by David D. Haddock
Since the depths of the Great Depression, the Securities and Exchange Commission (SEC) has tried to prevent insider trading in U.S. securities markets. Insiders - a firm's principal owners, directors, and management, as well as its lawyers, accountants, and similar fiduciaries - routinely possess information that is unavailable to the general public. Because some of that information will affect the prices of the firm's securities when it becomes public, insiders can profit by buying or selling in advance. Even before the thirties, insiders were liable under the common law if they fraudulently misled uninformed traders into accepting inappropriate prices. But the Securities Exchange Act of 1934 went further by forbidding insiders from even profiting passively from superior information.
One of the most famous instances of insider trading was Charles F. Fogarty's purchase of Texas Gulf Sulphur shares during 1963 and 1964. Fogarty, an executive vice president of Texas Gulf, knew that the company had discovered a rich mineral lode in Ontario that it could not publicize before concluding leases for mineral rights. In the meantime Fogarty purchased 3,100 Texas Gulf shares and earned $125,000 to $150,000 (in 1991 dollars).
The basic argument against insider trading is that insiders should not be permitted to earn such sums at the expense of uninformed traders. Yet in almost all other markets where information is important, insider trading is well established and widely accepted. For example, mineral leases are routinely bought by those better able than the sellers to evaluate a site's potential, as Texas Gulf Sulphur's behavior exemplified. Cattle buyers rely on superior estimates of what packers will pay when negotiating with ranchers. And so it goes, in markets for art, for real estate, for professional athletes - indeed in practically every market with substantial variations in prices. In all those markets a few buyers routinely profit from knowledge that most sellers do not possess, and a few sellers profit from knowledge that most buyers do not possess. Commentators rarely cast aspersions on such traders' ethics or contend that their transactions should be regulated because of the asymmetry in information. Why should securities markets be treated differently?
One reason frequently cited by policymakers and commentators is that insider trading undermines public confidence in the securities markets. If people fear that insiders will regularly profit at their expense, they will not be nearly as willing to invest. A similar argument is that companies prefer that their securities trade in "thick" markets - that is, markets with many traders, substantial capital available, and frequent opportunities to trade at readily observable prices. Efficient securities markets, it is argued, require a "level informational playing field" to avoid frightening away speculators, who contribute to securities market liquidity, and investors, who could invest their savings in markets with less risk of insider predation. Working on such a premise, over the last quarter-century the SEC has brought new and ever more stringent enforcement initiatives against insider trading.
Related to this argument is the harm that insider trading causes for "specialists." A specialist is someone whom the stock exchange appoints to ensure that a buyer of a particular security listed by the exchange can readily find a seller, and vice versa. These specialists must buy from or sell to any trader whose order cannot be offset against other orders arriving simultaneously. If, for example, a buyer wants a hundred shares of IBM, but no one wants to sell at that moment, the IBM specialist sells from his inventory of IBM stock. The specialist charges a "bid-ask spread" to cover the cost. A bid-ask spread implies that a slightly higher price is asked from someone who wishes to purchase a security than will be contemporaneously offered to someone who wishes to sell.
An inside trader, however, will sell securities to the specialist when only he knows that the securities will soon be worth less. After the price has fallen, the insider is free to repurchase the securities from the specialist for the lower price. If that occurs, the specialist loses money. If insider trading recurs, the security's specialist cannot continue indefinitely without recouping the funds being lost to informed traders. Therefore, specialists will insist on larger bid-ask spreads if insider trading is permitted and occurs often.
To investors, the bid-ask spread is a trading cost. If insider trading increased the spread but did nothing else, it would decrease a security's attractiveness relative to certificates of deposit, government bonds, and other assets. Raising new capital would, thus, be more costly for a firm whose securities were subjected to repeated insider trading. Hence, all else being equal, insider trading makes it harder for a firm to raise money when opportunities to undertake new projects arise.
But insider trading might also have offsetting benefits. Insider trading can be profitable only if securities prices move. Therefore, insiders hoping to trade on inside information may try to get the price to move by cutting the company's costs, seeking new products, and so on. While such actions benefit the insider, they also benefit the firm's security holders as a group.
Of course, insiders can also profit by borrowing and then selling securities when the price is apt to fall. Some argue that insider trading is more likely to harm companies because damage is easier to inflict. That argument, in turn, has been countered; major actions by a company require teams, not individuals. Efforts to damage a firm would likely be brought to the attention of higher management or shareholders by some ambitious team member looking to capitalize on the resulting gratitude. Unfortunately, no evidence has been presented to help resolve this debate.
A number of financial economists and law professors take the position that insider trading ought to be legal. They base their case on the proposition that insider trading makes the stock market more efficient. Presumably, the inside information will come out at some point. Otherwise, the insider would have no incentive to trade on the information. If insider trading was legal, this group argues, insiders would bid the prices of stocks up or down in advance of the information being released. The result is that the price would more fully reflect all information, both public and confidential, about a company at any given time.
