The Economics of Insider Trading: A Free Market Perspective

Abstract

We deny that asymmetrical information is a market failure. In order to make this case, we subject to critical scrutiny the strongest case for this thesis: the view that laws prohibiting insider trading are viable, necessary, or compatible with the rule of law.

Introduction

Insider trading regulations prohibit officers and other leaders of a corporation from buying or selling their company’s stock without prior disclosure of any material nonpublic information. Yet the securities industry is the only market where transactions based on unequally distributed information are considered to be so unfair and inequitable that they need be eliminated by regulation (consider other markets with asymmetrical information such as real estate, labor, commodities, etc.). Despite the numerous advantages of insider trading, including improved market price stability, increased transparency, earlier fraud detection, and efficient incentive compensation for employees, regulations have evolved on the false premise that insider trading undermines investor confidence in the fairness and integrity of the securities markets. Prior to the emergence of these federal regulations, early common law, publicly traded corporations, and stock exchanges all permitted insider trading because it does not violate the rights of non-inside investors. Furthermore, the market consequences of these regulations have proved costly, unwieldy, arbitrary, and ineffective. These laws should be repealed so that the market pricing mechanism and the entrepreneurial incentives of insider trading may prosper in a free market environment.

In “Background” section of this paper, we offer some background about our subject matter. In “SEC Justification” section is devoted to considering, and then rejecting, the defense of their position of the Securities and Exchange Commission (SEC). The burden of “Harmful to Investors” section is to analyze the claim that this practice is harmful to investors. We discuss delay and manipulation in “Delay, Manipulation” section; ask who benefits from insider trading regulations in “Who Benefits from Insider Trading Regulations?” section; address the issue of improved price stability in “Improved Price Stability” section; entrepreneurial compensation in “Entrepreneurial Compensation” section and the ineffectiveness of regulation in “The Ineffectiveness of Regulation” section. We conclude in “Conclusion” section.

Background

Before S.E.C. vs. Texas Gulf Sulphur (2nd Cir. 1968), the Securities Acts of 1933–1934 had evolved from “passively requiring full disclosure” to involving “corporate governance, accounting takeovers, investment banking, financial analysis, corporate counsel, and, not least, insider trading” (Manne 2003). Yet, in these proceedings Congress refused an early draft of the Securities and Exchange Act that contained a provision outlawing insider trading, perhaps because it would have covered members of their own branch of government. Insider trading not only remained legal, but “very common, well-known, and generally accepted” (Manne 2003). By 1961, the SEC created a new rule governing this practice: Rule 10b-5. Rule 10b-5 stipulated insiders have a duty to disclose material nonpublic information they possess before trading, or if they cannot make such disclosure, to abstain from engaging in such commercial interactions (Securities and Exchange Commission 2000). In 1968 the Second Circuit upheld Rule 10b-5 (SEC v. Texas Gulf Sulphur Co. 1968). Rule 10b-5 has since evolved into “…a judicial oak which has grown from little more than a legislative acorn,” as Supreme Court Justice William Rehnquist described it (Blue Chip Stamps v. Manor Drug Stores 1975). Courts and the SEC now use Rule 10b-5 broadly, as if it were a legislative statute, to enforce insider trading regulations.

SEC Justification

The SEC’s preferred justification for insider trading regulation is that it will cause a loss in market confidence (Levitt 1998). Some argue that the presence of insider trading deters potential investors, making equity markets less liquid (Loss 1970). As Manne puts it:

“I do not consider the SEC’s ‘official’ line on insider trading, that it destroys the confidence of investors and thus lessens both liquidity and investment, to have serious merit. Apart from being a nearly unfalsifiable proposition, it is devoid of the scantest economic or empirical content” (Manne 2006).

Another argument is that insider trading harms market liquidity by increasing transaction costs. The reason is that market makers would increase their bid-ask spread to compensate for losses (Bagehot 1971). This is known as the “adverse selection” argument, and even if it is theoretically plausible, it has been shown to be irrelevant in the real world, as there is strong evidence that insider trading is not a real concern for market participants (Dolgopolov 2004). Liquidity providers themselves simply are not concerned about insider trading. Regardless, as Stephen Bainbridge puts it:

“If any investors believe that the SEC’s enforcement actions have driven insider trading out of the markets… they require psychiatric rather than legal assistance. Nevertheless, the stock market remains robust” (Bainbridge 2006).

