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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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To be sure, the investor might not have sold if he had had the same information as the insider, but even so the rules governing insider trading are not the source of his problem. The information asymmetry between insiders and public investors arises out of the federal securities laws’ mandatory disclosure rules, which allow firms to keep some information confidential even if it is material to investor decision making. Unless immediate disclosure of material information is to be required, a step the law has been unwilling to take, there will always be winners and losers in this situation. Irrespective of whether insiders are permitted to inside trade or not, the investor will not have the same access to information as the insider. It makes little sense to claim that the shareholder is injured when his shares are bought by an insider, but not when they are bought by an outsider without access to information. To the extent the selling shareholder is injured, his injury thus is correctly attributed to the rules allowing corporate nondisclosure of material information, not to insider trading.

A more sophisticated argument is that the price effects of insider trading induce shareholders to make poorly advised transactions. In light of the evidence and theory recounted above in Section 6, however, it is doubtful whether insider trading produces the sort of price effects necessary to induce shareholders to trade. While derivatively informed trading can affect price, it functions slowly and sporadically (Gilson and Kraakman, 1984, p. 631). Given the inefficiency of derivatively informed trading, price or volume changes resulting from insider trading will only rarely be of sufficient magnitude to induce investors to trade.

Assuming for the sake of argument that insider trading produces noticeable price effects, however, and further assuming that some investors are misled by 786 Insider Trading 5650 those effects, the inducement argument is further flawed because many transactions would have taken place regardless of the price changes resulting from insider trading. Investors who would have traded irrespective of the presence of insiders in the market benefit from insider trading because they transacted at a price closer to the ‘correct’ price; that is, the price that would prevail if the information were disclosed (Dooley, 1980, pp. 35-36; Manne, 1966b, p. 114). In any case, it is hard to tell how the inducement argument plays out when investors are examined as a class. For any given number who decide to sell because of a price rise, for example, another group of investors may decide to defer a planned sale in anticipation of further increases.

14. Does Insider Trading Undermine Investor Confidence?

In the absence of a credible investor injury story, it is difficult to see why insider trading should undermine investor confidence in the integrity of the securities markets. Instead, any anger investors feel over insider trading appears to arise mainly from envy of the insider’s greater access to information.

The loss of confidence argument is further undercut by the stock market’s performance since the insider trading scandals of the mid-1980s. The enormous publicity given those scandals put all investors on notice that insider trading is a common securities violation. At the same time, however, the years since the scandals have been one of the stock market’s most robust periods. One can but conclude that insider trading does not seriously threaten the confidence of investors in the securities markets.

Macey (1991, p. 44) contends that the experience of other countries confirms this conclusion. For example, Japan only recently began regulating insider trading and its rules are not enforced. The same appears to be true of India. Hong Kong has repealed its insider trading prohibition. Both have vigorous and highly liquid stock markets.

15. Does Insider Trading Injure Issuers?

Unlike tangible property, information can be used by more than one person without necessarily lowering its value. If a manager who has just negotiated a major contract for his employer then trades in his employer’s stock, for example, there is no reason to believe that the managers conduct necessarily lowers the value of the contract to the employer. But while insider trading will not always harm the employer, it may do so in some circumstances.

Specifically, there are four significant potential harms connected with insider 5650 Insider Trading 787 trading that are worth considering. First, insider trading may delay the transmission of information or the taking of corporate action. Second, it may impede corporate plans. Third, it gives managers an incentive to manipulate stock prices. Finally, it may injure the firm’s reputation.

16. Delay

Insider trading becomes a plausible source of injury to the firm if it creates incentives for managers to delay the transmission of information to superiors.

Decision making in any entity requires accurate, timely information. In large, hierarchical organizations, such as publicly traded corporations, information must pass through many levels before reaching senior managers. The more levels, the greater the probability of distortion or delay intrinsic to the system.

This inefficiency can be reduced by downward delegation of decision making authority, but not eliminated. Even with only minimal delay in the upward transmission of information at every level, where the information must pass through many levels before reaching a decision maker, the net delay may be substantial.

If a manager discovers or obtains information (either beneficial or detrimental to the firm), he may delay disclosure of that information to other managers so as to assure himself sufficient time to trade on the basis of that information before the corporation acts upon it. As noted, even if the period of delay by any one manager is brief, the net delay produced by successive trading managers may be substantial (see Haft, 1982, pp. 1053-1060; but see Macey, 1991, pp. 36-37). Unnecessary delay of this sort harms the firm in several ways.

The firm must monitor the manager’s conduct to ensure timely carrying out of his duties. It becomes more likely that outsiders will become aware of the information through snooping or leaks (Easterbrook, 1981). Some outsider may even independently discover and utilize the information before the corporation acts upon it.

