Contemplating Disclosure-Based Insider Trading Regulation
TOTM friend Stephen Bainbridge is editing a new book on insider trading. He kindly invited me to contribute a chapter, which I’ve now posted to SSRN (download here). In the chapter, I consider whether a disclosure-based approach might be the best way to regulate insider trading.
As law and economics scholars have long recognized, informed stock trading may create both harms and benefits to society. With respect to harms, defenders of insider trading restrictions have maintained that informed stock trading is “unfair” to uninformed traders and causes social welfare losses by (1) encouraging deliberate mismanagement or disclosure delays aimed at generating trading profits; (2) infringing corporations’ informational property rights, thereby discouraging the production of valuable information; and (3) reducing trading efficiency by increasing the “bid-ask” spread demanded by stock specialists, who systematically lose on trades with insiders.
Proponents of insider trading liberalization have downplayed these harms. With respect to the fairness argument, they contend that insider trading cannot be “unfair” to investors who know in advance that it might occur and nonetheless choose to trade. And the purported efficiency losses occasioned by insider trading, liberalization proponents say, are overblown. There is little actual evidence that insider trading reduces liquidity by discouraging individuals from investing in the stock market, and it might actually increase such liquidity by providing benefits to investors in equities. With respect to the claim that insider trading creates incentives for delayed disclosures and value-reducing management decisions, advocates of deregulation claim that such mismanagement is unlikely for several reasons. First, managers face reputational constraints that will discourage such misbehavior. In addition, managers, who generally work in teams, cannot engage in value-destroying mismanagement without persuading their colleagues to go along with the strategy, which implies that any particular employee’s ability to engage in mismanagement will be constrained by her colleagues’ attempts to maximize firm value or to gain personally by exposing proposed mismanagement. With respect to the property rights concern, deregulation proponents contend that, even if material nonpublic information is worthy of property protection, the property right need not be a non-transferable interest granted to the corporation; efficiency considerations may call for the right to be transferable and/or initially allocated to a different party (e.g., to insiders). Finally, legalization proponents observe that there is little empirical evidence to support the concern that insider trading increases bid-ask spreads.
Turning to their affirmative case, proponents of insider trading legalization (beginning with Geoff’s dad, Henry Manne) have primarily emphasized two potential benefits of the practice. First, they observe that insider trading increases stock market efficiency (i.e., the degree to which stock prices reflect true value), which in turn facilitates efficient resource allocation among capital providers and enhances managerial decision-making by reducing agency costs resulting from overvalued equity. In addition, the right to engage in insider trading may constitute an efficient form of managerial compensation.
Not surprisingly, proponents of insider trading restrictions have taken issue with both of these purported benefits. With respect to the argument that insider trading leads to more efficient securities prices, ban proponents retort that trading by insiders conveys information only to the extent it is revealed, and even then the message it conveys is “noisy” or ambiguous, given that insiders may trade for a variety of reasons, many of which are unrelated to their possession of inside information. Defenders of restrictions further maintain that insider trading is an inefficient, clumsy, and possibly perverse compensation mechanism.
The one thing that is clear in all this is that insider trading is a “mixed bag” Sometimes such trading threatens to harm social welfare, as in SEC v. Texas Gulf Sulphur, where informed trading threatened to prevent a corporation from usurping a valuable opportunity. But sometimes such trading creates net social benefits, as in Dirks v. SEC, where the trading revealed massive corporate fraud.
As regular TOTM readers will know, optimal regulation of “mixed bag” business practices (which are all over the place in the antitrust world) requires consideration of the costs of underdeterring “bad” conduct and of overdeterring “good” conduct. Collectively, these constitute a rule’s “error costs.” Policy makers should also consider the cost of administering the rule at issue; as they increase the complexity of the rule to reduce error costs, they may unwittingly drive up “decision costs” for adjudicators and business planners. The goal of the policy maker addressing a mixed bag practice, then, should be to craft a rule that minimizes the sum of error and decision costs.
Adjudged under that criterion, the currently prevailing “fraud-based” rules on insider trading fail. They are difficult to administer, and they occasion significant error cost by deterring many instances of socially desirable insider trading. The more restrictive “equality of information-based” approach apparently favored by regulators fares even worse. A contractarian, laissez-faire approach favored by many law and economics scholars would represent an improvement over the status quo, but that approach, too, may be suboptimal, for it does nothing to bolster the benefits or reduce the harms associated with insider trading.
My new book chapter proposes a disclosure-based approach that would help reduce the sum of error and decision costs resulting from insider trading and its regulation. Under the proposed approach, authorized informed trading would be permitted as long as the trader first disclosed to a centralized, searchable database her insider status, the fact that she was trading on the basis of material, nonpublic information, and the nature of her trade. Such an approach would (1) enhance the market efficiency benefits of insider trading by facilitating “trade decoding,” while (2) reducing potential costs stemming from deliberate mismanagement, disclosure delays, and infringement of informational property rights. By “accentuating the positive” and “eliminating the negative” consequences of informed trading, the proposed approach would perform better than the legal status quo and the leading proposed regulatory alternatives at minimizing the sum of error and decision costs resulting from insider trading restrictions.
Please download the paper and send me any thoughts.
Filed under: 10b-5, corporate law, disclosure regulation, error costs, financial regulation, insider trading, markets, regulation, securities regulation, SSRN