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Insider trading and the public enforcement of private prohibitions: some complications in enforcing simple rules for a complex world

European Journal of Law and Economics volume 52, pages 307–322 (2021)Cite this article

Abstract

Accepting the argument made by Manne, Epstein and others that firms wishing to allow their employees to insider trade should be permitted to do so, this article shows that there is still a crucial role for government in regulating insider trading. In particular, allowing employees to profit by insider trading is a form of employee compensation that, in contradistinction from conventional forms of equity compensation, results in unknowable and effectively unlimited costs to the company. Since providing employee compensation in this form causes the company to lose control of its compensation expense, even if insider trading were legal, virtually every company would rely on conventional forms of employee compensation and prohibit its employees from insider trading. But, pace Manne, Epstein and others, companies lack the means to detect insider trading by their employees, and even when they do catch employees insider trading, companies can impose only mild contractual sanctions, generally not exceeding disgorgement of profits and dismissal. As a result, although an efficient agreement between a company and its employee would prohibit the employee from insider trading, this prohibition cannot be effectively enforced by the company. Government, with its usual law enforcement powers, is better able to detect insider trading and can impose more severe sanctions on violators, including criminal penalties. Government should thus enforce a ban on insider trading in those instances, which will be virtually all instances, in which a company prohibits its employees from insider trading. The efficient solution is thus a hybrid system of private prohibition and public enforcement. Such a system is not unusual but the norm. Employers prohibit employees from embezzling their money and stealing their property, and employees are subject to contractual sanctions and dismissal for violating these prohibitions, but we still need statutes against theft to generate an optimal level of deterrence. This is all the more true when the employee misappropriates information, which is much harder to detect than a theft of money or property.

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Notes

  1. The theoretical argument for such a discount is strong: the added risk faced by outside investors because they will sometimes be trading against better-informed insiders will lead such investors to discount the shares to reflect this risk. (Bainbridge, 2014; Dent, 2013; Mendelsohn, 1969; Wang, 1981). Empirical confirmation is found in Bhattarcharya and Daouk (2002).

  2. Clearly, many intermediate positions are possible, as the firm could allow some employees but not others to insider trade, could limit the amount or timing of such trading, and so on. Such complications do not affect the main arguments presented here.

  3. The single-owner theorem assumes that no one other than the contracting parties is harmed by the relevant transactions, i.e., that there are no externalities. This is plausible in the case of insider trading, though Easterbrook (1985) suggests an argument to the contrary: if some firms prohibited insider trading, investors could not determine which among them effectively enforced the prohibition and which did not, and so investors would discount the shares of all such firms alike.

  4. It is true that, if the insider had refrained from trading, the outside investor from whom he purchased would almost certainly have sold his shares to some other outside investor; if so, the selling outside investor is no worse off because of the insider’s trade. But the outside investor who would have purchased the shares and did not because the insider preempted the trade is worse off because he missed out on the gain the insider makes—unless, that is, that outside investor purchased from yet another outside investor, in which case that other outside investor loses out, and so on indefinitely. The effects of the insider’s trade ripple through the market, making it impossible to say which trades would have occurred had the insider not traded. The insider’s trade preempts some trades and induces others, and exactly which outside investors miss out on the profit of m dollars per share on the x shares involved cannot be determined (Wang, 1981). Nevertheless, some outside investors must miss out on this profit, for the shares the insider purchased would have been owned by some outside investor or other had the insider not purchased them.

  5. Manne (1966) is aware of the argument but equivocates, sometimes seemingly denying the conclusion and sometimes seemingly conceding but minimizing it. Thus, “[t]he insider’s gain is not made at the expense of anyone. The occasionally voiced objection to insider trading—that someone must be losing the specific money the insider trader makes—is not true in any relevant sense” (61); “no significant injury to corporate investors can result” from insider trading (180); and “the odds against [sic, of] any long-term investor’s being hurt by an insider trading on undisclosed information is [sic, are] almost infinitesimally small” (110) (all emphases added). Anderson (2015), who would legalize insider trading, concedes that insider trading makes outside investors worse off but argues, in effect, that the reduction in wealth they experience is damnum absque iniuria.

  6. As discussed below, however, since the amount of the expense could not be reasonably estimated, it could not in fact be recognized as an expense under GAAP. Clearly, this is a grave disadvantage of insider-trading profits as a form of employee compensation as compared to, say, stock options.

  7. Compare how an uncompensated taking amounts to a tax, which ought to be borne by all taxpayers proportionately, being imposed entirely on the affected property owner (Epstein, 1985).