Even if insider trading sometimes creates more harm than good, rules against it could be contractual (e.g., "employees of our company who trade on material, nonpublic information forfeit their pension rights") rather than mandated by government. Because the circumstances facing companies differ, insider trading might be advantageous for some companies and not for others. And if so, would it not be sensible to permit firms to "opt out" of insider trading enforcement? Interestingly, Texas Gulf insider Charles Fogarty was subsequently elevated to chief executive officer of his company. Moreover, following Fogarty's death, another insider, who was also known to have traded on the same information, was elevated to replace him. Clearly, Texas Gulf's board of directors and shareholders must not have found the trading completely reprehensible. Yet the law makes no provision for opting out, implicitly assuming that insider trading injures all companies. Policymakers never seriously ask who is harmed, who is helped (other than the insiders), and by how much.
Of course, insider trading can injure a firm if the trading elevates prices that the firm itself has to pay. For example, if Fogarty had purchased Ontario mineral rights before Texas Gulf Sulphur agents could acquire them, Texas Gulf would have been injured. Similarly, if Alpha, Inc., quietly tries to acquire control of Gamma Corp., unauthorized purchases of Gamma securities by Alpha's president could drive up Gamma's share price, thus making the acquisition more costly. But most litigated cases reflect trading in competition with ordinary participants in the securities markets, not with the insider's own firm.
Considered narrowly, most investors are on average neither hurt nor helped by insider trading because most investors are "time-function traders." That is, they buy securities (and other assets) when their income exceeds their expenditures, and sell securities when an emergency, the period of their life, or a propitious moment to initiate some project necessitates expenditures that exceed income. Hence, time-function traders do not try to "beat the market." Since statistical examinations show that insider trading affects securities prices even before nonpublic information is released, time-function traders can be harmed or helped by insiders. Suppose that an insider's trading has elevated a security price. Those time-function traders who, by chance, want to buy that security must pay a higher price for it, one closer to the price it will reach when the insider's information becomes public. But those time-function traders who chance to sell unwittingly realize a higher price as a result of the insider's action. Consequently, some time-function traders have lost, but others have gained. Over a time-function trader's lifetime, the reasonable expectation would be to break even.
Besides specialists the one group systematically injured by insider trading are "price-function traders" - those who trade securities because they believe the present price is inappropriate. If an insider secretly buys securities, the result is an increase in price. Because some price-function traders believe that the security is now overpriced, they sell, but soon regret their action. Few people, however, have the expertise to realize trading profits repeatedly. Those who "play the market" without such expertise soon lose their capital. Thus, few active investors - even the professionals who manage pension funds - are properly considered price-function traders.
Sometimes, through luck or effort, individuals with no formal relationship with a firm discover important nonpublic information about it. Like true insiders they can profit by trading prior to public awareness of the information. A peculiar feature of insider trading law is that informed trading is treated more leniently if the trader is such a "quasi insider" (often a market professional who holds a seat on an organized securities exchange) than if the trader is a true insider.
For example, in 1975 and 1976 Vincent Chiarella netted more than $60,000 (1991 dollars) by trading on important nonpublic information about firms other than his employer, a financial printing firm. Even though clients tried to mask sensitive information in documents that Chiarella's employer was hired to print, Chiarella was often able to "crack the code." By buying from uninformed individuals, Chiarella became a successful trader. Yet the Supreme Court ruled that Chiarella did not violate the insider trading regulations because he did not work for and thus was not an insider of any firm whose inside information he had discovered.
This decision is puzzling. Whether the benefits to companies from true insider trading outweigh the costs, at least there are potential benefits. Quasi-insider trading, in contrast, imposes many of the same costs on firms with no obvious benefits. Although there has been pressure to strengthen the rules against quasi insiders, the legal constraints on them are still not as stringent as those on true insiders.
One matter is clear. Because insider trading has little effect on time-function traders, they do not participate in the debate. Most proponents of stronger insider-trading laws are price-function traders - arbitragers, floor traders, investment bankers, and others who earn a living from the securities exchanges. Insiders are such traders' most potent competitors for trading profits from new information. Price-function traders benefit from laws curtailing insider trading whether or not firms, and hence common investors, do also.
Far from the clearly settled moral issue that naïve media pieces, movies, and novels would have it be, both the theory and the evidence of insider trading remain primitive and equivocal. Present rhetoric and law have far outrun present understanding.
David D. Haddock, who holds a Ph.D. in economics from the University of Chicago, is a professor of law at Northwestern University, where he teaches corporation law. He previously worked in the Office of the General Counsel of the Ford Motor Company, where he was chief of economic studies for antitrust matters.
