Suddenly
Unregistered
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There was a large thread that became an "insider trading" thread where it was declared by a poster that it was a fact that insider trading should be legal as it hurts no one.
Now... I was aware there were certain theories to that effect, but they were just that - a few theories, so I started questioning that premise and as a result I don't think the premise was expressed very well, and the argument really didn't go anywhere.
I thought that a shame since the theory is actually much more reasonable than it appeared to be in that thread. So, I decided to do what I should have done in the first place, lay out the theory and the basic problems with it as I see it.
Some background: Any knowledge I have w/r/t this topic is a result of some practical experience with smaller corporations, and from teaching a course in Business Law at a nearby college. One chapter was on insider trading and I wound up devoting some time to the theory that insider trading would be better off not being regulated. The material comes from that. This isn't a research paper, so there will be very little citing of sources. I'll just go from memory.
Insider trading is not, as it may seem, trading by someone with information others do not have. For the laws to apply, that information must come from the inside of the corporation appropriated in violation of the insider’s duty as an agent of the corporation and not available to the general public. Persons other than insiders can be in violation via legal theories analogous to “receipt of stolen property” where the outsider knows that the information was “stolen” and uses it anyway.
Even without the laws making it illegal, absent permission from shareholders, insider trading violates an insider’s duty to the shareholder as the agents shareholder.
Which brings me to the main point. Often when we hear arguments that insider trading should be legal we equate that to the idea that the insider must have some right to trade with insider information. However that is a bit of a strawman. When economists and such speak of this concept, it is more in line with the principle that shareholders should have the right (through their representatives on the board) to choose to allow the insiders to trade on inside information. This is a subtle but important distinction.
From a moral perspective the argument is simple. Consent. Stockholders choose whether to allow insider information by vote, just like any other corporate policy. Those who want to buy the stock are aware of company policy before they buy, so any financial setback from people trading on the market with better informed people is, from a moral standpoint, consented to.
More interesting is the economic justification. Obviously, if there were no benefit to allowing such trading, shareholders wouldn’t ever vote to allow it. One benefit to the shareholders is that they can, so to speak, “sell” the right to trade with inside information to the employees by making it part of a compensation package.
Insider trading is on the aggregate, a neutral activity, just as all other transfers of stuff. This is opposed to a negative aggregate, such as murder or arson, where less stuff emerges, or a positive aggregate, such as building a house, where raw materials become a finished useful product. This is not to say all neutral activities are equal to either the parties involved or society as a whole. A negotiated trade of a car for currency is a different story from me swiping your wallet.
So the theory goes, insider trading is overall neutral as far as it being a transfer. So, the question is what other effects does it have. One effect is it causes other people on average to receive lesser value from stock trades. Another is that it does to a point increase market efficiency in that information gets into the market faster. In the simple version, that is about it. These effects will affect companies differently depending on the size of the corporation and the market structure. Clearly, for a company with 2 owners where one is active in day to day business and one is not, the first effect is bigger than the second, if not only because the efficiency of the market is a worthless concept as there likely is no market for the shares. In a huge publicly traded corporation it can be a different story.
The legalization theory holds that some corporations are better off if they allow the trading as the combined effect of the sale of the rights and added market efficiency outweighs any lesser value from sale of stock. Furthermore, the theory holds that private enforcement against insider trading by the corporations not allowing the insider trading is more efficient than public enforcement by the government.
Another point in favor of legalization that doesn’t fit in nicely above is that there will always be insider trading activity that is impossible to regulate. An insider may chose to not sell or not buy based on inside information, and absent a Vulcan mind meld we would never know.
Two common criticisms of the above theory:
1) Allowing officers to trade on inside information creates perverse incentives, in that the officers will profit mostly from huge market swings than from creating shareholder wealth. This would create a conflict of interest, one that the corporation can’t really manage without climbing all over the officer’s butt with a magnifying glass. There are rebuttals to this, and one is by Libertarian economist and proponent of the “Austrian School of Economics” Alex Padilla. The rebuttal is on his website at http://www.alexpadilla.org/contents.htm, an article titled “Can Agency Theory Justify the Regulation of Insider Trading."
2) Insider trading harms the liquidity in small markets as it puts other speculators, as well as market specialists, at a disadvantage. Society prizes liquidity in its markets, that stocks can easily be converted to cash and vice versa. It encourages investment in the market when an investor can easily buy or sell. There are two classes of people that increase liquidity, speculative traders and specialists. Specialists are special traders that help “make a market” in a particular stock by maintaining an inventory and trading as needed. Insider trading means that they will be making on average a higher percentage of trades in poor situations where stock is likely to go down.
Also, speculative traders that make their living by exploiting a general informational advantage against investors who “do less homework” are now trading in a market with others that have an economic advantage. The logic behind allowing regular speculative investing and not insider trading is expressed best by footnote 10 in this article.
There is also the obvious fact that these market professionals suffer a negative consequence, but then again, absent liquidity these guys don't provide a service, so who cares.
3) The general argument that the private enforcement by firms not allowing the trading will be less efficient, if not a practical impossibility, and requiring such a level of shareholder vigilence will decrease liquidity as who needs the stress of keeping an eye on people. That Padilla dude mentioned above addresses this as well.
I’m sure there is something from some economist to contradict most everything I claim above. Economics is hardly an exact science, and there is discord at almost every level. However, this is as far as I can tell a balanced description of the “legalization” viewpoint.
