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«Abstract Insider trading is one of the most controversial aspects of securities regulation, even among the law and economics community. One set of ...»

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indicted on various charges. The most pertinent charges for our purposes are:

(1) O’Hagan violated 1934 Act Section 10(b) and Rule 10b-5 by trading on misappropriated nonpublic information; and (2) O’Hagan violated 1934 Act Rule 14e-3 by trading while in possession of nonpublic information relating to a tender offer. The Supreme Court upheld O’Hagan’s conviction on both counts. With respect to the misappropriation charge, the Court validated the theory as being designed to ‘protect the integrity of the securities markets 5650 Insider Trading 777 against abuses by “outsiders” to a corporation who have access to confidential information that will affect the corporation’s security price when revealed, but who owe no fiduciary or other duty to that corporation’s shareholders’.

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Henry Manne’s book Insider Trading and the Stock Market must be ranked among the truly seminal events in the economic analysis of corporate law (Manne, 1966a). It is only a slight exaggeration to suggest that Manne stunned the corporate law academy by daring to propose the deregulation of insider trading. The traditionalists’ response was immediate and vitriolic (see, for example, Schotland, 1967; Mendelson, 1969; see also Manne, 1970). In the long run, however, Manne’s daring was vindicated in at least one important respect. Although it is hard to believe at this remove, corporate law was regarded as moribund during much of the middle part of this century. Manne’s work on insider trading played a major role in ending that long intellectual drought by stimulating interest in economic analysis of corporate law. Whether one agrees with Manne’s views on insider trading or not, one must give him due credit for helping to stimulate the outpouring of important law and economics scholarship in corporate law and securities regulation during the 1980s and 1990s.

Manne identified two principal ways in which insider trading benefits society and/or the firm in whose stock the insider traded. First, he argued that insider trading causes the market price of the affected security to move toward the price that the security would command if the inside information were publicly available. If so, both society and the firm benefit through increased price accuracy. Second, he posited insider trading as an efficient way of compensating managers for having produced information. If so, the firm benefits directly (and society indirectly) because managers have a greater incentive to produce additional information of value to the firm.

6. The Effect of Insider Trading on the Price of Securities

There is general agreement that both firms and society benefit from accurate pricing of securities. The ‘correct’ price of a security is that which would be set by the market if all information relating to the security had been publicly disclosed. Accurate pricing benefits society by improving the economy’s allocation of capital investment and by decreasing the volatility of security prices. This dampening of price fluctuations decreases the likelihood of individual windfall gains and increases the attractiveness of investing in 778 Insider Trading 5650 securities for risk-averse investors. The individual corporation also benefits from accurate pricing of its securities through reduced investor uncertainty and improved monitoring of management’s effectiveness.

Although US securities laws purportedly encourage accurate pricing by requiring disclosure of corporate information, they do not require the disclosure of all material information. Where disclosure would interfere with legitimate business transactions, disclosure by the corporation is usually not required unless the firm is dealing in its own securities at the time.

When a firm lawfully withholds material information, its securities are no longer accurately priced by the market. If the undisclosed information is particularly significant, the error in price can be substantial. In the famous Texas Gulf Sulphur case, for example, TGS discovered an enormously valuable mineral deposit in Canada. When the deposit was discovered, TGS common stock sold for approximately $18 per share. By the time the discovery was disclosed, four months later, the price had risen to over $31 per share. One month after disclosure, the stock was selling for approximately $58 per share (SEC v. Texas Gulf Sulphur Co.). Pricing errors of this magnitude eliminate the benefits of accurate pricing. However, requiring TGS to disclose what it knew would have reduced the value of the information and thus the incentive to discover it.

Manne essentially argued insider trading is an effective compromise between the need for preserving incentives to produce information and the need for maintaining accurate securities prices. Manne offered the following example of this alleged effect: A firm’s stock currently sells at $50 per share.

The firm has discovered new information that, if publicly disclosed, would cause the stock to sell at $60. If insiders trade on this information, the price of the stock will gradually rise toward but will not reach the ‘correct’ price.

