By Stanislav Dolgopolov
Insider trading” refers to transactions in a company’s securities, such as stocks or options, by corporate insiders or their associates based on information originating within the firm that would, once publicly disclosed, affect the prices of such securities. Corporate insiders are individuals whose employment with the firm (as executives, directors, or sometimes rank-and-file employees) or whose privileged access to the firm’s internal affairs (as large shareholders, consultants, accountants, lawyers, etc.) gives them valuable information. Famous examples of insider trading include transacting on the advance knowledge of a company’s discovery of a rich mineral ore (Securities and Exchange Commission v. Texas Gulf Sulphur Co.), on a forthcoming cut in dividends by the board of directors (Cady, Roberts & Co.), and on an unanticipated increase in corporate expenses (Diamond v. Oreamuno). Although insider trading typically yields significant profits, these transactions are still risky. Much trading by insiders, though, is due to their need for cash or to balance their portfolios. The above definition of insider trading excludes transactions in a company’s securities made on nonpublic “outside” information, such as the knowledge of forthcoming market-wide or industry developments or of competitors’ strategies and products. Such trading on information originating outside the company is generally not covered by insider trading regulation.
Insider trading is quite different from market manipulation, disclosure of false or misleading information to the market, or direct expropriation of the corporation’s wealth by insiders. It also should be noted that transactions based on unequally distributed information are common and often legal in labor, commodities, and real estate markets, to name a few. Nevertheless, many people still find insider trading in corporate securities objectionable. One objection is that it violates the fiduciary duties that corporate employees, as agents, owe to their principals, the shareholders (Wilgus 1910). A related objection is that, because managers control the production of, disclosure of, and access to inside information, they can transfer wealth from outsiders to themselves in an arbitrary and hidden way (Brudney 1979; Clark 1986). The economic rationale advanced for prohibiting insider trading is that such trading can adversely affect securities markets (Khanna 1997) or decrease the firm’s value (Haft 1982).
Regulation of insider trading began in the United States at the turn of the twentieth century, when judges in several states became willing to rescind corporate insiders’ transactions with uninformed shareholders. One of the earliest (and unsuccessful) federal attempts to regulate insider trading occurred after the 1912–1913 congressional hearings before the Pujo Committee, which concluded that “the scandalous practices of officers and directors in speculating upon inside and advance information as to the action of their corporations may be curtailed if not stopped.” The Securities Acts of 1933–1934, passed by the U.S. Congress in the aftermath of the stock market crash, though aimed primarily at prohibiting fraud and market manipulation, also targeted insider trading. This federal legislation mandated disgorgement of profits made by corporate insiders on round-trip transactions (a purchase and later sale or a sale and later purchase) effected within six months, required disclosure of past inside transactions, and prohibited insiders from selling “borrowed” shares of their companies. However, the Securities Acts did not contain a broad prohibition of insider trading as such.
Broader enforcement of restrictions on insider trading began only in the 1960s, when the U.S. Securities and Exchange Commission (SEC) prosecuted the Cady, Roberts and Texas Gulf Sulphur cases using Rule 10b-5, a catch-all provision against securities fraud. In those and subsequent cases that shaped the evolution of the general insider trading prohibition, the SEC based its justification for regulation on the unfairness of unequal access to information, the violation of fiduciary duties by insiders, and the misappropriation of information as a form of property. The U.S. Congress and the SEC increased penalties for the use of inside information, extended the prohibition into derivatives markets, proscribed selective disclosure of information, and even placed restrictions on the use of certain types of “outside” information, dealing mainly with takeovers pursued by third parties. Nevertheless, federal legislators have never defined insider trading; in the 1980s, the SEC actually opposed efforts to do so. Since the U.S. Supreme Court decided United States v. O’Hagan in 1997, however, the judicial definition of proscribed activities has become fairly clear: it includes trading by corporate insiders and their associates on inside information as well as trading by individuals who misappropriate certain types of “outside” information from third parties.
As of 2004, at least ninety-three countries, the vast majority of nations that possess organized securities markets, had laws regulating insider trading. Several factors explain the rapid emergence of such regulation, particularly during the last twenty years: namely, the growth of the securities industry worldwide, pressures to make national securities markets look more attractive in the eyes of outside investors, and the pressure the SEC exerted on foreign lawmakers and regulators to increase the effectiveness of domestic enforcement by identifying and punishing offenders and their associates operating outside the United States. In some countries, insider trading had been regulated through private means before the arrival of public regulation, as the examples of the United Kingdom’s City Code on Takeovers and Mergers and the German Voluntary Insider Trading Guidelines show. At the same time, the effectiveness of the insider trading prohibition and the commitment to enforcing it have been low in most countries (Bhattacharya and Daouk 2002).