But let us accept, arguendo, this SEC claim. That is, we now posit for argument’s sake that insider trading really does reduce market confidence and increases transactions costs. Why should such stipulated facts justify a ban on the practice? After all, there are other phenomena that decrease the assurance investors have in markets. For example, free trade. The more countries newly brought into world markets, the more susceptible are they likely to be due to a host of causes of volatility: weather, wars, politics, elections, etc. Another case in point is innovation. Markets will surely be more volatile and thus risky if new inventions are allowed. Should we therefore prohibit all technological progress? Perish the thought! Then, there are movies and novels that undermine business, profits, markets, etc. Ban them too? And the same holds with regard to transactions costs. They are hardly the only relevant considerations. Suppose something brings about greater health, longer life, more pleasure, and reduces the costs of labor and raw materials, but also boosts transactions costs. Are we to rule such a phenomena out of court solely on that basis? Not if economic rationality has anything to say about the matter.Footnote 1

The SEC further argues that this type of trading is a violation of fiduciary duties by insiders (Wilgus 1910). However, prior to insider trading regulations publicly traded corporations did not chose to prohibit insider trading by its managers and employees in an effort to attract investors. In the event insider trading is deregulated, and if it is considered to be a violation of fiduciary duties, corporations will be pressured by their investors to prohibit insider trading by employees. As McGee and Block note: “(Fiduciary duties) do not pertain to all businessmen, but only to those who have voluntarily taken them upon themselves. And it is simply not true that the inside trader, merely in virtue of this status, has shouldered any obligations of this sort that do not pertain to us all” (Block and McGee 1992 , 2004).

What of the possible argument that to breach fiduciary responsibility must by nature involve fraud. McGee and Block further debunk this fallacy: “… in the perpetuation of this crime, the seller must lie about the product, or deceive the buyer in some manner or other. The stock market, however, is extremely impersonal. It is thus all but impossible for the vendor to swindle the purchaser. Far from being able to commit a hoax on the outsider, the insider does not even confront him face to face, or indeed have any other direct dealings with him” (Block and McGee 1992 , 2004).

Insider trading does not breach fiduciary responsibility. Furthermore, corporations, investors, and employees are free (and always have been) to enter into voluntary contracts whereby insider trading could be considered a violation of contract. Similar contracts exist prohibiting the sharing of trade secrets, and they are effective. The argument that insider trading necessarily breaches fiduciary responsibility cannot be sustained.

Harmful to Investors

Insider trading regulations are typically justified under the premise that such commercial interactions are unfair and inequitable. Proponents argue that when an investor trades with an insider possessing material nonpublic information he suffers in that the former buys or sells at the wrong price—one that does not reflect the undisclosed information. Manne has disproved this point; the practice of insider trading does no such harm to long-term investors (Manne 1966). This is because insider trading drives the price of a stock in the correct direction (Lin and Rozeff 1995 ; Meulbroek 1992).

The concept that insider trading improves the price accuracy of securities is generally accepted. The Texas Gulf Sulphur case provides a perfect example. On November 13, 1963, Texas Gulf Sulphur Co. (TGS) officers learned that the company had potentially struck a rich vein of ore, and over the next several months the company purchased surrounding land in the area. Meanwhile, insiders bought TGS stock and options. The company and its officers were within their legal rights to withhold the discovery from investors; it would have been extremely unwise to have released the information until it had finished purchasing land surrounding the find. However, the significant purchases by insiders and the sharp price rise had indicated to entrepreneurs that something was up. By March of 1964, rumors had spread throughout the market. By mid-April, when the company officials felt sure they could accurately indicate the extent of the discovery, shares of TGS had appreciated from ≈ $18 in November to ≈ $31. At that point, they reported it to the public. A month after disclosure TGS was selling for $58. Manne demonstrated that the insiders knew the shares were worth more than $18, so they purchased them, subsequently raising the price closer to its “real” value- $58. The insider trading prior to the April release did not hurt “outside” investors. If anything, even if they did not know why, those who sold the stock after the November discovery, but prior to the release of information were compensated more for their shares because of the insider’s purchases. Meanwhile, new investors who were speculating on rumors had to compensate the original investors more in order to benefit. If the insiders had not traded on their closely held information, the price would have presumably remained close to $18, and those outsiders who sold before the April release would not have been compensated at all despite having owned the shares when the discovery was made. Furthermore, the price would have risen even more dramatically in April, from approximately $18 to $58, supporting the hypothesis that insider trading improves price stability and accuracy. This process is known as “derivatively informed trading” (Gilson and Kraakman 1984).

“Derivatively informed trading affects market prices through a two step mechanism. 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 leaks, tipping of information, or observation of insider trades. Other traders gain insight by following the price fluctuations of the securities. Gradually these processes amplify the effect of the insiders’ trades. Absent of insider trading and the resulting derivatively informed trading, the stock price presumably would have remained in the (reduced) vicinity until the discovery was publicly disclosed and then rapidly risen to the correct price… thus the insider trading acted 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. In addition…it did so without injuring investors” (Bainbridge 2006).