Now... I was aware there were certain theories to that effect, but they were just that - a few theories, so I started questioning that premise and as a result I don't think the premise was expressed very well, and the argument really didn't go anywhere.
I thought that a shame since the theory is actually much more reasonable than it appeared to be in that thread. So, I decided to do what I should have done in the first place, lay out the theory and the basic problems with it as I see it.
Some background: Any knowledge I have w/r/t this topic is a result of some practical experience with smaller corporations, and from teaching a course in Business Law at a nearby college. One chapter was on insider trading and I wound up devoting some time to the theory that insider trading would be better off not being regulated. The material comes from that. This isn't a research paper, so there will be very little citing of sources. I'll just go from memory.
Insider trading is not, as it may seem, trading by someone with information others do not have. For the laws to apply, that information must come from the inside of the corporation appropriated in violation of the insider’s duty as an agent of the corporation and not available to the general public. Persons other than insiders can be in violation via legal theories analogous to “receipt of stolen property” where the outsider knows that the information was “stolen” and uses it anyway.
Even without the laws making it illegal, absent permission from shareholders, insider trading violates an insider’s duty to the shareholder as the agents shareholder.
Which brings me to the main point. Often when we hear arguments that insider trading should be legal we equate that to the idea that the insider must have some right to trade with insider information. However that is a bit of a strawman. When economists and such speak of this concept, it is more in line with the principle that shareholders should have the right (through their representatives on the board) to choose to allow the insiders to trade on inside information. This is a subtle but important distinction.
From a moral perspective the argument is simple. Consent. Stockholders choose whether to allow insider information by vote, just like any other corporate policy. Those who want to buy the stock are aware of company policy before they buy, so any financial setback from people trading on the market with better informed people is, from a moral standpoint, consented to.
More interesting is the economic justification. Obviously, if there were no benefit to allowing such trading, shareholders wouldn’t ever vote to allow it. One benefit to the shareholders is that they can, so to speak, “sell” the right to trade with inside information to the employees by making it part of a compensation package.
Insider trading is on the aggregate, a neutral activity, just as all other transfers of stuff. This is opposed to a negative aggregate, such as murder or arson, where less stuff emerges, or a positive aggregate, such as building a house, where raw materials become a finished useful product. This is not to say all neutral activities are equal to either the parties involved or society as a whole. A negotiated trade of a car for currency is a different story from me swiping your wallet.
So the theory goes, insider trading is overall neutral as far as it being a transfer. So, the question is what other effects does it have. One effect is it causes other people on average to receive lesser value from stock trades. Another is that it does to a point increase market efficiency in that information gets into the market faster. In the simple version, that is about it. These effects will affect companies differently depending on the size of the corporation and the market structure. Clearly, for a company with 2 owners where one is active in day to day business and one is not, the first effect is bigger than the second, if not only because the efficiency of the market is a worthless concept as there likely is no market for the shares. In a huge publicly traded corporation it can be a different story.
The legalization theory holds that some corporations are better off if they allow the trading as the combined effect of the sale of the rights and added market efficiency outweighs any lesser value from sale of stock. Furthermore, the theory holds that private enforcement against insider trading by the corporations not allowing the insider trading is more efficient than public enforcement by the government.
Another point in favor of legalization that doesn’t fit in nicely above is that there will always be insider trading activity that is impossible to regulate. An insider may chose to not sell or not buy based on inside information, and absent a Vulcan mind meld we would never know.
Two common criticisms of the above theory:
1) Allowing officers to trade on inside information creates perverse incentives, in that the officers will profit mostly from huge market swings than from creating shareholder wealth. This would create a conflict of interest, one that the corporation can’t really manage without climbing all over the officer’s butt with a magnifying glass. There are rebuttals to this, and one is by Libertarian economist and proponent of the “Austrian School of Economics” Alex Padilla. The rebuttal is on his website at http://www.alexpadilla.org/contents.htm, an article titled “Can Agency Theory Justify the Regulation of Insider Trading."
2) Insider trading harms the liquidity in small markets as it puts other speculators, as well as market specialists, at a disadvantage. Society prizes liquidity in its markets, that stocks can easily be converted to cash and vice versa. It encourages investment in the market when an investor can easily buy or sell. There are two classes of people that increase liquidity, speculative traders and specialists. Specialists are special traders that help “make a market” in a particular stock by maintaining an inventory and trading as needed. Insider trading means that they will be making on average a higher percentage of trades in poor situations where stock is likely to go down.
Also, speculative traders that make their living by exploiting a general informational advantage against investors who “do less homework” are now trading in a market with others that have an economic advantage. The logic behind allowing regular speculative investing and not insider trading is expressed best by footnote 10 in this article.
Harming those that provide liquidity will cause them to leave the market. Less liquidity means lest investment, which makes it harder to raise capital by selling stock, which harms the market as a whole.
There is also the obvious fact that these market professionals suffer a negative consequence, but then again, absent liquidity these guys don't provide a service, so who cares.
3) The general argument that the private enforcement by firms not allowing the trading will be less efficient, if not a practical impossibility, and requiring such a level of shareholder vigilence will decrease liquidity as who needs the stress of keeping an eye on people. That Padilla dude mentioned above addresses this as well.
I’m sure there is something from some economist to contradict most everything I claim above. Economics is hardly an exact science, and there is discord at almost every level. However, this is as far as I can tell a balanced description of the “legalization” viewpoint.
