Insider Trading and Nontrading
By Richard McKenzie
In late 2019, the House of Representatives passed the Insider Trading Prohibitions Act with the intent of further restricting stock market trading based on nonpublic information, by seeking to clarify what constitutes “insider trading.” In a Wall Street Journal op-ed, Lyle Roberts recently criticized the bill for making the law more confusing ( “The Insider Trading Law is Bad. Will Congress Make It Worse?,” Jan. 10).
Maybe so. My concern is more general, that basic insider trading law maintains the distorting effect of a legal asymmetry that was pointed out years ago by my former colleague (and close friend) at Clemson University, the late Myles Wallace: Corporate officers can’t benefit legally from insider information through trading, but they can gain from nonpublic information through “insider nontrading” (which can be hidden from SEC scrutiny).
To understand the consequences of this non-coverage in the law, consider a Pfizer vice president who goes into a board meeting where she learns that the company has a wonderful, effective, and soon-to-be-released new drug in its development pipeline, Viagra. If Viagra is announced at the meeting and the VP leaves the boardroom to buy a thousand shares of Pfizer stock (with an investment of just over $40,000 at today’s closing price,) she can be dragged into court for insider trading and be fined and given a stiff prison sentence.
Suppose the same VP holds a thousand shares of Pfizer stock that she plans to sell when she has time after the board meeting. But during the meeting, she learns about the release of Viagra and decides not to sell. She has engaged in “insider nontrading,” and gains financially. However, she will have done so with little fear of a court date, understandably, because insider nontrading is not mentioned in insider trading law, mainly because it is very difficult to detect and prosecute. (Imagine the SEC hauling executives into court for not doing something.)
Nevertheless, as Professor Wallace pointed out, this legal asymmetry can have consequences. On an ill-defined hunch that some big product announcement will be made at the next board meeting, suppose our VP loads up on Pfizer stock (buys, say, a million shares) at some appropriately distant time prior to the meeting. If her hunch is realized, she can keep her Pfizer stock, reaping, potentially, a substantial increase in her portfolio’s value. If no announcement is made, she can sell her Pfizer stock, suffering on her “bet” only the cost of two buy/sell brokerage commissions, no more than $10 today.
No one should be surprised if the legal asymmetry causes corporate officers and board members to hold more (or less, depending on their companies’ future prospects) of their companies’ stocks than if both insider trading and nontrading were (or could be) treated the same in the law. Everyone should also be bothered by the potential differential justice meted out to insider nontraders who can enjoy their gains while insider traders are thrown in the slammer for doing the same thing.
In his unstated manner, Myles was a genius at coming up with oddball, simple, but insightful arguments.
Richard McKenzie is an emeritus economics professor in the business school at the University of California, Irvine. His current book project has a working title of The Brain on Economics, which will advance his brain-centric modification of neoclassical economic.
See our archive of McKenzie’s Econlib Articles here.