Not only is insider trading a victimless crime, but also outside investors actually benefit because of the effects of derivatively informed trading. Furthermore, they are aided from improved price stability and thus improved confidence and reduced risk.

But, let us again resort to our contrary to fact conditional argument. Suppose the very opposite of the case, that is, posit that those not in the know actually are harmed by insider trading. Does this demonstrate that economic welfare would be improved by such regulations? No, of course not. We are all harmed every minute, no, every second, that the market process takes place. Jones purchases a loaf of bread. He thereby (very slightly) raises the price of this foodstuff to levels higher than otherwise would have obtained. He adds his demand for bread to that which already existed, and thus boosts prices for this commodity. In so doing, he hurts all other actual and would-be purchasers. Thanks to Jones, everyone else must pay more for this staple. Or, Smith sells some cows, thus reducing their price. All other owners of bovines lose out from this reduced terms of trade. Will an SEC prohibition of the economic acts of Smith and Jones enhance economic welfare? To think so is to opine that all market activity is injurious, and ought to be stopped in its tracks. This reductio ad absurdum leads directly to socialism.

Delay, Manipulation

Critics of insider trading have also claimed that deregulation would result in managers delaying the transmission of information to superiors. However, this objection falls seriously short of coherence. Manne argues that given the rapidity with which securities transactions can be conducted in modern secondary trading markets, these delays are likely to be trivial. Even if managers do delay the transmission of information to superiors, this would pale in comparison to the effects of current regulations; inside information is not transmitted to the public until weeks, if not months after it has occurred. Furthermore, as soon as the manager does act by trading in the market (or by not trading) the resulting change in volume or price serves as a pricing signal to non-inside investors.

Insider trading critics also argue that if managers are permitted to trade on insider information they have a strong incentive to manipulate the stock price in the correct direction while they are trading. Yet this argument fails to explain why executives would not still be incentivized to continue doing this even under current SEC regulations. This reality is clearly illustrated by the Enron scandal; insider trading regulations made it no less tempting for Enron executives to manipulate their books to their advantage.

There is a serious difficulty with all arguments revolving around the failure of the market to attain completely accurate pricing. It is the “Nirvana” fallacy. The point is, it is only in general equilibrium, toward which the market is always tending, but never reaching, that prices are “accurate” reflections of costs and values. To even contemplate this, apart from being a theoretical construct, is economically misbegotten. But that is precisely the fallacy of which the Nirvana-ists are guilty: maintaining that but for inside trading, the market would reach this bliss point; and that regulation will bring us there. Never in a million years; never in a billion.

Who Benefits from Insider Trading Regulations?

As we have seen, the justifications for the regulation of insider trading are vague, incomplete and fallacious. They have been refuted, over and over again, including in the present article. Why, then, do we have these laws on the books? One way to answer such questions is to enquire into qui bono: who profits from them?

Our claim is that this is due to that fact insider trading regulations tend to benefit elite investors (Haddock and Macey 1987). These market professionals who specialize in acquiring such knowledge and analyzing it, are ‘next in line’ to benefit from the knowledge of this information, behind insiders themselves. This constitutes one of the many ill side effects of these laws; elite investors have an advantage over their lesser competitors. Material, nonpublic information is not revealed until the company publicly discloses it in the form of a press release, market professions specialize in predicting this information purely because of its significant effect on the price of the security in question. Absent insider trading, prices of securities drift away from that of the correct price (the price it would be given perfect information and free market equilibrium) as the most recent press release becomes more irrelevant and outdated. Once the new information is released the price of the security changes significantly as high frequency traders and elite investors respond more quickly than average investors. This constitutes a clear advantage for investment banks, hedge funds, and other institutional investors and a demonstrable disadvantage for others.

Regulation also benefits regulators (Bainbridge 2002). For this reason these bureaucrats not only vehemently argue for the necessity of insider trading regulations but organizations such as the SEC frequently make efforts to extend the scope of their powers. For this reason the SEC often justifies its mandate on false premises while completely ignoring devastating critiques (Levitt 1998).