Who benefits from regulation of insider trading? One group of beneficiaries is market professionals—broker-dealers, securities analysts, floor traders, arbitrageurs, and institutional investors. The reason is that they are “next in line” for trading profits, as they possess an advantage over public investors in collecting and analyzing information (Haddock and Macey 1987). Regulation also, of course, benefits the regulators—that is, the SEC—by giving that agency greater power, prestige, and budget (Bainbridge 2002). However, the benefits from insider trading laws to small shareholders, the alleged primary beneficiaries, have been extensively debated.
Henry G. Manne popularized the economic analysis of insider trading (Manne 1966), although a similar book-length attempt by Frank P. Smith is dated a quarter century earlier (Smith 1941). The major public policy questions economists and legal scholars have tried to answer are: How extensive should restrictions on insider trading be and should they be mandatory through the means of public regulation or voluntary by individual companies and securities exchanges? Empirical research has focused on the profitability of insiders’ transactions, the effects of insider trading on securities prices and transaction costs, and the effectiveness of regulation. Such studies have had one common methodological problem: precise data on illegal insider trading, as opposed to disclosed insiders’ transactions, are, by their very nature, not readily available.
Many researchers argue that trading on inside information is a zero-sum game, benefiting insiders at the expense of outsiders. But most outsiders who bought from or sold to insiders would have traded anyway, and possibly at a worse price (Manne 1970). So, for example, if the insider sells stock because he expects the price to fall, the very act of selling may bring the price down to the buyer. In such a case, the buyer who would have bought anyway actually gains. But this does not mean that no one loses because of insider trading, although such losses are likely to be diffuse and not easily traceable (Wang and Steinberg 1996). The outsiders who lose in such a situation are buyers on the margin, who would not have bought unless the insider had sold and brought the price down slightly, and sellers who sold for less or could not sell at all. Consequently, some commentators argue that such systematic diversion of wealth from outsiders to insiders may decrease the share price and raise the corporate cost of capital (Mendelson 1969). However, long-term shareholders, as opposed to those speculating on short-term price movements, are rarely adversely affected by insider trading because the probability is low that such trading would affect the timing of their transactions and the corresponding market price (Manne 1966).
A controversial case is that of abstaining from trading on the basis of inside information (Fried 2003). For example, an insider who had planned to sell stock but abstains on the basis of positive inside information thereby marginally prevents a potential buyer from getting a better deal on the stock. In a sense, the insider’s abstention transfers wealth from the potential buyer to himself, although this does not happen consistently. Yet, it is clearly infeasible to monitor and prosecute insiders for not trading.
There is little disagreement that insider trading makes securities markets more efficient by moving the current market price closer to the future postdisclosure price. In other words, insiders’ transactions, even if they are anonymous, signal future price trends to others and make the current stock price reflect relevant information sooner. Accurately priced stocks give valuable signals to investors and ensure more efficient allocation of capital. The controversial question is whether insider trading is more or less effective than public disclosure. Insider trading’s advantage is that it introduces individual profit motives, does not directly reveal sensitive intercorporate information, and mitigates the management’s aversion to disclosing negative information (Carlton and Fischel 1983; Scott 1980). Insider trading’s potential disadvantage is that it may be a more ambiguous and less reliable signal than disclosure (Cox 1986). Empirical work demonstrates that insider trading does move prices in the correct direction (Meulbroek 1992). Some researchers argue, though, that this additional price accuracy only redistributes wealth instead of making the process of capital allocation more efficient, because insider trading speeds up the process by only a few days or weeks without affecting the long-run attractiveness of a company as an investment (Klock 1994).
Probably the most controversial issue in the economic analysis of insider trading is whether it is an efficient way to pay managers for their entrepreneurial services to the corporation. Some researchers believe that insider trading gives managers a monetary incentive to innovate, search for, and produce valuable information, as well as to take risks that increase the firm’s value (Carlton and Fischel 1983; Manne 1966). Researchers have also pointed out that 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). Their opponents contend that insider trading has some downside incentives and is likely to reward mere access to information rather than its production. The argument is that allowing insider trading may encourage managers to disclose information prematurely (Bainbridge 2002) or delay disclosure in order to arrange stock trades (Schotland 1967), to delay transmitting information to corporate decision makers (Haft 1982), to pursue excessively risky projects that increase trading profits but reduce corporate value (Easterbrook 1981), to increase tolerance for bad corporate performance by allowing insiders to profit on negative developments (Cox 1986), and to determine their compensation unilaterally (Clark 1986). This controversy has not been resolved and is difficult to test empirically.
