for example, Eggers and Hainmueller say there’s no clear method for reporting short-selling, one of the major ways to profit from inside information. This won’t do. We can’t rely on watchdog groups and peer-reviewed papers that take years to get published. By the time we know whether our elected representatives are profiting from their position, it’s old news, and we have a new crop of Congress members to worry about.

Worse still, even if academic gumshoes did work faster, it’s not clear what we could do about congressional insider trading under current law. Ziobrowski et al. may have found evidence of insider trading. But they may not have found evidence of a crime.

That’s because insider trading is a strange offense. It wasn’t even really illegal until the 1930s; before then, insider trading was just assumed, and retail investors mostly aspired to get in on the action. Eighty years later, most people have a strong sense that it should be illegal, but they may have a hard time articulating why. It’s not necessarily obvious who is hurt by insider trading.

Take an insider who buys shares in advance of a merger. Most people intuitively assume that he has defrauded the shares’ sellers, who could have made more money if they’d held on. But of course, they’d already instructed their brokers to sell the stock. If anything, insider trading probably raises the price the sellers got (though in practice, a typical insider probably can’t buy enough to move the price).

Of course, if our insider buys shares, someone else doesn’t get them … but there’s no way of knowing whether that person would have held on to the stock until the merger was announced. So the insider could possibly profit without making anyone noticeably worse off—indeed, by raising the price closer to the stock’s “true” value, he’s actually made the market more efficient. It’s arguably the closest thing that modern finance has to a victimless crime.

The law reflects our confusion about the harm caused by insider trading. Stephen Bainbridge, a law professor at UCLA, says, “The most widely used theory by SEC and the courts is that [insider trading] undermines investor confidence in the integrity of the markets.” But Bainbridge argues that this doesn’t necessarily make much sense, especially if you look at the current state of the law. In 1980, the Supreme Court ruled that Vincent Chiarella, a printer who had profited from stock trades he made after deducing the identity of the companies involved in merger prospectuses he was printing, was not guilty of insider trading. It takes more than “material nonpublic information” to make you an insider—you also must have a fiduciary duty to keep the information secret. If you overhear two executives in the ladies’ room chatting about an earnings surprise, they may be in trouble, but you are free to use that information however you wish.

Unless it’s the ladies’ room at your employer. Six years after Chiarella v. United States, R. Foster Winans, who wrote The Wall Street Journal’s Heard on the Street column, was convicted on 59 counts of financial fraud for tipping off brokers about the contents before publication. The case was decided by the U.S. Court of Appeals for the Second Circuit, which ruled that Winans had breached the insider-trading rules even though he had no fiduciary connection to the companies he wrote about. Winans, the Second Circuit ruled, had illegally misappropriated information that belonged to his employer. (Chiarella’s verdict might also have been upheld if he’d been convicted on these grounds, but that argument wasn’t raised at trial.)

Yet Bainbridge notes that in ruling that The Journal had a property right in the contents of its articles, the Second Circuit left open the possibility that The Journal could legally trade on the basis of its own articles. “This is why it’s not a confidence issue,” Bainbridge told me. “Surely if The WSJ were allowed to trade, this would shake investor confidence even more [than if Winans were].”

But if insider trading represents a sort of theft from a client or employer, it raises something of a conundrum: members of Congress don’t really have an employer. The law professor Donna Nagy has argued that they have a fiduciary duty to U.S. citizens, which they violate if they participate in insider trades. Ethically, this seems to be certainly true. But legally, Bainbridge thinks it’s a little more murky. He believes that members of Congress are effectively fiduciaries of no one. “There’s at least a strong argument,” he says, “that congressional insider trading is not illegal under current law.”

Certainly, the guardians of our laws don’t seem eager to pursue the question. No member of Congress has ever been investigated for insider trading. Four times since 2006, Congresswoman Louise Slaughter (D–New York) has sponsored the STOCK Act, which would explicitly make congressional insider trading illegal, and require members of Congress to disclose significant trades within 90 days. It’s never even come to a vote.

If we can’t require members of Congress to report their transactions in real time, the way corporate insiders have to—and we can’t—then maybe they should have to put their holdings in a blind trust, as executive-branch officials like the Treasury secretary often must. Or at least in index funds that mirror the broad market, so that their fortunes rise and fall along with the contents of our 401(k)s. This requirement would curb the related temptation to use legislation to help companies they’re invested in, which must at least occasionally plague even the most honorable legislators.

Otherwise, given the weakness of the oversight, Americans will continue to suspect the worst. One reason that the findings of Ziobrowski et al. may not have triggered much response is that everyone already believed their legislators were crooks—morally, if not legally. And that’s corrosive. In the end, the problem with congressional insider trading isn’t that it undermines confidence in the market—Congress frequently does that openly. The problem with congressional insider trading is that it erodes confidence in our political institutions. We can’t really afford to deplete that pitiful stock much further.

Megan McArdle is an Atlantic senior editor
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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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