Don Langevoort has posted a very interesting article on the questions of "how or why did the insider trading prohibition survive the retrenchment that happened to so many other elements of Rule 10b-5?," which is linked and summarized here.
Langevoort goes on to observe that:
The Supreme Court’s strange and intellectually ungainly judicial commitment to assertive insider trading regulation, even by some fairly conservative judges, shows how powerful a totemic symbol the prohibition of insider trading has become in “branding” the American securities markets as supposedly open and fair, and American securities regulation as the investors’ champion. Insider trading regulation had already taken on an expressive value far beyond its economic importance, which judges were reluctant to undercut.
My argument is that the Supreme Court embraced the continuing existence of the “abstain or disclose” rule, and tolerated constructive fraud notwithstanding its new-found commitment to federalism, because it accepted the central premise on which the expressive function of insider trading regulation is based: manifestations of greed and lack of self-restraint among the privileged, especially fiduciaries or those closely related to fiduciaries, threaten to undermine the official identity of the public markets as open and fair. The law effectively grants an entitlement to public traders that the marketplace will not be polluted by those kinds of insiders.
As an explanation of what the Supreme Court might have been thinking when it developed the modern insider trading prohibition, Langevoort's argument has much to commend it.
Assuming he's right about that question, however, it leaves open the question of whether the SCOTUS' policy choice makes any sense. I don't think so. I've tackled this issue in several places, most notably in The Law and Economics of Insider Trading: A Comprehensive Primer (February 2001). Available at SSRN: http://ssrn.com/abstract=261277.
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.
Let me repeat: If any investors believe that the SEC’s enforcement actions drove insider trading out of the markets, they are beyond mere legal help. And, if the Supreme Court believes that investors believe that, the Court needs help.
