«Abstract Insider trading is one of the most controversial aspects of securities regulation, even among the law and economics community. One set of ...»
Manne (1966a, pp. 116-119) asserted insider trading is an effective way to compensate corporate agents for innovations. The increase in the price of the security following public disclosure provides an imperfect but comparatively accurate measure of the value of the innovation to the firm. The entrepreneur can recover the value of his discovery through buying the firm’s securities prior to disclosure and selling them after the price rises. (Manne, 1970) later implicitly retreated from the distinction between entrepreneurs and managers, which vitiated some of the criticisms directed at his thesis. Because Manne did not retreat from the more general claim that insider trading was an efficient compensation scheme, most of the criticisms discussed in the next section remained viable.) Carlton and Fischel (1983, pp. 869-871) suggested a further refinement of Manne’s compensation argument. They likewise believed advance payment 5650 Insider Trading 781 contracts fail to compensate agents for innovations. The firm could renegotiate these contracts later to account for innovations, but renegotiation is costly and thus may not occur frequently enough to provide appropriate incentives for entrepreneurial activity. Carlton and Fischel suggested that one of the advantages of insider trading is that an agent revises his compensation package without renegotiating his contract.
9. Evaluating the Compensation Thesis
In evaluating compensation-based justifications for deregulating inside trading, it is crucial to determine whether the corporation or the manager owns the property right to the information in question. Some of those who favor deregulating insider trading deny that the property rights of firms to information produced by their agents include the right to prevent the manager from trading on the basis of that information. In contrast, those who favor regulation contend that when an agent produces information the property right to that information belongs to the principal. Where the property right to agent-produced information should be assigned is a question deferred to Section 20 below. This section focuses on the contention by those who favor regulating insider trading that it is an inefficient form of compensation.
Manne (1966b, pp. 117-119) rejected contractual and bonus forms of compensation as inadequate incentives for entrepreneurial inventiveness on the ground that they fail to accurately measure the value of the innovation to the firm. Some contend, however, that insider trading is not any more accurate.
They assert, for example, that even assuming the change in stock price accurately measures the value of the innovation, the insider’s compensation is limited by the number of shares he can purchase. This, in turn, is limited by his wealth. As such, the insider’s trading returns are based not on the value of his contribution, but on his wealth.
Another objection to the compensation argument is the difficulty of restricting trading to those who produced the information. Where information is concerned, production costs normally exceed distribution costs. As such, many firm agents may trade on the information without having contributed to its production.
A related objection is the difficulty of limiting trading to instances in which the insider actually produced valuable information. In particular, why should 782 Insider Trading 5650 insiders be permitted to trade on bad news? Allowing managers to inside trading reduces the penalties associated with a project’s failure because trading managers can profit whether the project succeeds or fails. If the project fails, the manager can sell his shares before that information becomes public and thus avoid an otherwise certain loss. The manager can go beyond mere loss avoidance into actual profitmaking by short selling the firm’s stock.
Easterbrook (1981) focused on the contingent nature of insider trading as a ground for rejecting compensation-based arguments. Because the agents trading returns cannot be measured in advance, neither can the true cost of his reward. As a result, selection of the most cost-effective compensation package is made more difficult. Moreover, the agent himself may prefer a less uncertain compensation package. If an agent is risk averse, he will prefer the certainty of $100,000 salary to a salary of $50,000 and a 10 percent chance of a bonus of $500,000 from insider trading. Thus, the shareholders and the agent would gain by exchanging a guaranteed bonus for the agents promise not to trade on inside information (see also Levmore, 1982).
As with the market efficiency argument, little empirical evidence supports or counters the compensation argument. The only useful empirical evidence is Givoly and Palmon’s (1985) finding that while insiders do earn abnormal returns from trading in their firm’s securities, these abnormal returns are based on the insiders’ superior assessment of their firm’s status and not on exploitation of inside information. If so, the compensation argument rests on fundamentally flawed assumptions.
10. Public Choice
Some critics of the insider trading prohibition contend that the prohibition can be explained by a public choice-based model of regulation in which rules are sold by regulators and bought by the beneficiaries of the regulation. This section focuses on slightly different, but wholly compatible, stories about insider trading told by Dooley (1980) and Haddock and Macey (1987). One explains why the SEC wanted to sell insider trading regulation, while the other explains to whom it has been sold.
11. The Sellers’ Story
its prestige. Administrators can maximize their salaries, power and reputation by maximizing the size of their agency’s budget. A vigorous enforcement program directed at a highly visible and unpopular law violation is surely an effective means of attracting political support for larger budgets. Given the substantial media attention directed towards insider trading prosecutions, and the public taste for prohibiting insider trading, it provided a very attractive subject for such a program.
