Should Insider Trading be Legalized
The following blog will be in two parts and is from one of my more gifted students from UNH, Olivia Marchioni. It was a research paper from the course, Contemporary Issues in Economics, and is one of the best written pieces I have seen on this topic.
Definition and History of Insider Trading
According to the SEC, insider trading is “trading that takes place when those privileged with confidential information use the special advantage of that knowledge to reap profits or avoid losses on the stock market, to the detriment of the source of the information and to the typical investors who buy or sell their stock without the advantage of inside information (Newkirk). The SEC defines “insiders” as officers and directors of a company, or those who own more than ten percent of the company’s equity (Howden 46). Put more simply, insider trading (IT) is the “illegal trading in securities by individuals or firms possessing important non-public information” (Meulbroek 1661). It is generally thought that asymmetry of information gives insiders an unfair advantage. In an attempt to make it fairer, the government regulates insiders’ transactions in company securities and monitors to ensure that the rules are followed (Lskavyan 207). Insider trading legislation was formed in the midst of the Great Depression, when financial markets appeared to be operating inefficiently (Howden 46). Following the United States stock market crash of 1929, Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934, which were aimed at restoring investors’ trust in financial markets and controlling the abuses thought to have contributed to the crash (Stoltmann). This legislation prohibited insider trading in the U.S. and has been in effect since the 1930’s.
The debate about the pros and cons of allowing insider trading has been quite controversial in law, economics, and finance literature in recent years (Bhattacharya and Hazem 76). Proponents of legalizing insider trading champion its benefits, including its ability to foster efficient capital markets, compensate executives, and induce innovation (Muelbroek 1661). Opponents of insider trading argue that it produces abusive managerial practices and hinders the functioning of securities markets (Muelbroek 1661). Current theories relying on the arguments of private property, fairness, ethics, or market efficiency have led to conflicting empirical results (Howden 45). It is difficult to do empirical research on this topic because isolating trading based on private information is challenging. Past research has used data on legal inside trades by executives that were required to be reported to the SEC. Prudent insider traders are not likely to report incriminating unlawful or unethical transactions to the SEC (Meulbroek 1662). As a result of limited data, there have been ambiguous conclusions regarding the effects of legalizing insider trading and what parties would benefit most from a change in legislation. The gains and losses from insider trading are not clearly defined or known (Howden 47). No countries with developed capital markets completely permit insider trading, so the effects are also ultimately unknown. One can only speculate how the stock market would perform under legalized insider trading (Dent 262). Considering the complexity of insider trading, this paper restricts its attention to an economic topic: the potential unintended consequences of legalizing insider trading, including negative changes in corporate governance, a lack of public disclosure, deterrent of investment, and ultimately a failure of the stock market.
The most common argument made in support of legalizing IT is that it improves market efficiency. The efficient market hypothesis says that, in a strong-form efficient market, a security’s price reflects all available public and private information (Finnerty 1141). The hypothesis assumes no individual can have higher expected trading profits because of a monopolistic access to information, since all past, present, private, and public information is available (Finnerty 1141). The U.S. is a semi-strong form efficient market because private information is not typically available. Insiders do have monopolistic access to information, with which they can gain higher yields. Economists in strong favor of free market capitalism, such as Manne and Carlton and Fischer, assert that insider trading fosters greater efficiency in capital markets because it allows a more rapid reflection of information in stock prices. Results of empirical studies reveal that insider trading is in fact associated with immediate price movements and quick price discovery. Studies show that “cumulative abnormal return on insider trading days are half as large as the price reaction to the public revelation of the information on which the insider traded” (Meulbroek 1663) This ultimately suggests that the stock market detects informed trading and reflects the information into the stock price before information is made public. Analysis of insider trade volume implies that “both the amount traded by insider trading and trade-specific characteristics, such as trade size, direction, and frequency, signal the presence of an informed trader to the market” (Meulbroek 1663). By responding to these characteristics and incorporating the private information into the stock price, the markets become more efficient. Milton Friedman said on the topic, “You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that” (qtd. in Howden 50). One journalist argues that IT regulations force investors to “make today’s trades based on yesterday’s information” (Bandow). Those in favor of deregulation bring up valid points regarding market efficiency.
While there tends to be little disagreement today that insider trading does make the securities market more efficient, there is controversy about whether or not it is more effective than public disclosure. Some researchers argue that additional price accuracy “only redistributes wealth instead of making the process of capital allocation more efficient,” because insider trading speeds up price adjustment by only a few days or weeks without affecting the long-run attractiveness of a company as an investment (Klock 297). The short advance of information that legalized insider trading could provide would not likely equate to such a significant improvement in efficiency as has been hypothesized. Dent argues that even if insider trading enhances the accuracy of prices in the stock market, it is doubtful that it generates much benefit. He asserts that even in the absence of insider trading, the market for frequently traded securities is already quite efficient (250). Any benefit from the additional accuracy caused by insider trading would likely be trivial (Dent 250). Hu and Noe provide additional support of Dent’s stance by arguing that the “existence of a sophisticated securities analysis industry in the U.S. means that it does not face the issue of a major information gap” (34). The Nobel Prize winner in economics, Eugene Fanta, has also shown in his research that U.S. equities markets are essentially “efficient” in an informational sense as they are (Breslow).
Other economists including Fishman and Hagerty, and Benabou and Laroque, argue that legalizing insider trading can actually have the opposite effect because “unregulated insider trading reduces market efficiency by deterring other traders from acquiring information” (qtd. in Lskavyan 208). This point also has validity. If market analysts or specialists no longer have any incentive to do research and to stay vigilant about discovering new information, it is unknown what the consequences would be. It is also argued that insiders may have reduced incentives to release information, which can make stock prices less informative. These are interesting theories and are certainly effective in playing devil’s advocate to the classic economical view on market efficiency. Considering the widespread disagreement about its benefits, the market efficiency argument alone is weak in justifying the legalization of insider trading.
