Focus Areas:    corporate law | Insider Trading | Securities Regulation

Learning to Love Insider Trading

Today’s Wall Street Journal includes a terrific article explaining why insider trading should be deregulated. Following up on last week’s high-profile insider trading charges, George Mason economist Don Boudreaux, whose Cafe Hayek posts are essential reading, succinctly sets forth the deregulatory position (which was first and most famously articulated by Geoff’s dad, Henry Manne). Boudreaux explains that:

1. Insider trading leads to a more efficient allocation of capital by ensuring that stocks are accurately priced.

2. Insider trading protects investors against stock mispricing (a la Enron), which ultimately corrects itself and can cause huge investor losses. (On this point, Boudreaux quotes the senior Manne’s comments from a radio interview:

I don’t think the scandals [such as those at Enron and Global Crossing] would ever have erupted if we had allowed insider trading because there would be plenty of people in those companies who would know exactly what was going on, and who couldn’t resist the temptation to get rich by trading on the information, and the stock market would have reflected those problems months and months earlier than they did under this cockamamie regulatory system we have.

I made a similar point in this article.)

3. Insider trading encourages investors to diversify, which is generally a good investment strategy and will lead to fewer wipe-outs (and their accompanying social stresses).

4. The ban on insider trading can reach only decisions to trade on the basis of material non-public information, not undetectable decisions to refrain from trades one otherwise would have made. As Boudreaux explains:

This bias is not only a source of prosecutorial unfairness; its existence casts doubt on the assumption that insider trading is so harmful that it must be treated as a criminal offense. After all, if capital markets continue to function as well as they do given that many investment decisions potentially influenced by inside information are unstoppable because they are undetectable, why believe that the detectable portion of investment decisions influenced by inside information would be harmful if they were legal?

5. Insider trading may, in fact, harm a company’s business by, for example, thwarting a value-enhancing transaction that otherwise would have occurred. The classic historical example is the insider trading in the Texas Gulf Sulphur case, where the company had discovered a valuable ore deposit and was trying to buy up land around the deposit at favorable prices. Insider purchases of TGS stock and call options drove up the price of TGS stock, tipped off neighboring landowners that they should demand a higher price for their property, and thereby harmed the corporate enterprise.

6. Corporations can protect themselves (and their investors) against harmful trading on the basis of material non-public information by creating their own insider trading policies.

7. Capital market pressures will lead corporations to adopt insider trading rules that maximize the value of the enterprise and thus provide the best possible outcome for investors. Corporations themselves, responding to the specific conditions of the capital and labor markets in which they participate (I mention labor markets because the ability to engage in insider trading can be an element of one’s compensation), are more likely than centralized regulators to achieve a value-maximizing policy.

Boudreaux has mastered the art of saying a lot, very clearly, in a small number of words. His article is terrific weekend reading.

Posted in 10b-5, business, corporate law, insider trading, markets, securities regulation