Improved Price Stability

While it is virtually undisputed that insider trading improves price stability and provides for the more efficient allocation of capital, the benefits of the former are often overlooked. When taking into consideration the market pricing mechanism’s power to promote social coordination, it becomes evident that increased price accuracy in securities markets due to deregulated insider trading would prove beneficial to the investment world. Since Manne published Insider Trading and the Stock Market in (Manne 1966) a vast amount of empirical research has confirmed the idea that insider trading improves security price accuracy. The only significant arguments are with regard to the extent and timeliness of the elasticity of the price effect (Lin and Rozeff 1995). Other empirical research has gone further in arguing that insider trading is a “noisy” device for communicating the accurate stock value (Cox 1986). Furthermore, research experiments suggest that inside information is rapidly assimilated into markets and that this may occur even with very few insiders participating in the market (Friedman et al., 1984). There is practically no disagreement that insider trading, whether legal or illegal, drives the prices of securities toward a more accurate valuation.

Meanwhile, instability caused by insider trading regulation also gives incentives to investors to speculate on the results of earnings reports rather than investigate the underlying value of the security. When inside information reaches markets through SEC regulated financial statements the results typically cause the price of securities to fluctuate rapidly as the market disseminates and reacts to the information. If insiders were trading on the information the price would not fluctuate as rapidly as the information would already be incorporated into the price. These rapid price fluctuations give elite investors capable of accurate prediction the advantage of being able to exploit the price changes without having to commit capital to the security over a long period of time. Meanwhile, long-term investors who either cannot predict the results of the reports as accurately or who are risk adverse and uninterested in speculating on the results, are at a disadvantage. Once again, while it is not the case that speculation is “bad,” regulations that encourage speculation and put long-term investors at a disadvantage should not be seen as protecting investors. Insider trading regulations distort the prices of securities.

Entrepreneurial Compensation

Perhaps the most controversial issue is whether insider trading is an efficient way to pay managers for their entrepreneurial innovations and other types of discoveries. It is hardly disputed that this practice would provide a monetary incentive to employees to innovate, search for, and produce valuable information. Furthermore, it encourages managers and executives to take increased risks that could potentially add to the firm’s value (Carlton and Fischel 1983). This type of incentive is especially important in a modern day economy where much of the innovation and progress taking place is within the walls of large corporations. Employees who are innovators have the ability of benefiting from their additional efforts and ideas by sharing in the profits of the company for which they work. The existence of bonuses and stock options as a form of incentive-based compensation are evidence that companies are frequently looking for ways to motivate their employees to be more entrepreneurial.

Furthermore, compensation in the form of insider trading is cheap for long-term shareholders because it does not come from corporate profits (Hu and Noe 1997). This means that if insider trading were deregulated companies could, at their option, foster entrepreneurship and innovation without even having to commit any capital. If insiders are allowed to trade on information privy to them, corporations may even be able to pay managers less because they have insider opportunities (Hebner and Kato 1997). This not only benefits shareholders, managers, and employees but also indirectly enhances the entire economy; innovation leads to increased productivity and an increase in the standard of living for everyone, including the poor (Smith 1776/2001).

Consider the following numerical example. A mining company has a choice in the contract it offers its helicopter pilot—geologist. It can pay him a low salary, say $70,000 per year, and allow him to use any information he garners while searching for resources, in a limited way. Or, it may offer him much greater remuneration, for example $250,000 per year, along with a contract that strictly prohibits his personal use of any knowledge of resource location that comes his way. Are both these contracts compatible with the ethic (Rothbard 1982) of the free enterprise system? Of course they are: neither violates the non-aggression principle of libertarianism (Rothbard 1982). Which is the correct decision on this controversial issue? We cannot say,Footnote 2 as this is an entrepreneurial issue, not one of economic principle, the context of this present paper.

Critics of insider trading as a form of executive and employee compensation argue that it merely rewards access to information rather than its production. However, what they fail to recognize is that only those entrepreneurs who produce materially beneficial innovations and products are able to know the value of their contributions. Furthermore, insiders are already capable of enjoying the rewards of their co-workers’ success by investing in their company. The difference is that deregulated insider trading would allow for entrepreneurs specifically to reap the rewards of their actions.

Furthermore, it is argued that insider trading may encourage managers to disclose information prematurely (Bainbridge 2002). This argument fails to recognize a number of aspects of a deregulated market with insider trading. As Michel Dooley explained:

“Manne’s principle argument was that insider trading was primarily a matter of contract between the corporation and its officers and directors. The parties might or might not agree to the use of confidential information as a form of compensation. … Taking its cue from state corporation law, the (SEC should) have realized that the common law has always adopted a hands-off approach with regard to the amount of explicit compensation paid to corporate executives. However, the agency has always taken a strict stance against hidden forms of implicit compensation and required divestiture of corporate opportunities, disgorgement of profits made from unauthorized use of corporate property and the like. This arrangement of rules-lenient with regard to explicit compensation and strict with regard to secret compensation-is eminently sensible.”Footnote 3

In other words, publicly traded corporations would be responsible for handling the premature disclosure of information just as they already self-regulate many of their corporate secrets.

