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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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Further, Carlton and Fischel argue managers have strong incentives to maximize the value of their services to the firm. Therefore they are unlikely to risk lowering that value for short-term gain by adopting policies detrimental to long-term firm profitability. Finally, Carlton and Fischel alternatively argue that even if insider trading creates incentives for management to choose high-risk projects, these incentives are not necessarily harmful. Such incentives would act as a counterweight to the inherent risk aversion that otherwise encourages managers to select lower risk projects than shareholders would prefer.

Carlton and Fischel are correct that shareholders may prefer higher-risk projects. Because shareholders hold residual claims, they will prefer that the firm invest in projects with a significant upside potential. This is true even if 790 Insider Trading 5650 such ventures pose a substantial risk because shareholders earn no return until all prior claims are paid. However, shareholders would not approve high-risk projects where the increased risk is not matched by a commensurate increase in potential return. Allowing insider trading may encourage management to select negative net present value investments, not only because shareholders bear the full risk of failure, but also because failure presents management with an opportunity for profit through short-selling. As a result, shareholders might prefer other incentive schemes.

18. Manipulation

Manipulation of stock prices, as a form of fraud, harms both society and individuals by decreasing the accuracy of pricing by the market. Some of those who favor regulation of insider trading argue that if managers are permitted to trade on inside information they have a strong interest in keeping the stock pricing stable or in moving it in the correct direction while they are trading.

Therefore, they have a strong incentive to use manipulative practices (see, for example, Schotland, 1967, pp. 1449-1450).

Manne (1970, p. 575) acknowledged that manipulation is harmful and that manipulation of stock prices would cease if insider trading could be effectively eliminated because nobody would then benefit from it. Manne’s principal response to the manipulation argument is not that it is wrong, but that the costs of producing perfect compliance with a prohibition against insider trading are unacceptably high. Like most arguments in this debate, the thrust of the manipulation rationale depends on whose estimate of the costs is correct.

19. Injury to Reputation

Suppose that insider trading was shown to harm not the issuer, but the issuer’s shareholders. It has been said that insider trading by corporate managers may ‘cast a cloud on the corporation’s name, injure stockholder relations and undermine public regard for the corporation’s securities’ (Diamond v.

Oreamuno; compare Macey, 1984, pp. 42-43; discussing threat of reputational injury posed for the Wall Street Journal when one of its reporters traded on confidential information. But see Freeman v. Decio, arguing that injury to reputation is ‘speculative’.) Reputational injury of this sort translates into direct financial injury, by raising the firm’s cost of capital, if investors demand a premium (by paying less) when buying stock in a firm whose managers inside trade.

5650 Insider Trading 791 Because shareholder injury is a critical underlying premise of the reputational injury story, however, this argument would appear to collapse at the starting gate. As we have seen, it is very hard to create a plausible shareholder injury story.

As such, the reputational injury story must turn to more generalized notions of fairness. At this stage in the analysis, virtually all commentators make one of two moves. One group tries to find sources of unfairness unrelated to the question of shareholder injury, while the other simply asserts that insider trading is not unfair absent a credible story of investor injury. The former move fails. As Bainbridge (1986, pp. 56-61) argues, insider trading is not unfair to investors in any meaningful sense of the term (see also Easterbrook, 1981, pp.

323-330; Macey, 1991, pp. 23-31).

Some contend that the latter move also fails precisely because most people do not examine the problem dispassionately. Even though insider trading is not actually unfair, the reputational injury story may remain viable if most investors believe it to be unfair. This perception of unfairness most likely proceeds from resentment of the insider’s informational advantage, which suggests that it may be based on envy as much as on fairness norms. As an advertising slogan once put it, however, image is everything. If one’s definition of efficiency takes into account seemingly irrational preferences, perhaps a prohibition of insider trading can be justified as a means of avoiding this sort of reputational injury. Whether efficiency should include such preferences is a question beyond the scope of this essay.

Assuming the validity of the reputational injury story, arguendo, the reputational impact of insider trading probably is minimal in most cases. The principal problem is the difficulty investors have in distinguishing those firms in which insider trading is frequent from those in which it is infrequent. If they are unable to do so, individual firms are unlikely to suffer a serious reputational injury in the absence of a truly major scandal.

20. Insider Trading as Theft: A Property Rights Analysis

There is an emerging consensus that the federal insider trading prohibition is most easily justified as a means of protecting property rights in information (see, for example, U.S. v. Chestman; Bainbridge, 1993, pp. 21-23; Dooley, 1995, pp. 820-823; Easterbrook, 1981; Macey, 1984). For an argument that the property rights approach has explanatory as well as justificatory power, see Bainbridge (1995, pp. 1256-1257). In contrast, for a vociferous critique of the law and economics literature on insider trading generally and the property rights approach in particular, see Karmel (1993).

