In a recent tweet, my old friend Alan Reynolds plugged a 2003 op-ed article (“The Case for Insider Training”) by Henry Manne railing against legal prohibitions against insider trading. Reynolds’s tweet followed his earlier tweet railing against the indictment of Rep. Chris Collins for engaging in insider trading after learning that the small pharmaceutical company (Innate Pharmaceuticals) of which he was the largest shareholder transmitted news that a key clinical trial of a drug the company was developing had failed, making a substantial decline in the value of the company’s stock inevitable once news of the failed trial became public. Collins informed his own son of the results of the trial, and his son then shared that information with the son’s father-in-law and other friends and acquaintances, who all sold their stock in the firm, causing the company’s stock price to fall by 92%.
Reynolds thinks that what Collins did was just fine, and invokes Manne as an authority to support his position. Here is how Manne articulated the case against insider trading in his op-ed piece, which summarizes a longer 2005 article (“Insider Trading: Hayek, Virtual Markets and the Dog that Did not Bark”) published in The Journal of Corporate Law.
Prior to 1968, insider trading was very common, well-known, and generally accepted when it was thought about at all.
A similar observation – albeit somewhat backdated — might be made about slavery and polygamy.
When the time came, the corporate world was neither able nor inclined to mount a defense of the practice, while those who demanded its regulation were strident and successful in its demonization. The business community was as hoodwinked by these frightening arguments as was the public generally.
Note the impressive philosophical detachment with which Manne recounts the historical background.
Since then, however, insider trading has been strongly, if by no means universally, defended in scholarly journals. There have been three primary economic arguments (not counting the show-stopper that the present law simply cannot be effectively enforced.) The first and generally undisputed argument is that insider trading does little or no direct harm to any individual trading in the market, even when an insider is on the other side of the trades.
The assertion that insider trading does “little or no direct harm” is patently ridiculous inasmuch as it is based on the weasel word “direct” so that the wealth transferred from less informed to better informed traders cannot result in “direct” harm to the less-informed traders, “direct harm” being understood to occur only when theft or fraud is used to effect a wealth transfer. Question-begging at its best.
The second argument in favor of allowing insider trading is that it always (fraud aside) helps move the price of a corporation’s shares to its “correct” level. Thus insider trading is one of the most important reasons why we have an “efficient” stock market. While there have been arguments about the relative weight to be attributed to insider trading and to other devices also performing this function, the basic idea that insider pushes stock prices in the right direction is largely unquestioned today.
“Efficient” (scare quotes are Manne’s) pricing of stocks and other assets certainly sounds good, but defining “efficient” pricing is not so easy. And even if one were to grant that there is a well-defined efficient price at a moment in time, it is not at all clear how to measure the social gain from an efficient price relative to an inefficient price, or, even more problematically, how to measure the social benefit from arriving at the efficient price sooner rather than later.
The third economic defense has been that it is an efficient and highly desirable form of incentive compensation, especially for corporation dependent on innovation and new developments. This argument has come to the fore recently with the spate of scandals involving stock options. These are the closes substitutes for insider trading in managerial compensation, but they suffer many disadvantages not found with insider trading. The strongest argument against insider trading as compensation is the difficulty of calibrating entitlements and rewards.
“The difficulty of calibrating entitlements and rewards” is simply a euphemism for the incentive of insiders privy to adverse information to trade on that information rather than attempt to counteract an expected decline in the value of the firm.
Critics of insider trading have responded to these arguments principally with two aggregate-harm theories, one psychological and the other economic. The first, the faraway favorite of the SEC, is the “market confidence” argument: If investors in the stock market know that insider trading is common, they will refuse to invest in such an “unfair” market.
