Insider trading is something we hear a lot about these days. To most people, the practice smells of foul play, and federal law restricts it. But the inside story of insider trading is something very different, as we shall see. The alleged ill effects on shareholders in particular and on the economy in general are mostly illusory, and in fact insider trading produces benefits that are little understood.
If I may first indulge in a little personal history: I was once a corporate insider. Two friends and I started an engineering services firm in 1982, and we set it up as a corporation. The paperwork required to register the corporation was minimal, but the law allowed us to offer shares only to specially qualified individuals, in addition to ourselves and our employees. Actually this rule wasn’t binding on us. We didn’t want to be answerable to strangers so the only “outsiders” we sold to were a couple of relatives, whom we later bought out.
Most Silicon Valley firms like ours aim to “go public” at some point—that is, sell shares to the general public to raise additional capital and reward early investors. We had no such ambition. We did not want to jump through all the hoops required in an initial public offering, nor did we want the continuing hassle of running a public corporation. (Since that time hassles have been multiplied by Sarbanes-Oxley.) However, we might have benefited from something short of a full public offering, where we would have offered shares to a wider but still limited set of shareholders.
Yet SEC rules allow only a very restricted offering or a full public offering, and nothing in between.
What if we had gone public? The law would have restricted our ability to trade our own shares for reasons roughly as follows: Insider trading would violate our fiduciary responsibility to our shareholders. As managers of a public corporation we would have placed ourselves under a board of directors answerable to shareholders. Our job would be to watch out for shareholder interests, not subordinate them to our own private gain.
There is some truth in these arguments. Shareholders can never be totally sure that management is looking out for their interests. Corporate regulations and employment contracts can do a lot to minimize these “agency problems,” as they are called, but perfection is not possible. Purchasers of shares should be aware of the risks they take and act accordingly. But none of this justifies insider-trading restrictions.
Before we delve into insider trading, a little about prices generally and stock prices in particular. Unhampered prices play a vital but little-understood role in transmitting information. Short-term fluctuations aside, stock prices convey investors’ aggregate judgment about the earning potential of corporations. If some significant event occurs that would impact that potential, price changes rapidly spread the news that something is up. But “rapidly” does not mean “instantly,” even in the Internet era. Someone is necessarily first to hear and understand the news, and that person or group can reap gains unavailable to those not in the know. The second wave of traders to find out would gain a little less, and so forth. Is there something unfair about gains and losses due to unequal information? Not if we want the price system to do its job. As gravity keeps water moving downhill, information disparities provide profit opportunities that motivate the trades, which keep information flowing. Indeed, anyone who buys or sells shares (except perhaps someone who sells in order to use the proceeds for consumption) does so because he believes he has information that is not widely known and therefore not adequately reflected in the current price.
Consequences of Restriction
What happens when insiders are not allowed to trade on an important piece of news? That news will get out eventually, and the first people to find out about it will be outsiders just beyond the gates. These will very likely be securities analysts, whose full-time job is to keep abreast of developments in public companies. So they, the firms they work for, and their clients would be the first to benefit from the news. The news will eventually reach most shareholders, but later than it would otherwise. Instead of early profits accruing to insiders, they will accrue to professionals, and this makes no difference to most shareholders, especially long-term shareholders.
During a time when the dissemination of significant news about a company is blocked by insider-trading restrictions, that company’s shares are mispriced relative to where the price would be if the news were out. If the news is bad investors will buy at prices they would not have paid had they heard the news. Movement of capital toward more productive uses is inhibited. If it is good some sellers will let go of their shares at prices they would not have accepted had they heard. Movement of capital toward such firms is inhibited. In either case there is a net loss to the economy.
Insider trading might have averted the Enron debacle. Enron’s managers were using a complex web of partnerships to keep losses off the books. Several insiders must have had at least partial knowledge of these shenanigans. They would have had substantial incentive to dump their shares or even sell short had the rules permitted it. They might have blown the cover on Enron a lot sooner.
