Rebirth of Reason


On Insider Trading
by Merlin Jetton

Is insider trading right or wrong? The minority opinion is that there is nothing wrong with it, so it should be legal. People holding the minority opinion tend to be those who advocate free enterprise and individual rights. For example, the Cato Institute and The Atlas Society have articles favoring the legalization of insider trading. Capitalism.org is pro-insider trading.

While I also advocate free enterprise and individual rights, insider trading is one issue on which I agree with the majority. That is, I agree with the conclusion, not necessarily why. The most common criticism of insider trading is that it is unfair, but those who say it is unfair are often vague about to whom it is unfair. I will try to be clearer. Else the charge is misdirected. Some say it is unfair simply if the buyer and seller have unequal information, the one with insider information presumably having more, especially material information the other party doesn't have. However, that is not my argument.

This is a complicated topic. For brevity I will not explain what "insider trading", "material nonpublic information", "tippees", "misappropriation", "mosaic", etc. mean. There are many other easy-to-find places a reader can learn more about them.

I will focus on the usual instrument, common stocks. Stocks are property of its owners. A corporation relies on the use of shareholder money/investment to conduct its business. Officers, employees, and board members have a major responsibility to do their best for the corporation and hence the shareholders. I believe fulfilling said responsibility requires keeping outside shareholders well-, timely-, and equally-informed. Similar to "equality before the law", my principle is "equality before the corporation." All outside shareholders should have equal opportunity to get material information from insiders and act upon it at the same time. For insiders to selectively favor some shareholders (even non-shareholders) over other shareholders in getting such material information is a diminution of property rights of the shareholders who don't get the same information, or at least have the opportunity to get it. How is it moral for an insider to selectively convey material information to some shareholders (even non-shareholders) but not others? All shares carry equal rights -- to vote, receive dividends, and receive financial reports such as quarterly earnings. Inside shareholders and other favored shareholders do not pay more for their shares to justify such privileges as receiving more information, getting it sooner, or receiving higher dividends per share.

I recommend those who believe insider trading should be completely legal imagine what common stock investing would be like if it were so. It would be absurd for a corporation to admonish, restrict or penalize its own employees/officers/board members for using material nonpublic information. It would be absurd to try to restrict those on a government payroll to not take advantage of material nonpublic information such as legislation-to-be or a future announcement about whether or not a drug will be approved or disapproved by the Food & Drug Administration.

Some Arguments Made by Advocates of Legalizing Insider Trading

This section will address some arguments such people have made in favor of legalization or against the opposite position.

Argument #1: A ban on insider trading delays the release of relevant information about publicly traded companies. This means slower adjustment of stock prices to relevant information, which inhibits rather than promotes market efficiency.

This seems to me to confound "delayed" or "sooner" with "slower". With a ban and reliable, highly public information conveyed by authorized spokespersons, adjustment could be quite rapid. It just might be a little later without leaks. With a ban the material information is leaked slowly and isn't dispersed as quickly as when made by such authorized spokespersons.

Secondly, I would like to know how this alleged efficiency occurs. Suppose somebody with material nonpublic information decides to sell corporation X stock and buy corporation Y stock, presumably Y being more efficient than X. The trade does not move capital from X to Y. The only time X or Y gets more or less capital in the form of stock is when it issues new shares or does a stock buyback. So the second sentence of the argument seems to be a non sequitur.

Thirdly, no ban might cause less efficiency in some cases. Imagine corporation X desires to acquire corporation Y, and a successful acquisition would bring greater efficiency. Typically company X would need to offer a price 30-40% higher than corporation Y's current share price in order to acquire enough shares for the offer to succeed. If material nonpublic information about the intended acquisition is leaked well before corporation X can complete its due diligence and actually make the tender offer, the price of Y's shares may rise so quickly that the acquisition no longer makes economic sense. Without a tender offer from X, there is no substantial guidance to what Y's stock price is or should be as an acquisition target.

Lastly, with no ban, anyone could claim to have "inside info". Imagine all the rumors and consequent fact-checking required. Would that increase market efficiency?

Argument #2: Under a ban, some insiders break the law and trade on inside information anyway, whether by tipping off family and friends, trading related stocks, or otherwise. Thus, bans reward dishonest insiders who break the law and put law-abiding insiders at a competitive disadvantage.

With no ban, dishonest rumor makers would be encouraged. Imagine how many investment newsletter writers would claim to have "inside information" and hype their services even more than they do now (this also applies to argument #1).

Argument #3: Some people have more investment knowledge than others anyway. So why ban insider trading to try to make their knowledge more equal?

It is not simply a matter of how knowledgeable the parties are, but of the opportunities to knowledge made by the corporation. Here is a baseball analogy. Clearly Albert Pujols and Ryan Braun are more capable hitters than a "good field - no hit" reserve infielder. But should the umpire also favor Albert Pujols and Ryan Braun by effectively shrinking the strike zone when they bat but not when said reserve infielder bats? What is moral about a corporation selectively giving material information to somebody such as Martha Stewart or Raj Rajaratnam (even non-shareholders) without telling other shareholders? For those who contend it is okay for a corporation to treat its shareholders unequally, how far does that go? Would it be fair to pay unequal dividends per share, too?
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