Another economic argument for insider trading is that it provides efficient compensation to holders of large blocks of stock (Demsetz 1986; Thurber 1994). Such shareholders, who provide valuable corporate monitoring and sometimes cannot diversify their portfolios easily—and thus bear the disproportionate risk of price fluctuations—are compensated by trading on inside information. However, proponents of regulation point out that such an arrangement would allow large shareholders to transfer wealth from smaller shareholders to themselves in an arbitrary fashion and, possibly, provoke conflicts between these two groups (Maug 2002). This concern may explain why the SEC, in 2000, adopted Regulation FD (FD stands for “full disclosure”) banning selective disclosure of information by corporations to large shareholders and securities analysts.
A common contention is that the presence of insider trading decreases public confidence in, and deters many potential investors from, equity markets, making them less liquid (Loss 1970). But the possibility of trading with better-informed insiders would likely cause investors to discount the security’s price for the amount of expected loss rather than refusing to buy the security (Carney 1987). Empirical comparisons across countries do not clearly demonstrate that stricter enforcement of insider trading regulation has directly caused more widespread participation in equities markets. Another argument is that insider trading harms market liquidity by increasing transaction costs. The alleged reason is that market makers—specialized intermediaries who provide liquidity by continuously buying and selling securities, such as NYSE specialists or NASDAQ dealers—consistently lose from trading with insiders and recoup their losses by increasing their bid-ask spread (the differential between buying and selling prices) (Bagehot 1971). Yet, the lack of actual lawsuits by market makers, except in options markets, is strong evidence that insider trading is not a real concern for them. Moreover, econometric attempts to find a relationship between the bid-ask spread and the risk of insider trading have been inconsistent and unreliable (Dolgopolov 2004).
Empirical research generally supports skepticism that regulation of insider trading has been effective in either the United States or internationally, as evidenced by the persistent trading profits of insiders, behavior of stock prices around corporate announcements, and relatively infrequent prosecution rates (Bhattacharya and Daouk 2002; Bris 2005). Even in the United States, disclosed trading by corporate insiders generally yields them abnormal profits (Pettit and Venkatesh 1995). Thus, insider trading regulation may affect the behavior of certain categories of traders, but it does not eliminate profits from trading on private information. The likely explanation for the fact that profits remain is that the regulation shifts insiders’ emphasis from legal to illegal trading, changes insiders’ trading strategies, or transfers profits to market professionals. For these reasons, some scholars doubt the value of such laws to public investors; moreover, enforcement is costly and could be dangerously selective.
Several researchers have proposed that market professionals (notably, securities analysts) be allowed to trade on inside information (Goshen and Parchomovsky 2001). These researchers reason that such professionals enjoy economies of scale and scope in processing firm-specific and external information and are removed from corporate decision making. Therefore, allowing market professionals to trade on inside information would create more liquidity in securities markets and stimulate competition in the acquisition of information. The related argument is that the “outside” search for information is more socially valuable, even if it is occasionally more costly, and that trading by corporate insiders may crowd out securities research on external factors (Khanna 1997). Thus, the proponents of regulation argue that unrestricted insider trading would adversely affect the process of gathering and disseminating information by the securities industry, and this point of view has some empirical support (Bushman et al. 2005). On the other hand, permitting insiders to trade on inside information may allow companies to pay managers less because they have insider-trading opportunities. In fact, there is evidence from Japan and the United States that the cash portion of executive salaries is lower when potential trading profits are higher (Hebner and Kato 1997; Roulstone 2003). If market professionals could trade legally on private information but insiders could not, public shareholders would still lose, while being unable to recoup their trading losses in the form of higher corporate profits because of lower managerial compensation (Haddock and Macey 1987).
Despite numerous and extensive debates, economists and legal scholars do not agree on a desirable government policy toward insider trading. On the one hand, absolute information parity is clearly infeasible, and information-based trading generally increases the pricing efficiency of financial markets. Information, after all, is a scarce economic good that is costly to produce or acquire, and its subsequent use and dissemination are difficult to control. On the other hand, insider trading, as opposed to other forms of informed trading, may produce unintended adverse consequences for the functioning of the corporate enterprise, the market-wide system of publicly mandated disclosure, or the market for information. While the effects of insider trading on securities prices and insiders’ profits have been extensively studied empirically, the incentive effects of insider trading and its impact on the inner functioning of corporations are not well known. It also should be considered that individual firms have an incentive to weigh negative and positive consequences of insider trading and decide, through private contracting, whether to allow it. The case for having public regulation of insider trading must, therefore, rest on such factors as inefficiency of private enforcement or insider trading’s overall adverse impact on securities markets.