Absent insider trading or leaks, the stock’s price will remain at $50 until the information is publicly disclosed and then rapidly rise to the correct price of $60. Thus, insider trading acts as a replacement for public disclosure of the information, preserving market gains of correct pricing while permitting the corporation to retain the benefits of nondisclosure (Manne, 1966a, pp. 80-90) Texas Gulf Sulphur provides anecdotal evidence for this effect. The TGS insiders began active trading in its stock almost immediately after discovery of the ore deposit. During the four months between discovery and disclosure, the price of TGS common stock gradually rose by over $12. Arguably, this price increase was due to inside trading. In turn, the insiders’ profits were the price society paid for obtaining the beneficial effects of enhanced market efficiency.

Despite this and similar anecdotes, empirical justification for the deregulatory position remains scanty. Early market studies indicated insider trading had an insignificant effect on price in most cases (Schotland, 1967, p.

1443). Subsequent studies suggested the market reacts fairly quickly when 5650 Insider Trading 779 insiders buy securities, but the initial price effect is small when insiders sell (Finnerty, 1976). In an important study, Givoly and Palmon (1985) found that while transactions by insiders were followed by a strong price effect, identifiable insider transactions were only rarely based on exploitation of nonpublic information. If they are correct, then the market efficiency rationale for deregulation loses much of its force: insider trading simply is not communicating inside information to the market. These and similar studies are problematic, however, because they relied principally (or solely) on the transactions reports corporate officers, directors, and 10 percent shareholders are required to file under §16(a). Because insiders are unlikely to report transactions that violate rule 10b-5, and because much illegal insider trading activity is known to involve persons not subject to the §16(a) reporting requirement, conclusions drawn from such studies may not tell us very much about the price and volume effects of illegal insider trading. Accordingly, it is significant that a more recent and widely-cited study of insider trading cases brought by the SEC during the 1980s found that the defendants’ insider trading led to quick price changes (Meulbroek, 1992). That result supports Manne’s empirical claim, subject to the caveat that reliance on data obtained from SEC prosecutions arguably may not be conclusive as to the price effects of undetected insider trading due to selection bias, although Meulbroek’s study addressed that concern by segmenting the sample into subsets, one of which was less likely to be contaminated by selection bias, and finding that the results did not differ significantly across the subsets. Finally, the SEC’s chief economist has reached the perhaps debatable conclusion that pre-announcement price and volume run-ups in takeovers are most likely attributable to factors other than insider trading (Rosenbaum and Bainbridge, 1988, p. 235).

In theory, of course, the supply/demand effects of insider trading should have only a minimal impact on the affected security’s price. A given security ‘represents only a particular combination of expected return and systematic risk, for which there is a vast number of substitutes’ (Gilson and Kraakman, 1984, p. 630). The correct measure for the supply of securities is not simply the total of the firm’s outstanding securities, but the vastly larger number of securities with a similar combination of risk and return. Therefore, the supply/demand effect of a relatively small number of insider trades should not have a significant price effect.

The price effect of undisclosed insider trading is an example of what Gilson and Kraakman (1984, p. 630) call the ‘derivatively informed trading mechanism’ of market efficiency. Derivatively informed trading affects market prices through a two-step mechanism. First, those individuals possessing material nonpublic information begin trading. Their trading has only a small effect on price. Some uninformed traders become aware of the insider trading 780 Insider Trading 5650 through leakage or tipping of information or through observation of insider trades. Other traders gain insight by following the price fluctuations of the securities. Finally, the market reacts to the insiders’ trades and gradually moves toward the correct price. The problem is that while derivatively informed trading can affect price, it functions slowly and sporadically. Given the inefficiency of derivatively informed trading, the market efficiency justification for insider trading loses much of its force.

7. Insider Trading as an Efficient Compensation Scheme

Even Manne (1966a, p. 110) admitted that price effect is not a strong argument against a bar on insider trading. Instead, Manne’s deregulatory argument rested mainly on the claim that allowing insider trading was an effective means of compensating entrepreneurs in large corporations. Manne (1966b, p. 116) distinguished corporate entrepreneurs from mere corporate managers. The latter simply operate the firm according to predetermined guidelines. Because the firm and the manager know what the manager will do and what his abilities are, salary is an appropriate method of compensation. By contrast, an entrepreneur’s contribution to the firm consists of producing new valuable information. The entrepreneur’s compensation must have a reasonable relation to the value of his contribution to give him incentives to produce more information. Because it is rarely possible to ascertain the information’s value to the firm in advance, predetermined compensation, such as salary, is inappropriate for entrepreneurs.

8. Insider Trading as Entrepreneurial Compensation

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