792 Insider Trading 5650

There are essentially two ways of creating property rights in information:

allow the owner to enter into transactions without disclosing the information or prohibit others from using the information. In effect, the federal insider trading prohibition vests a property right of the latter type in the party to whom the insider trader owes a fiduciary duty to refrain from self-dealing in confidential information. To be sure, at first blush, the insider trading prohibition admittedly does not look very much like most property rights.

Enforcement of the insider trading prohibition admittedly differs rather dramatically from enforcement of, say, trespassing laws. The existence of property rights in a variety of intangibles, including information, however, is well-established. Trademarks, copyrights, and patents are but a few of the better-known examples of this phenomenon. In context, moreover, even the insider trading prohibition’s enforcement mechanisms are not inconsistent with a property rights analysis. Where public policy argues for giving someone a property right, but the costs of enforcing such a right would be excessive, the state often uses its regulatory powers as a substitute for creating private property rights. Insider trading poses just such a situation. Private enforcement of the insider trading laws is rare and usually parasitic on public enforcement proceedings (Dooley, 1980, pp. 15-17). Indeed, the very nature of insider trading arguably makes public regulation essential precisely because private enforcement is almost impossible. The insider trading prohibition’s regulatory nature thus need not preclude a property rights-based analysis.

The rationale for prohibiting insider trading is precisely the same as that for prohibiting patent infringement or theft of trade secrets: protecting the economic incentive to produce socially valuable information. (An alternative approach is to ask whether the parties, if they had bargained over the issue, would have assigned the property right to the corporation or the inside trader.

For a hypothetical bargain-based argument that the property right would be assigned to the corporation in the lawyer-corporate client context, see Bainbridge (1993, pp. 27-34).) As the theory goes, the readily appropriable nature of information makes it difficult for the developer of a new idea to recoup the sunk costs incurred to develop it. If an inventor develops a better mousetrap, for example, he cannot profit on that invention without selling mousetraps and thereby making the new design available to potential competitors. Assuming both the inventor and his competitors incur roughly equivalent marginal costs to produce and market the trap, the competitors will be able to set a market price at which the inventor likely will be unable to earn a return on his sunk costs. Ex post, the rational inventor should ignore his sunk costs and go on producing the improved mousetrap. Ex ante, however, the inventor will anticipate that he will be unable to generate positive returns on his up-front costs and therefore will be deterred 5650 Insider Trading 793 from developing socially valuable information. Accordingly, society provides incentives for inventive activity by using the patent system to give inventors a property right in new ideas. By preventing competitors from appropriating the idea, the patent allows the inventor to charge monopolistic prices for the improved mousetrap, thereby recouping his sunk costs. Trademark, copyright, and trade secret law all are justified on similar grounds.

This argument does not provide as compelling a justification for the insider trading prohibition as it does for the patent system. A property right in information should be created when necessary to prevent conduct by which someone other than the developer of socially valuable information appropriates its value before the developer can recoup his sunk costs. Insider trading, however, often does not affect an idea’s value to the corporation and probably never entirely eliminates its value. Legalizing insider trading thus would have a much smaller impact on the corporation’s incentive to develop new information than would, say, legalizing patent infringement.

The property rights approach nevertheless has considerable justificatory power. Consider the prototypical insider trading transaction, in which an insider trades in his employer’s stock on the basis of information learned solely because of his position with the firm. There is no avoiding the necessity of assigning the property right to either the corporation or the inside trader. A rule allowing insider trading assigns the property right to the insider, while a rule prohibiting insider trading assigns it to the corporation.

From the corporation’s perspective, we have seen that legalizing insider trading would have a relatively small effect on the firm’s incentives to develop new information. In some cases, however, insider trading will harm the corporation’s interests and thus adversely affect its incentives in this regard.

This argues for assigning the property right to the corporation, rather than the insider.

Those who rely on a property rights-based justification for regulating insider trading also observe that creation of a property right with respect to a particular asset typically is not dependent upon there being a measurable loss of value resulting from the asset’s use by someone else. Indeed, creation of a property right is appropriate even if any loss in value is entirely subjective, both because subjective valuations are difficult to measure for purposes of awarding damages and because the possible loss of subjective values presumably would affect the corporation’s incentives to cause its agents to develop new information. As with other property rights, the law therefore should simply assume (although the assumption will sometimes be wrong) that assigning the property right to agent-produced information to the firm maximizes the social incentives for the production of valuable new information.

794 Insider Trading 5650 Because the relative rarity of cases in which harm occurs to the corporation weakens the argument for assigning it the property right, however, the critical issue may be whether one can justify assigning the property right to the insider.

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