Although delay is a plausible source of harm to the issuer, its importance is easily exaggerated. The available empirical evidence scarcely rises above the anecdotal level, but does suggest that measurable delay attributable to insider trading is rare (Dooley, 1980, p. 34). Given the rapidity with which securities transactions can be conducted in modern secondary trading markets, moreover, a manager need at most delay corporate action long enough for a five minute telephone conversation with his stockbroker. Even if the manager wished to cover his tracks by trading through an elaborate network of off-shore shell corporations, very little delay is entailed once the network is up and running.

Delay (either in transmitting information or taking action) also often will be readily detectible by the employer. Finally, and perhaps most importantly, 788 Insider Trading 5650 insider trading may create incentives to release information early just as often as it creates incentives to delay transmission and disclosure of information.

17. Interference with Corporate Plans Trading during the planning stage of an acquisition is the paradigm example of how insider trading may affect corporate plans. If the managers charged with overseeing the acquisition buy shares in the target, the price of the target’s shares may rise, making the takeover more expensive. Price and volume changes caused by their trading also might tip off others to the secret, interfering with the bidder’s plans, as by alerting the target to the need for defensive measures.

The trouble with this argument, of course, is its dependence upon price and volume effects. As the theory and empirical evidence recounted above in Section 6 suggest, price or volume changes resulting from insider trading may raise the marginal cost of corporate plans but will only rarely pose significant obstacles to carrying corporate plans forward.

The risk of premature disclosure poses a more serious threat to corporate plans. The issuer often has just as much interest in when information becomes public as it does in whether the information becomes public. Suppose Target, Inc., enters into merger negotiations with a potential acquirer. Target managers who inside trade on the basis of that information will rarely need to delay corporate action in order to effect their purchases. Having made their purchases, however, the managers now have an incentive to cause disclosure of Target’s plans as soon as possible. Absent leaks or other forms of derivatively informed trading, the merger will have no price effect until it is disclosed to the market, at which time there usually is a strong positive effect.

Once the information is disclosed, the trading managers will be able to reap substantial profits, but until disclosure takes place, they bear a variety of firm-specific and market risks. The deal, the stock market, or both may collapse at any time. Early disclosure enables the managers to minimize those risks by selling out as soon as the price jumps in response to the announcement.

If disclosure is made too early, a variety of adverse consequences may result.

If disclosure triggers competing bids, the initial bidder may withdraw from the bidding or demand protection in the form of costly lock-ups and other exclusivity provisions. Alternatively, if disclosure does not trigger competing bids, the initial bidder may conclude that it overbid and lower its offer accordingly. In addition, early disclosure brings the deal to the attention of regulators and plaintiffs’ lawyers sooner than necessary.

An even worse case scenario is suggested by the classic insider trading case, SEC v. Texas Gulf Sulphur Co. In TGS, insiders who knew of a major ore 5650 Insider Trading 789 discovery traded over an extended period of time. During that period the corporation was attempting to buy up the mineral rights to the affected land.

Had the news leaked prematurely, the issuer at least would have had to pay much higher fees for the mineral rights, and may well have lost some land to competitors. Given the magnitude of the strike, which eventually resulted in a 300-plus percent increase in the firm’s market value, the harm that would have resulted from premature disclosure was immense.

Although insider trading probably only rarely causes the firm to lose opportunities, it may create incentives for management to alter firm plans in less drastic ways to increase the likelihood and magnitude of trading profits.

For example, trading managers can accelerate receipt of revenue, change depreciation strategy, or alter dividend payments in an attempt to affect share prices and insider returns (Brudney, 1979). Alternatively, the insiders might structure corporate transactions to increase the opportunity for secret-keeping.

Both types of decisions may adversely affect the firm and its shareholders.

Moreover, as Levmore (1982, p. 149) suggests, this incentive may result in allocative inefficiency by encouraging overinvestment in those industries or activities that generate opportunities for insider trading.

Easterbrook (1981, p. 332) identifies a related perverse incentive created by insider trading. Managers may elect to follow policies that increase fluctuations in the price of the firm’s stock. ‘They may select riskier projects than the shareholders would prefer, because if the risks pay off they can capture a portion of the gains in insider tradings and, if the project flops, the shareholders bear the loss.’ In contrast, Carlton and Fischel (1983, pp.

874-876) assert that Easterbrook overstates the incentive to choose high-risk projects. Because managers must work in teams, the ability of one or a few managers to select high-risk projects is severely constrained through monitoring by colleagues. Cooperation by enough managers to pursue such projects to the firm’s detriment is unlikely because a lone whistle-blower is likely to gain more by exposing others than he will by colluding with them.

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