Since the depths of the Great Depression, the Securities and Exchange Commission (SEC) has tried to prevent insider trading in U.S. securities markets. Insiders - a firm's principal owners, directors, and management, as well as its lawyers, accountants, and similar fiduciaries - routinely possess information that is unavailable to the general public. Because some of that information will affect the prices of the firm's securities when it becomes public, insiders can profit by buying or selling in advance. Even before the thirties, insiders were liable under the common law if they fraudulently misled uninformed traders into accepting inappropriate prices. But the Securities Exchange Act of 1934 went further by forbidding insiders from even profiting passively from superior information.
One of the most famous instances of insider trading was Charles F. Fogarty's purchase of Texas Gulf Sulphur shares during 1963 and 1964. Fogarty, an executive vice president of Texas Gulf, knew that the company had discovered a rich mineral lode in Ontario that it could not publicize before concluding leases for mineral rights. In the meantime Fogarty purchased 3,100 Texas Gulf shares and earned $125,000 to $150,000 (in 1991 dollars).
The basic argument against insider trading is that insiders should not be permitted to earn such sums at the expense of uninformed traders. Yet in almost all other markets where information is important, insider trading is well established and widely accepted. For example, mineral leases are routinely bought by those better able than the sellers to evaluate a site's potential, as Texas Gulf Sulphur's behavior exemplified. Cattle buyers rely on superior estimates of what packers will pay when negotiating with ranchers. And so it goes, in markets for art, for real estate, for professional athletes - indeed in practically every market with substantial variations in prices. In all those markets a few buyers routinely profit from knowledge that most sellers do not possess, and a few sellers profit from knowledge that most buyers do not possess. Commentators rarely cast aspersions on such traders' ethics or contend that their transactions should be regulated because of the asymmetry in information. Why should securities markets be treated differently?
One reason frequently cited by policymakers and commentators is that insider trading undermines public confidence in the securities markets. If people fear that insiders will regularly profit at their expense, they will not be nearly as willing to invest. A similar argument is that companies prefer that their securities trade in "thick" markets - that is, markets with many traders, substantial capital available, and frequent opportunities to trade at readily observable prices. Efficient securities markets, it is argued, require a "level informational playing field" to avoid frightening away speculators, who contribute to securities market liquidity, and investors, who could invest their savings in markets with less risk of insider predation. Working on such a premise, over the last quarter-century the SEC has brought new and ever more stringent enforcement initiatives against insider trading.
Related to this argument is the harm that insider trading causes for "specialists." A specialist is someone whom the stock exchange appoints to ensure that a buyer of a particular security listed by the exchange can readily find a seller, and vice versa. These specialists must buy from or sell to any trader whose order cannot be offset against other orders arriving simultaneously. If, for example, a buyer wants a hundred shares of IBM, but no one wants to sell at that moment, the IBM specialist sells from his inventory of IBM stock. The specialist charges a "bid-ask spread" to cover the cost. A bid-ask spread implies that a slightly higher price is asked from someone who wishes to purchase a security than will be contemporaneously offered to someone who wishes to sell.
An inside trader, however, will sell securities to the specialist when only he knows that the securities will soon be worth less. After the price has fallen, the insider is free to repurchase the securities from the specialist for the lower price. If that occurs, the specialist loses money. If insider trading recurs, the security's specialist cannot continue indefinitely without recouping the funds being lost to informed traders. Therefore, specialists will insist on larger bid-ask spreads if insider trading is permitted and occurs often.
To investors, the bid-ask spread is a trading cost. If insider trading increased the spread but did nothing else, it would decrease a security's attractiveness relative to certificates of deposit, government bonds, and other assets. Raising new capital would, thus, be more costly for a firm whose securities were subjected to repeated insider trading. Hence, all else being equal, insider trading makes it harder for a firm to raise money when opportunities to undertake new projects arise.
But insider trading might also have offsetting benefits. Insider trading can be profitable only if securities prices move. Therefore, insiders hoping to trade on inside information may try to get the price to move by cutting the company's costs, seeking new products, and so on. While such actions benefit the insider, they also benefit the firm's security holders as a group.
Of course, insiders can also profit by borrowing and then selling securities when the price is apt to fall. Some argue that insider trading is more likely to harm companies because damage is easier to inflict. That argument, in turn, has been countered; major actions by a company require teams, not individuals. Efforts to damage a firm would likely be brought to the attention of higher management or shareholders by some ambitious team member looking to capitalize on the resulting gratitude. Unfortunately, no evidence has been presented to help resolve this debate.
A number of financial economists and law professors take the position that insider trading ought to be legal. They base their case on the proposition that insider trading makes the stock market more efficient. Presumably, the inside information will come out at some point. Otherwise, the insider would have no incentive to trade on the information. If insider trading was legal, this group argues, insiders would bid the prices of stocks up or down in advance of the information being released. The result is that the price would more fully reflect all information, both public and confidential, about a company at any given time.