Further, critics of this type of trading argue that insiders would delay the dissemination of information while simultaneously maintaining insiders would disclose prematurely (Bainbridge 2002 ; Schotland 1967 ; Haft 1982). More likely, as suggested by empirical evidence, inside information is rapidly assimilated into markets even with only a few participants (Friedman et al., 1984). This indicates that insiders lack the ability to delay the dissemination of information beyond the level of which they are already capable (via the contract between employers and employees). Thus, they can hardly benefit from its premature disclosure. Regardless, this hardly constitutes a valid argument for the expensive and necessarily arbitraryFootnote 4 enforcement of insider trading regulations.

Another argument is that insider trading only provides efficient compensation to those capable of purchasing a significant number of shares. Basically, it only really rewards those managers who are already wealthy (Thurber 1994). While it is true that those lacking the capital to purchase shares will not be able to share in the benefits of insider trading, this hardly constitutes an argument against the practice. While some insiders will benefit from having more wealth than others this is hardly due to the nature of insider trading itself, and more from the fact that economic inequalities tend to exist in a capitalist society.Footnote 5 This does not change the fact that insider trading provides motivation to these managers and employees and simultaneously does not harm non-insiders nor anyone else.

The Ineffectiveness of Regulation

Much of the empirical evidence regarding the effectiveness of insider trading regulations suggests that it is still very common. Behavior of stock prices before and after public announcements of important material information point to the fact that insider trading is still prevalent (Morgenson 2012). Yet relatively infrequent prosecution rates suggest that the SEC is not even catching it. 87 countries worldwide have insider trading laws, but enforcement has only taken place in 36 of them (Bhattacharya and Daouk 2002 ; Bris 2005). As noted in the New York Times:

“Indeed, the S.E.C. filed roughly 60 insider trading cases in its 2011 fiscal year alone. But…many involved minor players and small sums. Of the 93 people charged during that period, 37 had pocketed less than $100,000 on their inside trades, according to the S.E.C.; 19 made $50,000 or less; and one netted just $8,391. Lewis D. Lowenfels, an expert in securities laws in New York, says the S.E.C. is wasting time and money by going after small fish” (Morgenson 2012).

Meanwhile, evidence shows that disclosed trading profits by corporate insiders generally yield abnormal profits (Pettit and Venkatesh 1995). Furthermore, the SEC itself admits that insider trading is more common now than ever (Levitt 1998).

The cost of enforcing insider trading regulations is also very high. Empirical research suggests that insider trading regulations raise the cost of equity by as much as 5 % (Bhattacharya and Daouk 2002 ; Bris 2005). This is due to the costs corporations incur by adhering to insider trading regulations. In addition, taxpayer money funds the SEC’s ineffective operation. This constitutes a serious misallocation of capital; this money could potentially be much better spent simply preventing and uncovering traditional fraud much like the recent Madoff scandal. Better yet, return these monies to the long-suffering taxpayer and allow private certification agencies to deal with the Madoffs of the world. End the SEC!

Conclusion

SEC regulations of insider trading lack material justification; insider trading is not unfair or inequitable. Furthermore, the market effects of such regulations are undesirable and are unfair and inequitable to average traders, insiders and non-insiders. Moreover, they are ineffective and costly. Meanwhile, the benefits of insider trading, including efficient market valuation, price stability, fraud detection, and entrepreneurial compensation are important aspects of a healthy functioning capitalist economy that should be permitted to occur.

Notes

  1. 1.

    Ronald Coase has done yeoman work in bringing transactions costs to our attention, see Coase (1960). For a severe critique of overemphasizing the importance of these types of costs, see Rothbard (1990).

  2. 2.

    Other than, whichever maximizes profits with a greater likelihood, from the businessman’s point of view.

  3. 3.

    This is a quote from Michael Dooley, quoted in Bainbridge’s introduction to the insider trading volume of Manne’s collective works. Dooley (1999).

  4. 4.

    It is very difficult to determine who knew what when.

  5. 5.

    They also exist under socialism. See Mises (1922).

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Smith, T., Block, W.E. The Economics of Insider Trading: A Free Market Perspective. J Bus Ethics 139, 47–53 (2016). https://doi.org/10.1007/s10551-015-2621-5

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Keywords

  • Insider trading
  • Asymmetrical information
  • Market failure
  • Rule of law

Mathematics Subject Classification

  • D82