Focus Areas:    corporate law | Insider Trading | Securities Regulation

An Insider Trading Policy a Monkey Would Love

As Josh noted, Henry Manne recently published a WSJ op-ed arguing for liberalization of insider trading on efficiency grounds — chiefly, because such trading “aids capital allocation decisions and informs business executives through market-price feedback of the best predictions about the value of new plans.” (For a more complete statement of Henry’s argument, see here.)

Today’s WSJ includes several letters in response, including one by Kenneth Kehl, who accuses Henry of “emphasiz[ing] efficiency at the expense of fair play.” I hear versions of this “I Don’t Care If It’s Efficient, It’s Just Not Fair” argument all the time. They’re generally unpersuasive, for if insider trading were legal, any investor who bought stock of a company that had not privately (i.e., contractually) banned such trading would know what she was getting herself into and would be compensated (via a price adjustment) for the risk associated with such trading.

Kehl’s argument, though, is not actually a fairness argument; he’s really concerned with efficiency. You can see this in the little thought experiment he proposes:

Let [Manne] start a poker game with several strangers, and let him explain to the others that he will volunteer to be the “insider” for the purpose of making the game more efficient. He will then during each hand walk around at will looking at the others’ cards and bet accordingly. When the others complain, let him say that they are free to use information gleaned from observing his bets. The game would come to an end in short order. The stock market is analogous to a game, and fairness is more important for its health than some marginal improvement in efficiency.

Kehl’s argument, then, is that perceived fairness is necessary to ensure that players stay in the game. In other words, insider trading should be banned because it results in a rigged game and will therefore make capital markets less liquid by scaring away outside investors. Former SEC Chairman Arthur Levitt expressed a similar sentiment when he stated that “[i]f the investor thinks he’s not getting a fair shake, he’s not going to invest, and that’s going to hurt capital markets in the long run.” (The Epidemic of Insider Trading, Bus. Week., Apr. 29, 1995, p. 78.)

The problem with this “Fairness Is Necessary for Capital Market Liquidity” argument is that it flies in the face of experience. As Dennis Carlton and Dan Fischel explained in their wonderful article, The Regulation of Insider Trading, 35 Stan. L. Rev. 857, 880 (1983),

[T]he notion that exchanges are harmed by insider trading is hard to square with the following facts: (1) the stock market was successful pre-1933 (before insider trading laws); (2) the stock market was successful pre-1960’s (before judicial extension of insider trading laws); (3) the stock market is currently successful despite the existence of legal and perhaps illegal insider trading.

I’ve made these points dozens of times in arguing for the liberalization of insider trading, and I’d have to say that they have almost no traction (with non-economists). Even when I can get folks to agree that insider trading (1) could be an efficient compensation mechanism, (2) would lead to a more efficient allocation of capital, (3) would protect investors from overvalued equity and the horrendous costs it imposes, and (4) would ultimately lead to a world with more wealth, they still generally oppose it because it just seems unfair to them.

What’s going on here? I really don’t know, but I think it might have something to do with how we’re hard-wired. Let me explain.

In recent years, behavioral economists and cognitive psychologists have observed that individuals are sometimes willing to give up wealth in order to obtain what they perceive to be a fair outcome. Consider, for example, results from experiments involving the Ultimatum Game. In that game, one person, the “offeror,” is directed to propose some division of an asset (usually some amount of money) between himself and another, the “offeree.” The offeror then offers that allocation to the offeree, who can choose to accept or reject it. If the offeree accepts the division, the asset is split as the offeror proposed. If the offeree rejects the proposal, then neither party gets anything.

Obviously, the reasonable outcome would be for the offeror to propose to give the offeree the minimum amount possible (say, $1 out of $10 if the thing being split was a pile of ten one dollar bills). And the offeree should accept whatever he’s offered, for the alternative is to walk away empty-handed. One might thus expect that offerors would make stingy proposals and that offerees would accept them.

When the game is actually played, that’s not what tends to happen. Instead, offerors offer to give offerees some amount closer to half the pie (say, $4 out of $10), and offerees tend to refuse offers that are relatively low, even though their refusal means they walk away with nothing.

Now, there’s lots of debate over what’s going on here, but a leading theory is that there’s something about humans that makes them willing to give up wealth in order to honor some sense of fairness.

And it seems humans aren’t alone. Research by Sarah Brosnan and Frans de Waal shows that female capuchin monkeys are similarly willing to sacrifice wealth for fairness. Brosnan and de Waal trained pairs of monkeys to give human handlers small granite rocks. In exchange for the rocks, the monkeys would receive a reward: a cucumber slice. This is apparently a pretty good deal for the moneys, who were almost always willing to play along . . . at least so long as they were treated equally. After a while, the primatologists began giving one of the moneys in each pair a tasty grape instead of a cucumber slice. At this point, many of the non-favored monkeys refused to participate in the routine, choosing to forego a sweet deal (a cucumber slice for very little work) rather than sanction an unfairness. The situation only worsened when the primatologists began giving grapes to one monkey without receiving the pebble in exchange. Such severe unfairness was enough to drive a full 80 percent of the non-favored monkeys out of the game — even though their non-participation meant no more easy cucumbers. The monkeys were, in other words, willing to sacrifice wealth in order to make a statement about fairness. (See here and here.)

Does this not explain so much about business law — like the persistence of the insider trading ban or, better yet, Regulation FD, which has almost certainly resulted in less efficient securities markets in the name of “fair disclosure”? (See here and here.) James Surowiecki makes this point in his delightful book, The Wisdom of Crowds, which Henry cited in his op-ed.

Quite frankly, I’m not sure whether we humans should fight these urges or embrace them. I’m pretty sure, though, that those of us who would like to see insider trading legalized (i.e., left to private contract) are never going to get anywhere until we can tell a “fairness story.” I attempted a version of such story in my recent article, Overvalued Equity and the Case for an Asymmetric Insider Trading Regime, but we’ve got some pretty entrenched urges to overcome.