Using scare quotes around “unfair” as if the idea that trading with asymmetric information might be unfair were illogical or preposterous, Manne stumbles into an inconsistency of his own by abandoning the very efficient market hypothesis that he otherwise steadfastly upholds. According to the efficient market hypothesis that market prices reflects all publicly available information, movements in stock prices are unpredictable on the basis of publicly available information. Thus, investors who select stocks randomly should, in the aggregate, and over time, just break even. However, traders with inside information make profits. But if it is possible to break even by picking stocks randomly, who are the insiders making their profits from? The renowned physicist Niels Bohr, who was fascinated by stock markets and anticipated the efficient market hypothesis, argued that it must be the stock market analysts from whom the profits of insiders are extracted. Whether Bohr was right that insiders extract their profits only from market analysts and not at all from traders with randomized strategies, I am not sure, but clearly Bohr’s basic intuition that profits earned by insiders are necessarily at the expense of other traders is logically unassailable.
Thus investment and liquidity will be seriously diminished. But there is no evidence that publicity about insider trading ever caused a significant reduction in aggregate stock market activity. It is merely one of many scare arguments that the SEC and others have used over the years as a substitute for sound economics.
Manne’s qualifying adjective “significant” is clearly functioning as a weasel world in this context, because the theoretical argument that an understanding that insiders may freely trade on their inside information would, on Manne’s own EMH premises, clearly imply that stock trading by non-insiders would in the aggregate, and over time, be unprofitable. So Manne resorts to a hand-waving argument about the size of the effect. The size of the effect depends on how widespread insider trading and how-well informed the public is about the extent of such trading, so he is in no position to judge its significance.
The more responsible aggregate-harm argument is the “adverse selection” theory. This argument is that specialists and other market makers, when faced with insider trading, will broaden their bid-ask spreads to cover the losses implicit in dealing with insiders. The larger spread in effect becomes a “tax” on all traders, thus impacting investment and liquidity. This is a plausible scenario, but it is of very questionable applicability and significance. Such an effect, while there is some confirming data, is certainly not large enough in aggregate to justify outlawing insider trading.
But the adverse-selection theory credited by Manne is no different in principle from the “market confidence” theory that he dismisses; they are two sides of the same coin, and are equally derived from the same premise: that the profits of insider traders must come from the pockets of non-insiders. So he has no basis in theory to dismiss either effect, and his evidence that insider trading provides any efficiency benefit is certainly no stronger than the evidence he dismisses so blithely that insider trading harms non-insiders.
In fact the relevant theoretical point was made very clearly by Jack Hirshleifer in the important article (“The Private and Social Value of Information and the Reward to Inventive Activity”) about which I wrote last week on this blog. Information has social value when it leads to a reconfiguration of resources that increases the total output of society. However, the private value of information may far exceed whatever social value the information has, because privately held information that allows the better-informed to trade with the less-well informed enables the better-informed to profit at the expense of the less-well informed. Prohibiting insider trading prevents such wealth transfers, and insofar as these wealth transfers are not associated with any social benefit from improved resource allocation, an argument that such trading reduces welfare follows as night does day. Insofar as such trading does generate some social benefit, there are also the losses associated with adverse selection and reduced market confidence, so the efficiency effects, though theoretically ambiguous, are still very likely negative.
But Manne posits a different kind of efficiency effect.
No other device can approach knowledgeable trading by insiders for efficiently and accurately pricing endogenous developments in a company. Insiders, driven by self-interest and competition among themselves will trade until the correct price is reached. This will be true even when the new information involves trading on bad news. You do not need whistleblowers if you have insider trading.
Here again, Manne is assuming that efficient pricing has large social benefits, but that premise depends on the how rapidly resource allocation responds to price changes, especially changes in asset prices. The question is how long does it take for insider information to become public information? If insider information quickly becomes public, so that insiders can profit from their inside information only by trading on it before the information becomes public, the social value of speeding up the rate at which inside information is reflected in asset pricing is almost nil. But Manne implicitly assumes that the social value of the information is very high, and it is precisely that implicit assumption that would have to be demonstrated before the efficiency argument for insider trading would come close to being persuasive.
Moreover, allowing insiders to trade on bad news creates precisely the wrong incentive, effectively giving insiders the opportunity to loot a company before it goes belly up, rather than take any steps to mitigate the damage.
While I acknowledge that there are legitimate concerns about whether laws against insider trading can be enforced without excessive arbitrariness, those concerns are entirely distinct from arguments that insider trading actually promotes economic efficiency.
Uneasy Money 