Second, during the prohibition’s formative years, there was a major effort to federalize corporation law. In order to maintain its budgetary priority over competing agencies, the SEC wanted to play a major role in federalizing matters previously within the state domain. Regulating insider trading was an ideal target for federalization. Rapid expansion of the federal insider trading prohibition purportedly demonstrated the superiority of federal securities law over state corporate law. Because the states had shown little interest in insider trading for years, federal regulation demonstrated the modernity, flexibility and innovativeness of the securities laws. The SEC’s prominent role in attacking insider trading thus placed it in the vanguard of the movement to federalize corporate law and ensured that the SEC would have a leading role in any system of federal corporations law.
12. The Buyers’ Story
Haddock and Macey (1987) argue that the insider trading prohibition is supported and driven in large part by market professionals, a cohesive and politically powerful interest group, which the current legal regime effectively insulates from insider trading liability (see also Macey, 1991). Only insiders and quasi-insiders such as lawyers and investment bankers have a greater degree of access to nonpublic information that might affect a firm’s stock price than do market professionals. By basing insider trading liability on breach of fiduciary duty, and positing that the requisite fiduciary duty exists with respect to insiders and quasi-insiders but not with respect to market professionals, the prohibition protects the latter’s ability to profit from new information about a firm.
Market professionals benefit in a variety of ways from the present ban.
When an insider trades on an impersonal secondary market, the insider takes advantage of the fact that the market maker’s or specialist’s bid-ask prices do not reflect the value of the inside information. Because market makers and specialists cannot distinguish insiders from non-insiders, they cannot protect themselves from being taken advantage of in this way. When trading with insiders, the market maker or specialist thus will always be on the wrong side of the transaction. If insider trading is effectively prohibited, however, the 784 Insider Trading 5650 market professionals are no longer exposed to this risk.
Professional securities traders likewise profit from the fiduciary duty-based insider trading prohibition. Because professional investors are often active traders, they are highly sensitive to the transaction costs of trading in securities.
Prominent among these costs is the specialist’s and market-maker’s bid-ask spread. If a ban on insider trading lowers the risks faced by specialists and market makers, some portion of the resulting gains should be passed on to professional traders in the form of narrower bid-ask spreads.
Analysts and traders are further benefited by a prohibition on insider trading, because only insiders are likely to have systematic advantages over market professionals in the competition to be the first to act on new information. Market professionals specialize in acquiring and analyzing information. They profit by trading with less well-informed investors or by selling information to them. If insiders can freely trade on nonpublic information, however, some portion of the information’s value will be impounded into the price before it is learned by market professionals, which will reduce their returns (Haddock and Macey, 1987).
Circumstantial evidence for Haddock and Macey’s thesis is provided by SEC enforcement patterns. The frequency of insider trading prosecutions rose dramatically after the US Supreme Court’s decision in Chiarella v. U.S., 445 U.S. 222 (1980), which held that insider trading is only unlawful if the trader violated a fiduciary duty owed to the party with whom he trades. Strikingly, however, in the years immediately prior to Chiarella, enforcement proceedings often targeted market professionals. After Chiarella, market professionals were rarely charged (Dooley, 1995, pp. 832-834).
C. The Argument for Regulation
Efficiency-based arguments for regulating insider trading (as opposed to those grounded on legislative intent, equity, or fairness) fall into three main categories: (1) insider trading harms investors and thus undermines investor confidence in the securities markets; (2) insider trading harms the issuer of the affected securities; and (3) insider trading amounts to theft of property belonging to the corporation and therefore should be prohibited even in the absence of harm to investors or the firm. This section considers these arguments seriatim.
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13. Does Insider Trading Injure Investors?
Insider trading is said to harm the investor in two principal ways. Some contend that the investor’s trades are made at the ‘wrong price’. A more sophisticated theory posits that the investor is induced to make a bad purchase or sale. Neither argument proves convincing on close examination.
An investor who trades in a security contemporaneously with insiders having access to material nonpublic information likely will allege injury in that he sold at the wrong price; that is, a price that does not reflect the undisclosed information. If a firm’s stock currently sells at $10 per share, but after disclosure of the new information will sell at $15, a shareholder who sells at the current price thus will claim a $5 loss. The investor’s claim, however, is fundamentally flawed. It is purely fortuitous that an insider was on the other side of the transaction. The gain corresponding to shareholder’s ‘loss’ is reaped not just by inside traders, but by all contemporaneous purchasers whether they had access to the undisclosed information or not (Bainbridge, 1986, p. 59).