In an earlier post, I mentioned that James Cox has a new paper on the famous Texas Gulf Sulphur decision, in which he explores various rationales for regulating insider trading that can be discerned from the factual background of the opinion (as opposed to the legal analysis in the opinion, which I have demonstrated elsewhere is completely bogus, as the court hopelessly misrepresented the precedents on which it relied). One concerned delayed disclosure, which I discussed in a prior post. The other one he advances is potential interference with corporate plans:
The employee defendants in TGS did not reveal to Timmins landowners their secret knowledge of K-55-1. Nonetheless, their trading and tipping posed the same risks to TGS’s ability to exploit its discovery. It is reasonable to fear that trading, certainly as massive as was carried out by the TGS defendants, could have alerted markets and TGS competitors of on-going material, secret developments at the firm. If this surmise is plausible, then ... proscription of the agent’s threatening conduct would be a reasonable prophylaxis.
I agree that interference with corporate plans is a legitimate concern, as I explained in my insider trading text. But I don't think it is a particularly strong argument for a federal prohibition of insider trading under the securities laws.
Trading during the planning stage of an acquisition is a classic example of how insider trading might adversely interfere with corporate plans. If managers charged with overseeing an acquisition buy shares in the target, and their trading has a significant up-ward effect on the price of the target’s stock, the takeover will be more expensive. If their trading causes significant price and volume changes, that also might tip off others to the secret, interfering with the bidder’s plans, as by alerting the target to the need for defensive measures.
The risk of premature disclosure poses an even more serious threat to corporate plans. The issuer often has just as much interest in when information becomes public as it does in whether the information becomes public. Suppose Target, Inc., enters into merger negotiations with a potential acquirer. Target managers who inside trade on the basis of that information will rarely need to delay corporate action in order to effect their purchases. Having made their purchases, however, the managers now have an incentive to cause disclosure of Target’s plans as soon as possible. Absent leaks or other forms of derivatively informed trading, the merger will have no price effect until it is disclosed to the market, at which time there usually is a strong positive effect. Once the information is disclosed, the trading managers will be able to reap substantial profits, but until disclosure takes place, they bear a variety of firm-specific and market risks. The deal, the stock market, or both may collapse at any time. Early disclosure enables the managers to minimize those risks by selling out as soon as the price jumps in response to the announcement.
If disclosure is made too early, a variety of adverse consequences may result. If disclosure triggers competing bids, the initial bidder may withdraw from the bidding or demand protection in the form of costly lock-ups and other exclusivity provisions. Alternatively, if disclosure does not trigger competing bids, the initial bidder may conclude that it overbid and lower its offer accordingly. In addition, early disclosure brings the deal to the attention of regulators and plaintiffs’ lawyers earlier than necessary.
An even worse case scenario is suggested by SEC v. Texas Gulf Sulphur Co. Recall that insiders who knew of the ore discovery traded over an extended period of time. During that period the corporation was attempting to buy up the mineral rights to the affected land. If the news had leaked prematurely, the issuer at least would have had to pay much higher fees for the mineral rights, and may well have lost some land to competitors. Given the magnitude of the strike, which eventually resulted in a 300–plus percent increase in the firm’s market price, the harm that would have resulted from premature disclosure was immense.
Although insider trading probably only rarely causes the firm to lose opportunities, it may create incentives for management to alter firm plans in less drastic ways to increase the likelihood and magnitude of trading profits. For example, trading managers can accelerate receipt of revenue, change depreciation strategy, or alter dividend payments in an attempt to affect share prices and insider returns. Alternatively, the insiders might structure corporate transactions to increase the opportunity for secret keeping. Both types of decisions may adversely affect the firm and its shareholders. Moreover, this incentive may result in allocative inefficiency by encouraging overinvestment in those industries or activities that generate opportunities for insider trading.
Judge Frank Easterbrook has identified a related perverse incentive created by insider trading. Managers may elect to follow policies that increase fluctuations in the price of the firm’s stock. They may select riskier projects than the shareholders would prefer, because, if the risks pay off, they can capture a portion of the gains in insider trading and, if the project flops, the shareholders bear the loss. In contrast, Professors Carlton and Fischel assert that Easterbrook overstates the incentive to choose high-risk projects. Because managers must work in teams, the ability of one or a few managers to select high-risk projects is severely constrained through monitoring by colleagues. Cooperation by enough managers to pursue such projects to the firm’s detriment is unlikely because a lone whistle-blower is likely to gain more by exposing others than he will by colluding with them. Further, Carlton and Fischel argue managers have strong incentives to maximize the value of their services to the firm. Therefore, they are unlikely to risk lowering that value for short-term gain by adopting policies detrimental to long-term firm profitability. Finally, Carlton and Fischel alternatively argue that even if insider trading creates incentives for management to choose high-risk projects, these incentives are not necessarily harmful. Such incentives would act as a counterweight to the inherent risk aversion that otherwise encourages managers to select lower risk projects than shareholders would prefer. Allowing insider trading may encourage management to select negative net present value investments, however, not only because shareholders bear the full risk of failure, but also because failure presents management with an opportunity for profit through short-selling. As a result, shareholders might prefer other incentive schemes.
But what does all of this have to do with the policies underlying securities regulation? The risk that insiders may interfere with corporate plans to facilitate their trading is more a matter of state fiduciary duty law than federal securities law.