The second most common argument for legalizing insider trading is that it can be used as compensation. Proponents of insider trading say the alleged benefit is that, in some situations, insider-trading profits are the best way to compensate executives and induce innovation. Proponents assert that a corporation could lower executives’ salaries and increase shareholder dividends by offering insider trading as a form of compensation (Howden 47). The idea is that if insiders cannot be rewarded with the ability to use inside information, salaries will have to increase to provide greater incentives and rewards. This allows managers who “cheat” by participating in insider trading to be overcompensated (Howden 47). If this were true, firms would have to reduce all salaries accordingly to avoid overcompensating dishonest employees (Howden 47). This creates complications in determining salaries and appropriate compensation, and is also a potential cost to employees. Bebchuk and Jolls also contest that insider trading “imposes additional costs on shareholders who bear the costs of the creation of information while company insiders enjoy the benefits” (qtd. in Howden 47). In such a case, shareholders would benefit more by simply allowing insider trading and adjusting salaries (Howden 47). Researchers have 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 34). In essence, insider trading is said to be the best way to fairly and effectively compensate employee whilst maximizing shareholder profits.
It is also believed 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; Manne). In “Insider Trading and The Stock Market,” Henry Manne says, “The entrepreneur's compensation must have a reasonable relation to the value of his contribution to give him incentives to produce more information. Because it is rarely possible to ascertain information's value to the firm in advance, predetermined compensation, such as salary, is inappropriate for entrepreneurs” (172). This implies that IT plays a valuable role in both compensating and incentivizing executives whilst increasing the value of the firm. However, today, most employees who have no created valuable information are the ones involved in insider trading. The innovators are not the ones being compensated (Dent 249). Using insider trading as compensation would require that the corporation determine who on a team is primarily responsible for innovation, who is permitted to trade, and when they are permitted to trade. It would cost time and money to coordinate the logistics of such a compensation program and to ensure that such privileges are not abused within the organization. Employees may also prevent free-flow of information within the organization by attempting to work alone or hide projects from colleagues in order to be sole benefactor of the right to insider trading (Dent 267). Insider trading as a form of compensation would be difficult to control or to use effectively.
Cost of Equity
Cost of equity is important because one of the major purposes of stock markets is to make it easier for corporations to secure financing through equity. Cost of equity reflects the rate of return required by stockholders in order to take on the risk of investing in the company. It is pertinent to know if legal IT would affect this rate of return. Manne argues that the cost of equity may be higher in markets that do not allow insider trading because “less efficient markets means investors would demand higher returns to compensate for fact they find it difficult to analyze firms” (qtd. in Bhattacharya and Hazem 77). Manne’s argument assumes that without private information and accurate stock prices, the risk of investing increases, which increases the cost of equity.
However, using four different approaches, Bhattacharya and Hazem found that the cost of equity would be lower in markets that enforce the prohibition of insider trading (77). “Lower inside trading reduces the cost of equity indirectly by increasing liquidity (reducing the liquidity premium) and directly by improving corporate governance” (Bhattacharya and Hazem 92). The studies done by Bhattacharya and Hazem found that the corporate cost of equity declines significantly when a country creates laws the forbid insider trading and actually enforces those laws (Dent 262). Bhattacharya and Hazem found that in a stock market where insiders trade without punishment, this “may cause liquidity providers to protect themselves by increasing their sell price and decreasing their buy price” (Bhattacharya and Hazem 76). In other words, these “liquidity providers” – specialized intermediaries who continuously buy and selling securities, such as NASDAQ dealers – increase their spread (the difference between what they pay for a company’s stock and the price they sell it for) in order to protect themselves from losses incurred by trading with insiders. This would increase transaction costs, which would cause a stock trader to require a higher return on equity (Bhattacharya and Hazem 76). The second reason why Bhattacharya and Hazem argue that cost of equity may be higher is because large shareholders could require higher returns if corporate management decides to maximize profits using insider tips rather than by monitoring and analyzing markets (76). If corporate profits increase with minimal cost, shareholders expect greater returns. Ultimately, this increase in the cost of equity could have unintended consequences, as will be discussed later.
Property Rights of Information
A third common rationale used to support legalizing IT is the property rights of information. Proponents of legalization, including Stephen Bainbridge, argue that information is the property of a corporation, which should allow them to decide what to do with that information (Dent 271). Some would allocate that property right to managers. However, assigning this right to managers could ultimately lead to the unintended consequence of poor managerial conduct, which will be discussed later in this paper (Dent 271). The property rights argument raises the question of how a corporation can exploit a property right with respect to its own stock. Bainbridge does not address this issue.
It would be unwise to treat inside information as property that can be exploited by a company in trading for its own account. According to economists such as Milton Friedman, corporations are supposed to be managed with a shareholder perspective. The goal should be to maximize shareholder profits, not to focus on inside tips and trading schemes (Dent 271). If insider trading were permitted on the grounds of property rights, a company would trade its own stock based on nonpublic information. Dent argues that, “it would be inconsistent with efficiency for a corporation to trade against its own shareholders for the benefit of some other stakeholder, such as employees” (271). There are many complications associated with assigning property rights to specific individuals and determining which stakeholder should benefit from such property rights. Literature often fails to explain how this would be done. The property rights argument is also weak in asserting why corporations are entitled to utilize insider trading.
2nd half next month
John Tommasi is a retired Senior Lecturer of Economics & Finance from Bentley University and the University of New Hampshire.