  8. The argument is not fanciful. Even in a world where insider trading is illegal, the defendant in Chiarella v. United States was a junior employee at a financial printer, and the defendant in SEC v. Musella was an office manager at an elite law firm. When the author was practicing law with another such firm, an individual posed as a car service driver in hopes of overhearing attorneys discussing MNPI.

  9. Manne’s only argument for this is that “eventually the office boy’s Cadillac will show up in the company parking lot” (Manne, 1966). Insider traders are rarely such fools.

  10. E.g., in SEC v. Afriye, the defendant traded through an account opened in the name of his mother. In In the Matter of Carl D. Johns, the defendant concealed his trades by altering brokerage statements and trade confirmations submitted to his employer and by falsely certifying that he had complied with the employer’s policies on insider trading.

  11. Charles Martin, a managing director at Vigilant Compliance, reports that “many trading cases, not only include having non-reported brokerage accounts, but trading through spouses and other familial relationships to conceal trading on MNPI” (email dated October 29, 2020, on file with the author).

  12. Liu and Walsh (2015), a comprehensive handbook widely used by compliance professionals, never mentions requiring employees to disclose their tax returns. Charles Martin, the managing director at Vigilant Compliance mentioned in note 11 above, reports he has never heard of a company imposing such a requirement.

  13. Reports of suspicious activity from financial institutions involved in placing trades and from whistleblowers also figure prominently in the current enforcement regime (Austin, 2015).

  14. Epstein (1995, 2016) notes that companies routinely disclose MNPI to their lawyers and bankers on the understanding that they will not trade on it, and he argues that this shows that contractual prohibitions could equally restrain employees from insider trading. This argument assumes, implausibly, that the threat of jail time plays no role in deterring lawyers and bankers from insider trading. In fact, one purpose of the contractual restrictions Epstein mentions is to make lawyers and bankers subject to the insider-trading laws under the misappropriation theory of insider trading. See United States v. O’Hagan and Rule 10b-5(2).

  15. Afriye, mentioned in note 10, was sentenced to 45 months in prison, O’Hagan to 41 months. The plumber and the investment banker in McClatchey each served several months.

  16. This result might even be possible under current law. As is well known, the federal securities laws include no express ban on insider trading. Rather, such trading is said to violate §10(b) of the Exchange Act, which prohibits, in connection with the purchase or sale of any security, the use of “any manipulative or deceptive device or contrivance in contravention of such rules” as the SEC may prescribe, and Rule 10b-5, which implements this section and prohibits, in connection with the purchase or sale of any security, “any device, scheme, or artifice to defraud” as well as “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.” Both classical insider trading, in which the offender trades securities of the company of which he is an insider, and misappropriation insider trading, in which the offender trades securities of one entity on the basis of MNPI entrusted to him by another person or entity, are said to violate Rule 10b-5 on the theory that using information entrusted to one for a corporate purpose to make a profit for one’s own account is fraudulent or deceitful. As Epstein (2016) and others have observed, this conclusion is strained. Such conduct violates an agent’s fiduciary duty to his principal, but a fiduciary breach is not a fraud. Much less is a breach of contract a fraud, even when the beached upon party is unaware of the breach. More to the point, if an employer expressly agrees that an employee may trade on the employer’s MNPI and the employer publicly discloses this agreement, then it is quite impossible to argue that the employee’s trades have defrauded or deceived anyone. Those trades should be beyond the scope of Rule 10b-5, which means that the employer could effectively opt out of the legal prohibition on insider trading. The SEC would surely oppose such a result, however, and how courts would rule on the matter is difficult to say.

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Statutes and Regulations

  • Economic Espionage Act of 1996, 18 U.S.C. §1831-§1839.

  • Securities Exchange Act of 1934, §10(b), 15 U.S.C. §78j(b).

  • Securities Exchange Act of 1934, §21(d), 15 U.S.C. §78u(b).

  • Securities Exchange Act of 1934, §32, 15 U.S.C. §78ff.

  • Rule 10b-5, 17 CFR § 240.10b5.

  • Rule 10b-5(2), 17 CFR § 240.10b5-2.

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  1. University of Iowa College of Law, Iowa City, IA, 55242, USA

    Robert T. Miller

  2. Classical Liberal Institute, New York University Law School, New York, NY, 10012, USA

    Robert T. Miller

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Miller, R.T. Insider trading and the public enforcement of private prohibitions: some complications in enforcing simple rules for a complex world. Eur J Law Econ 52, 307–322 (2021). https://doi.org/10.1007/s10657-021-09700-x

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Keywords

  • Insider trading
  • Employment
  • Employee compensation
  • Agency costs
  • Monitoring costs
  • Enforcement costs

JEL Classification

  • G14
  • K22
  • M50
  • M52