In today's WSJ, George Mason economics professor Donald Boudreaux proposed that we ought to be "learning to love insider trading":
Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets. The result is prices that lie.Nope. Insider trading simply does not have the effects Boudreaux ascribes to it. In my book, Securities Law: Insider Trading (Turning Point Series), I explain that:
And when prices lie, market participants are misled into behaving in ways that harm not only themselves but also the economy writ large. ...
In short, overall economic efficiency is reduced.
It's in the public interest, therefore, that prices adjust as quickly and as completely as possible to underlying economic realities—that prices adjust to convey to market participants as clearly as possible the true state of those realities.
As argued forcefully by Henry Manne in his 1966 book "Insider Trading and the Stock Market," prohibitions on insider trading prevent asset prices from adjusting in this way. Mr. Manne, dean emeritus at George Mason University School of Law, pointed out that when insiders trade on their nonpublic, nonproprietary information, they cause asset prices to reflect that information sooner than otherwise and therefore prompt other market participants to make better decisions.
Basic economic theory tells us that the value of a share of stock is simply the present discounted value of the stream of dividends that will be paid on the stock in the future. Because the future is uncertain, however, the amount of future dividends, if any, cannot be known. In an efficient capital market, a security’s current price thus is simply the consensus guess of investors as to the issuing corporation’s future prospects. 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. Because the market cannot value nonpublic information and because corporations (or outsiders) frequently possess material information that has not been made public, however, market prices often deviate from the “correct” price. Indeed, if it were not for this sort of mispricing, insider trading would not be profitable.
No one seriously disputes that both firms and society benefit from accurate pricing of securities. 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 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 U.S. 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 withholds material information, its securities are no longer accurately priced by the market. In Texas Gulf Sulphur, when the ore deposit was discovered, TGS common stock sold for approximately eighteen dollars per share. By the time the discovery was disclosed, four months later, the price had risen to over thirty-one dollars per share. One month after disclosure, the stock was selling for approximately fifty-eight dollars per share. The difficulty, of course, is that TGS had gone to considerable expense to identify potential areas for mineral exploration and to conduct the initial search. Suppose TGS was required to disclose the ore strike as soon as the initial assay results came back. What would have happened? Landowners would have demanded a higher price for the mineral rights. Worse yet, competitors could have come into the area and bid against TGS for the mineral rights. In economic terms, these competitors would “free ride” on TGS’s efforts. TGS will not earn a profit on the ore deposit until it has extracted enough ore to pay for its exploration costs. Because competitors will not have to incur any of the search costs TGS had incurred to find the ore deposit, they will have a higher profit margin on any ore extracted. In turn, that will allow them to outbid TGS for the mineral rights. A securities law rule requiring immediate disclosure of the ore deposit (or any similar proprietary information) would discourage innovation and discovery by permitting this sort of free riding behavior—rational firms would not try to develop new mines if they knew competitors will be able to free ride on their efforts. In order to encourage innovation, the securities laws therefore generally permit corporations to delay disclosure of this sort of information for some period of time. As we have seen, however, the trade-off mandated by this policy is one of less accurate securities prices.
Manne essentially argued that 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 fifty dollars per share. The firm has discovered new information that, if publicly disclosed, would cause the stock to sell at sixty dollars. If insiders trade on this information, the price of the stock will gradually rise toward the correct price. Absent insider trading or leaks, the stock’s price will remain at fifty dollars until the information is publicly disclosed and then rapidly rise to the correct price of sixty dollars. 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.
Despite the anecdotal support for Manne’s position provided by Texas Gulf Sulphur and similar cases, empirical evidence on point remains scanty. Early market studies indicated insider trading had an insignificant effect on price in most cases. Subsequent studies suggested the market reacts fairly quickly when insiders buy securities, but the initial price effect is small when insiders sell. These studies are problematic, however, because they relied principally (or solely) on the transactions reports corporate officers, directors, and 10% shareholders are required to file under Section 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. 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 the study in question admittedly made strenuous efforts to avoid any such bias.
Evaluating the efficient pricing thesis requires a brief digression into efficient capital market theory. Along with the portfolio theory and the theory of the firm, the efficient capital markets hypothesis has been one of the three economic theories most influential on corporate and securities law. In brief, the hypothesis asserts that in an efficient market current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never overpriced or under-priced: the current price is an accurate reflection of the market’s consensus as to the commodity’s value. Of course, there is no real world condition like this, but the securities markets are widely believed to be close to this ideal.
The so-called semi-strong form of the hypothesis posits that current prices incorporate all publicly available information. The semi-strong form predicts that prices will change only if the information is new. If the information had been previously leaked, or anticipated, the price will not change. If correct, investors cannot expect to profit from studying available information because the market will have already incorporated the information accurately into the price.
The strong form of the hypothesis holds that prices incorporate all information, whether publicly available or not. The strong form makes no intuitive sense: how can the market, which after all is not some omnipotent supernatural being but simply the aggregate of all investors, value information it does not know. If the strong form were true, moreover, insider trading could not be a profitable trading strategy.
Empirical tests of the hypothesis have generally tended to confirm the semi-strong form, while disproving the strong form. To be sure, the validity of the efficient capital markets hypothesis is still hotly debated in academic circles. It is probably fair to say, however, that most scholars regard it as the best available description of how markets behave.
In an efficient market, how does insider trading affect stock prices? Although Manne’s assertion that insider trading moves stock prices in the “correct” direction—i.e., the direction the stock price would move if the information were announced--seems intuitively plausible, the anonymity of impersonal market transactions makes it far from obvious that insider trading will have any effect on prices. Accordingly, we need to look more closely at the way in which insider trading might work its magic on stock prices.
If you studied price theory in economics, your initial intuition may be that insider trading affects stock prices by changing the demand for the issuing corporation’s stock. Economics tells us that the price of a commodity is set by supply and demand forces. The equilibrium or market clearing price is that at which consumers are willing to buy all of the commodity offered by suppliers. If the supply remains constant, but demand goes up, the equilibrium price rises and vice-versa.
Suppose an insider buys stock on good news. The supply of stock remains constant (assuming the company is not in the midst of a stock offering or repurchase), but demand has increased, so a higher equilibrium price should result. All of which seems perfectly plausible, but for the inconvenient fact that a given security represents only a particular combination of expected return and systematic risk, for which there is a vast number of substitutes. The correct measure for the supply of securities thus 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. Accordingly, the supply/demand effect of a relatively small number of insider trades should not have a significant price effect. Over the portion of the curve observed by individual traders, the demand curve should be flat rather than downward sloping.
Instead, if insider trading is to affect the price of securities it is through 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 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.