Megan McArdle ventures into insider trading policy and goes seriously awry:
The ostensible reason for insider trading bans is that they maintain retail investor faith in the market, by keeping them from getting rooked by unscrupulous dealings. Believe it or not, there are some arguments against this logic, but assume it's correct. ...
I know, I know . . . INSIDER TRADING!!!! WE ALL KNOW IT'S VERY BAD!!! But to the extent it's bad, it's bad because it lets the sophisticated and connected take advantage of the innocent.
Nope. I deal with this issue at some considerable length in my book Securities Law: Insider Trading
Does Insider Trading Injure Investors?
Insider trading is said to harm the investor in two principal ways. Some contend that the investor’s trades are made at the “wrong price.” A more sophisticated theory posits that the investor is induced to make a bad purchase or sale. Neither argument proves convincing on close examination.
An investor who trades in a security contemporaneously with insiders having access to material nonpublic information likely will allege injury in that he sold at the wrong price; i.e., a price that does not reflect the undisclosed information. If a firm’s stock currently sells at $10 per share, but after disclosure of the new information will sell at $15, a shareholder who sells at the current price thus will claim a $5 loss. The investor’s claim, however, is fundamentally flawed. It is purely fortuitous that an insider was on the other side of the transaction. The gain corresponding to shareholder’s “loss” is reaped not just by inside traders, but by all contemporaneous purchasers whether they had access to the undisclosed information or not. Bainbridge (1986, p.59) .
To be sure, the investor might not have sold if he had had the same information as the insider, but even so the rules governing insider trading are not the source of his problem. The information asymmetry between insiders and public investors arises out of the federal securities laws’ mandatory disclosure rules, which allow firms to keep some information confidential even if it is material to investor decisionmaking. Unless immediate disclosure of material information is to be required, a step the law has been unwilling to take, there will always be winners and losers in this situation. Irrespective of whether insiders are permitted to inside trade or not, the investor will not have the same access to information as the insider. It makes little sense to claim that the shareholder is injured when his shares are bought by an insider, but not when they are bought by an outsider without access to information. To the extent the selling shareholder is injured, his injury thus is correctly attributed to the rules allowing corporate nondisclosure of material in-formation, not to insider trading.
A more sophisticated argument is that the price effects of insider trading induce shareholders to make poorly advised transactions. In light of the evidence and theory recounted above in Section 6, however, it is doubtful whether insider trading produces the sort of price effects necessary to induce shareholders to trade. While derivatively informed trading can affect price, it functions slowly and sporadically. Gilson and Kraakman (1984, p.631) . Given the inefficiency of derivatively informed trading, price or volume changes resulting from insider trading will only rarely be of sufficient magnitude to induce investors to trade.
Assuming for the sake of argument that insider trading produces noticeable price effects, however, and further assuming that some investors are misled by those effects, the inducement argument is further flawed because many transactions would have taken place regardless of the price changes resulting from insider trading. Investors who would have traded irrespective of the presence of insiders in the market benefit from insider trading because they transacted at a price closer to the “correct” price; i.e., the price that would prevail if the information were disclosed. Dooley (1980, p.35-36) ; Manne (1966b, p.114) . In any case, it is hard to tell how the inducement argument plays out when investors are examined as a class. For any given number who decide to sell because of a price rise, for example, another group of investors may decide to defer a planned sale in anticipation of further increases.
Does Insider Trading Undermine Investor Confidence?
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.
- BAINBRIDGE, Stephen M., “The Insider Trading Prohibition: A Legal and Economic Enigma,” 38 University of Florida Law Review 35-68 (1986).
- BAINBRIDGE, Stephen M., “Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition,” 52 Washington & Lee Law Review 1189-1269 (1995).
- DOOLEY, Michael P., “Enforcement of Insider Trading Restrictions,” 66 Virginia Law Review 1-89 (1980).
- MACEY, Jonathan R., “Insider Trading: Economics, Politics, Policy’ (American Enterprise Institute Press 1991).
- MANNE, Henry G., “In Defense of Insider Trading,” 44 Harvard Business Review, Nov./Dec., 1966b, 113-122.
