The Washington Post recently reported on the considerable attention the SEC and Justice Department are devoting to enforcement of the insider trading laws. Who can forget the recent high profile case against Martha Stewart, which is only the very tip of a large iceberg? Is this a useful expenditure of government resources?
Henry Manne's 1966 book Insider Trading and the Stock Market stunned the SEC and corporate law academy by daring to propose the deregulation of insider trading. Manne argued that insider trading benefits both society and the firm in whose stock the insider traded. First, he argued, insider trading causes the market price of the affected security to move toward the price that the security would command if the inside information were publicly available. If so, both society and the firm benefit through increased price accuracy. Second, he posited insider trading as an efficient way of compensating managers for having produced information. If so, the firm benefits directly (and society indirectly) because managers have a greater incentive to produce additional information of value to the firm.
Although I have tremendous respect for Manne's daring in proposing such provocative arguments, I'm afraid I don't buy either one. As to the first, Manne argued (correctly) that both firms and society benefit from accurate pricing of securities. 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. But while U.S. securities laws purportedly encourage accurate pricing by requiring disclosure of corporate information, they in fact 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.
Manne argued insider trading is an effective compromise between the need for preserving incentives to produce information and the need for maintaining accurate securities prices. Suppose, for example, that 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 but will not reach 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.
The problem with this argument is that insider trading affects stock market prices through what is known as "derivatively informed trading." 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. But 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.
As for Manne's second argument, insider trading in fact appears to be a very inefficient scheme for compensating corporate managers. Even assuming a change in stock price that accurately measures the value of the innovation, the insider's "compensation" from insider trading is limited by the number of shares he can purchase. This, in turn, is limited by his wealth. As such, the insider's trading returns are based, not on the value of his contribution to the corporation, but on his wealth.
Another objection to the compensation argument is the difficulty of restricting trading to those who produced the information. Where information is concerned, production costs normally exceed distribution costs. As such, many firm agents may trade on the information without having contributed to its production.
A related objection is the difficulty of limiting trading to instances in which the insider actually produced valuable information. In particular, why should insiders be permitted to trade on bad news? Allowing managers to profit from inside trading reduces the penalties associated with a project's failure because trading managers can profit whether the project succeeds or fails. If the project fails, the manager can sell his shares before that information becomes public and thus avoid an otherwise certain loss. The manager can go beyond mere loss avoidance into actual profit making by short selling the firm's stock.
In sum, the arguments for deregulating insider trading are not very persuasive. But that doesn't answer the question, why do we regulate insider trading? Efficiency-based arguments for regulating insider trading (as opposed to those grounded on legislative intent, equity, or fairness) fall into three main categories: (1) insider trading harms investors and thus undermines investor confidence in the securities markets; (2) insider trading harms the issuer of the affected securities; and (3) insider trading amounts to theft of property belonging to the corporation and therefore should be prohibited even in the absence of harm to investors or the firm. Only the latter proves very persuasive.
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. There are striking doctrinal parallels, moreover, between insider trading and these other types of property rights in information. Using another's trade secret, for example, is actionable only if taking the trade secret involved a breach of fiduciary duty, misrepresentation, or theft. Likewise, insider trading is only unlawful if the use of the information involves a breach of fiduciary duty by the insider.
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. 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 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, legalizing insider trading likely 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.
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. On close examination, the argument for assigning the property right to the insider is considerably weaker than the argument for assigning it to the corporation. As we have seen, Manne argued that legalized insider trading would be an appropriate compensation scheme. In other words, society might allow insiders to inside trade in order to give them greater incentives to develop new information. As we have also seen, however, this argument founders because insider trading in fact is an inefficient compensation scheme.
The economic theory of property rights in information thus cannot justify assigning the property right to insiders rather than to the corporation. Because there is no avoiding the necessity of assigning the property right to the information in question to one of the relevant parties, the argument for assigning it to the corporation therefore should prevail.
None of this is to say that the precise set of rules the SEC has adopted is ideal. To the contrary, as I detailed in my book on insider trading, there are serious problems with a number of features of the current enforcement regime. As to the basic question of whether we ought to regulate insider trading, however, economic efficiency commands an affirmative answer.