In summary, insider-trading regulations benefit securities professionals, harm insiders, misallocate capital, and have no substantial effect on small long-term shareholders. They may occasionally block the revelation of corporate misdeeds. They do increase the power and budget of the Securities and Exchange Commission bureaucracy, which enforces the rules.
Qui Est In, Qui Est Out
Insider trading is restricted but not entirely forbidden. Just what constitutes the “bad” kind of insider trading? This is generally understood to be trading on information originating within a company that could have a material effect on the share price had it been publicly known. The law applies not only to insiders—employees and directors—but also to any outsiders to whom inside information is disclosed.
As precise as this definition may sound, it rests on some very shaky concepts. First, the source of a particular piece of information isn’t always clear. Second, how is materiality established? Suppose a firm is expected to win a particular contract and an insider learns that it has been lost. If the contract amounts to 1 percent of a firm’s annual revenue, is that material? Ten percent? And how is a defendant supposed to establish that a particular fact was “widely known” at some particular time?
We see that insider-trading regulations are subjective and arbitrary, rivaling antitrust laws in this respect. It is no wonder that Congress never defined insider trading and that the SEC resisted defining it for many years; the courts have had to make up the rules as cases arose. Every so often someone like Martha Stewart is thrown to the lions, drawing cheers from the jealous and spreading fear to successful and therefore high-profile managers.
Vagueness and subjectivity make insider trading well-nigh impossible to police. Difficult as it is to decide whether a particular transaction violated the rules, it is impossible to police nontrading. What if an insider had planned to sell but, having heard inside good news, decides to hold instead? Insider gains from such inaction could be very real but impossible to detect or punish.
Alternatives to Government Regulation
Shareholders who object to insider trading are usually thought to have no alternative but government regulation. That’s just not so. Insider trading could be prohibited or restricted by corporate bylaw provisions. Outside auditors would monitor management behavior, and suspected violations would be referred to arbitrators. It might seem inefficient for small shareholders to expend the time and energy necessary to get together and pursue possible corporate violations. But following David Friedman’s innovative ideas on law and economics, we can imagine shareholders selling in advance their rights to recover damages from possible future violations. Specialists could acquire these rights and pursue violations efficiently. Corporate management would be well aware of the watchful eyes of these specialists.
There are several classes of restrictions that might be added to bylaws. A blanket prohibition of insider trading would be unlikely to be adopted because, as we have seen, it could hamper the dissemination of important information. More important, blanket prohibition would likely be frowned on by most market participants, making it more difficult for the corporation to raise new equity or debt capital and thereby suppressing share prices to the detriment of shareholders big and small. In addition, by depriving insiders of profit opportunities from trading, blanket prohibition would make it more difficult to recruit the best managers.
But there are times when secrecy does serve the shareholders, such as during a takeover bid. Managers of a corporation accruing shares of a takeover target would not want that news to get out prematurely, because if it did, outsiders could bid up the target shares. Just as employees are bound to protect corporate trade secrets, they could be contractually obligated to keep sensitive matters like takeover information secret.
Another possible bylaw provision would merely require disclosure of insider trading. While this would help get information out faster, it might also discourage insiders and hamper recruitment. Short sales (sales of borrowed stock in anticipation of a price decline) might also be forbidden, likely with mixed results.
Only a free-market trial could show what works and what doesn’t. Any vagueness or inconsistencies in the rules that are tried would become evident and would be discarded or cleaned up. While we can’t be sure what would evolve, it does seem likely that some limited restrictions would emerge. Independent agencies could confer ratings on the restrictive practices of particular corporations, and management would be keen on earning a four-star rating.
In summary, insider trading is not the problem it is made out to be. Freely adopted bylaw provisions that impose selective restraints would be superior to arbitrary one-size-fits-all regulations imposed by a politicized bureaucracy. This idea is just one example of a wider argument in favor of contract law over government law. The free market allows for discovery of the best ways to inhibit and punish undesirable behavior—ways politicians and bureaucrats never could discover.
[Editor’s note: this essay first appeared in the Freeman on Dec 20 2010]