Do Investors Really Think the Playing Field is Level?

BLPB asks:

Would you invest in the stock of publicly traded companies if you knew that every time insiders became aware of market-moving information they would first trade on it themselves, then share it with their quid-pro-quo "friends" who would then also proceed to trade on it, and only then release the information publicly?  Sure, by the time you sold (assuming it's bad news) your stock could well be very accurately priced--but how much consolation is that?  And even if a bunch of really smart people could present you with some nifty arguments about how you're actually not hurt (heck, you're actually better off) by allowing this sort of activity--are you really rushing off to pay to play this sort of game?  How much of a discount is sufficient to make this sort of playing field level for you?

To which I would answer: If you're an investor who thinks that the playing field is level today, with draconian insider trading penalties and massive enforcement efforts, you are too stupid to be allowed to go out in public let alone put money in the stock market.

Look, any investor with the common sense God gave gravel knows that insider trading is rampant. Not every trade, of course, but you are regularly going to be on the opposite side of an insider with better knowledge. Despite this certainty, investors continue to invest eagerly.

As I have argued elsewhere:

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. As Bainbridge (1995, p.1241-42) observes, 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. If any investors believe that the SEC’s enforcement actions drove insider trading out of the markets, they are beyond mere legal help. 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.

Comments

[Stephen Gregg]

I have cited your arguments, which I find very persuasive, to my Bus Orgs prof. This spring semester I am taking Securities Regulations with him. He is one of the editors of the BLPB. He is a great guy, a great prof, and very reasonable.

[KG]

It could be that the (at least illusion of) SEC enforcement of insider trading laws helps spur confidence in the markets. Additionally, in the 1990s, with the advent of internet trading, many more people got into the market than would have otherwise been in the market, so there may be alternate causes of the market growth (and one can legitimately argue that those who entered the fray in the 1990s via e-trade and scottrade and the rest probably should not have been in the market to begin with). I would suspect that insider trading is a lower risk for institutional investors (mutual funds, money market accounts, etc) or even for those who rely primarily on stockbrokers (fiduciaries) to make trades for them. But for people making trades on their own, I think a decent argument can be made that insider trading laws make sense, in the same way that consumer protection laws make sense - if there is not at least an illusion of fairness in the market, capitalism fails, and I don't think there are many out there who are going to like the alternatives.