Why the insider trading prohibition is mandatory rather than just a default rule

A while back, I received the following email from a fellow corporate law professor:

Steve: I'm teaching insider trading to my corporations class today. I use your casebook, and I just read through your Insider Trading book. I like your summary of the property rights rationale for insider trading regulation, and I'm with you 100% right up to the end. But, if you want to treat insider information as a property right like trade secrets, how do you deal with the fact that insider trading liability is not waivable by the corporation-- i.e., the party with the entitlement?

It seems, following the property rights theory, that inside information should be a right of the corporation in the first instance, but it should be up to the firm after that to decide whether they want to allow insiders to use it (just as firms can, I presume, allow insiders to use trade secrets). Part of the answer here might involve the desirability of federal enforcement of insider trading. But couldn't the information be a property right with federal enforcement? That is, the firm ought to be able to opt-out of enforcement actions. They can't, of course. But doesn't that hurt the property rights theory? Maybe we just have to throw up our hands and go with the public choice explanation at this point (SEC won't allow corps to waive b/c they want to keep enforcing these cases)?

It's a great question. I answered with an excerpt from my article "Insider Trading under the Restatement of the Law Governing Lawyers," 19 Journal of Corporation Law 1 (1993). In this article I argued (1) that the rule of legal ethics actually authorize insider trading (I know that sounds nuts, I was surprised too when I realized it) and (2) that the rules should be changed to forbid lawyers from using confidential client information to make inside trading profits. In the excerpt that follows, I deal with the question of whether the prohibition should be a default rule that the client and lawyer are free to change or a mandatory rule. I conclude that it should be a mandatory rule (albeit somewhat tentatively, I must admit).

Because most property rights are freely alienable, our treatment of confidential client information as a species of property suggests that the client is entitled to decide whether its lawyer may make personal use of that information. On the other hand, not all property rights are alienable. Whether the prohibition should be cast as an alienable or an inalienable property right thus remains open to question.

Another way of phrasing the question is to ask whether the prohibition of insider trading should be a default or a mandatory rule. Default rules in corporate law are analogous to alienable property rights. Just as shareholders generally are protected by the doctrine of limited liability unless they give a personal guarantee of the corporation's debts, patentholders have exclusive rights to their inventions unless they authorize another's use by granting a license. Continuing the analogy, mandatory rules in corporate law are comparable to inalienable property rights. Just as corporate law proscribes vote buying, the law prohibits one from selling one's vote in a presidential election.

So phrased, the insider trading problem becomes a subset of one of the fiercest debates in the corporate law academy; namely, the extent to which mandatory rules are appropriate in corporate law. While a detailed analysis of this debate is beyond this Article's scope, a few words on the subject seem appropriate. Generally speaking, default rules are preferable. As we have seen, so long as the default rule is properly chosen, most parties will be spared the need to reach a private agreement on the issue in question. Default rules in this sense provide cost savings comparable to those provided by standard form contracts, because both can be accepted without the need for costly negotiation. At the same time, however, because the default rule can be modified by contrary agreement, idiosyncratic parties wishing a different rule can be accommodated. Given these advantages, a fairly compelling case ought to be required before we impose a mandatory rule.

In general, like virtually all federal securities laws, the insider trading prohibition is mandatory in nature. Whatever the merits of that approach as a general matter, its extension to insider trading by lawyers turns out to be a relatively close question. On balance, however, a mandatory rule seems preferable.

In the first instance, society obtains no direct benefit when lawyers inside trade. Proponents of deregulating insider trading argue that doing so would make the stock markets more efficient, because insider trading would move stock prices towards their correct levels. Even if true, this argument would not suffice if insider trading generates costs elsewhere in the system that offset the gains in market efficiency. In any case, however, both theory and empirical evidence indicate that legalizing insider trading would not substantially improve market efficiency.

Allowing parties to opt out of the prohibition may provide indirect social benefits if doing so allows private parties to maximize the gains available from transacting. Any gains to be had from using a default rule, however, are likely to be quite small. The parties' incentives plus the high transaction costs they face suggest that few will find it worthwhile to bargain out of the general rule. To be sure, as long as anyone prefers opting out, a mandatory rule imposes costs on them. Those costs, however, may be justifiable.

Assume there are two groups of clients. One group believes the magnitude of the risks posed by insider trading is large enough, even if the probability of harm is small, to justify proscribing insider trading by its lawyers. Accordingly, this group is willing to pay higher fees to lawyers who promise not to inside trade. The other group is willing to allow insider trading by its lawyers, so long as they can also pay lower legal fees. An unscrupulous lawyer will try to maximize his income by working for clients in the first group while secretly trading on inside information. Clients in the first group will be aware of this phenomenon, but the high enforcement costs associated with insider trading make it almost impossible for them to distinguish between honest and dishonest lawyers. A prohibition of insider trading enforced by public law enforcement agencies makes these clients better off, but makes the second group worse off. If one believes that most clients fall into the first group, however, a prohibition of insider trading would be efficient so long as one is willing to use the Kaldor-Hicks definition of efficiency. A transaction is Kaldor-Hicks efficient if it makes at least one person better off and that person could compensate anyone who is made worse off. If the first group of clients could compensate the second for any losses a prohibition causes them, and still be better off, the prohibition thus is Kaldor-Hicks efficient.

A mandatory rule also may be Kaldor-Hicks efficient when viewed from the lawyer's perspective. Assume there are two groups of lawyers: one wishes to promise to refrain from insider trading and to provide a credible bond for that promise; the other does not. A mandatory rule backed up by public enforcement and the threat of both criminal and civil sanctions makes the latter group worse off, but makes the former group better off by making their bond much more credible. Again, the question is whether the aggregate gains to the first group are large enough that they could compensate the second and still be better off.

Whether a mandatory prohibition is Kaldor-Hicks efficient either from the client's or the lawyer's perspective is yet another empirical question in search of an answer. For the reasons discussed above, however, I suspect that almost all clients and most lawyers in fact fall into the first groups. A mandatory rule is thus likely to be Kaldor-Hicks efficient.

Even if it could be demonstrated that allowing insider trading by lawyers is not Kaldor-Hicks efficient, however, a mandatory rule might still be justifiable. Consider that the types of property deemed inalienable often involve deeply-held, albeit somewhat fuzzy notions of fairness. In these areas, society often forbids demonstrably efficient transactions. Given the widely shared distaste for insider trading, it seems likely that society would insist upon a mandatory prohibition even if using a default rule is unarguably more efficient. To be sure, some may argue that legal rules should reflect the predicted behavior of rational economic actors, not irrational fairness arguments. But this is an example of what Professor Demsetz referred to as the "if only people were different" fallacy. As Demsetz pointed out, tastes must be incorporated into the concept of efficiency. If investors have a taste for prohibiting insider trading, it thus does no good to say that the world would be a more efficient place if insider trading were allowed.