Even if insider trading sometimes creates more harm than good, rules against it could be contractual (e.g., "employees of our company who trade on material, nonpublic information forfeit their pension rights") rather than mandated by government. Because the circumstances facing companies differ, insider trading might be advantageous for some companies and not for others. And if so, would it not be sensible to permit firms to "opt out" of insider trading enforcement? Interestingly, Texas Gulf insider Charles Fogarty was subsequently elevated to chief executive officer of his company. Moreover, following Fogarty's death, another insider, who was also known to have traded on the same information, was elevated to replace him. Clearly, Texas Gulf's board of directors and shareholders must not have found the trading completely reprehensible. Yet the law makes no provision for opting out, implicitly assuming that insider trading injures all companies. Policymakers never seriously ask who is harmed, who is helped (other than the insiders), and by how much.
Of course, insider trading can injure a firm if the trading elevates prices that the firm itself has to pay. For example, if Fogarty had purchased Ontario mineral rights before Texas Gulf Sulphur agents could acquire them, Texas Gulf would have been injured. Similarly, if Alpha, Inc., quietly tries to acquire control of Gamma Corp., unauthorized purchases of Gamma securities by Alpha's president could drive up Gamma's share price, thus making the acquisition more costly. But most litigated cases reflect trading in competition with ordinary participants in the securities markets, not with the insider's own firm.
Considered narrowly, most investors are on average neither hurt nor helped by insider trading because most investors are "time-function traders." That is, they buy securities (and other assets) when their income exceeds their expenditures, and sell securities when an emergency, the period of their life, or a propitious moment to initiate some project necessitates expenditures that exceed income. Hence, time-function traders do not try to "beat the market." Since statistical examinations show that insider trading affects securities prices even before nonpublic information is released, time-function traders can be harmed or helped by insiders. Suppose that an insider's trading has elevated a security price. Those time-function traders who, by chance, want to buy that security must pay a higher price for it, one closer to the price it will reach when the insider's information becomes public. But those time-function traders who chance to sell unwittingly realize a higher price as a result of the insider's action. Consequently, some time-function traders have lost, but others have gained. Over a time-function trader's lifetime, the reasonable expectation would be to break even.
Besides specialists the one group systematically injured by insider trading are "price-function traders" - those who trade securities because they believe the present price is inappropriate. If an insider secretly buys securities, the result is an increase in price. Because some price-function traders believe that the security is now overpriced, they sell, but soon regret their action. Few people, however, have the expertise to realize trading profits repeatedly. Those who "play the market" without such expertise soon lose their capital. Thus, few active investors - even the professionals who manage pension funds - are properly considered price-function traders.
Sometimes, through luck or effort, individuals with no formal relationship with a firm discover important nonpublic information about it. Like true insiders they can profit by trading prior to public awareness of the information. A peculiar feature of insider trading law is that informed trading is treated more leniently if the trader is such a "quasi insider" (often a market professional who holds a seat on an organized securities exchange) than if the trader is a true insider.
For example, in 1975 and 1976 Vincent Chiarella netted more than $60,000 (1991 dollars) by trading on important nonpublic information about firms other than his employer, a financial printing firm. Even though clients tried to mask sensitive information in documents that Chiarella's employer was hired to print, Chiarella was often able to "crack the code." By buying from uninformed individuals, Chiarella became a successful trader. Yet the Supreme Court ruled that Chiarella did not violate the insider trading regulations because he did not work for and thus was not an insider of any firm whose inside information he had discovered.
This decision is puzzling. Whether the benefits to companies from true insider trading outweigh the costs, at least there are potential benefits. Quasi-insider trading, in contrast, imposes many of the same costs on firms with no obvious benefits. Although there has been pressure to strengthen the rules against quasi insiders, the legal constraints on them are still not as stringent as those on true insiders.
One matter is clear. Because insider trading has little effect on time-function traders, they do not participate in the debate. Most proponents of stronger insider-trading laws are price-function traders - arbitragers, floor traders, investment bankers, and others who earn a living from the securities exchanges. Insiders are such traders' most potent competitors for trading profits from new information. Price-function traders benefit from laws curtailing insider trading whether or not firms, and hence common investors, do also.
Far from the clearly settled moral issue that naïve media pieces, movies, and novels would have it be, both the theory and the evidence of insider trading remain primitive and equivocal. Present rhetoric and law have far outrun present understanding.
David D. Haddock, who holds a Ph.D. in economics from the University of Chicago, is a professor of law at Northwestern University, where he teaches corporation law. He previously worked in the Office of the General Counsel of the Ford Motor Company, where he was chief of economic studies for antitrust matters.