David R. Henderson  

Insider Trading

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The news that the feds are charging Mark Cuban with "insider trading" raises an interesting issue: what's wrong with insider trading? You might think it's obvious. If so, read the articles on insider trading in the 1st and 2nd editions of The Concise Encyclopedia of Economics. Some highlights from each.

From the 1st edition, an article by David D. Haddock of Northwestern University:

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 [who had engaged in insider trading of his company's stock] 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.

And Haddock's closing paragraph:

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.

From the 2nd edition, an article by Stanislav Dolgopolov of the University of Michigan Law School, in which Dolgopolov addresses the "cui bono" question:

Who benefits from regulation of insider trading? One group of beneficiaries is market professionals--broker-dealers, securities analysts, floor traders, arbitrageurs, and institutional investors. The reason is that they are "next in line" for trading profits, as they possess an advantage over public investors in collecting and analyzing information (Haddock and Macey 1987). Regulation also, of course, benefits the regulators--that is, the SEC--by giving that agency greater power, prestige, and budget (Bainbridge 2002). However, the benefits from insider trading laws to small shareholders, the alleged primary beneficiaries, have been extensively debated.

Note the "power" part of the above quote. When government officials use their discretionary power to prosecute some people and not others, are they using their power to go after people who have displeased them on other grounds? Could it be, for example, Cuban's willingness to follow the bailout closely and critically? HT to Karen DeCoster on this latter angle.



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COMMENTS (9 to date)
frank cross writes:

The case for banning insider trading, I believe, is as follows.

Investors will not want to play in a stock market that is rigged, where they can be taken advantage of by insiders. While this would give firms an advantage to contract out of it, this is inferior because it has transaction costs for investors, potentially considerable ones, in identifying the precise nature of the prohibition for each firm and also there is the risk that the company simply would choose not to enforce the contract, if the perpetrator were caught (and of course the probability of catching the perpetrator depends on the uncertain monitoring of the company).

There is some empirical evidence here and to my knowledge it all shows that insider trading prohibitions strength stock markets.

Steve Roth writes:

When government officials use their discretionary power to prosecute some people and not others, are they using their power to go after people who have displeased them on other grounds?

Like, U.S. attorneys, for instance?

In the current administration, almost certainly.

David R. Henderson writes:

Steve,
Good point. I think this happens in every administration. Thousands of wrongs don't make a right.
David

Randy writes:

The laws against insider trading encourage the idea that the markets are in the realm of "the public". That is, the laws replace the possibility of insider fraud with a probability of sytemic fraud. Of the two, the possibility of insider fraud is much easier for the potential investor to compensate for.

Randy writes:

Question; Is there any fundamental difference between insider training and a government bailout? Obviously, I'm thinking there's not.

Jeff writes:

frank cross is right. How this can not be obvious to anyone is an interesting question in its own right.

Chad Seagren writes:

Consider the following scenarios:

Scenario A
An executive of a pharmaceutical company learns that the FDA is going to approve a drug that is expected to be very profitable/successful. He buys stock before the information "becomes public" and enjoys a profit as the share price skyrockets.

Scenario B
An executive of a pharmaceutical company plans on selling some of the stock he has in the company in an effort to balance out his portfolio. He learns that the FDA is going to approve a drug that is expected to be very profitable/successful. He decides to hold onto the stock and enjoys a profit as the share price skyrockets.

In both cases the individual profits from the action (or inaction) taken on the basis of "insider" information. But only one is illegal and subjects the individual to SEC scrutiny/harrassment. The law against insider trading is arbitrary and capricious and enables agents of the government to create much mischief.

Brad Hutchings writes:

SEC Chairman Chris Cox recused himself from the vote to bring the suit because one of his deputies wrote a scathing email to Cuban concerning his funding of a movie that movement conservatives were upset about. Cox was my Congressman before going to the SEC. I met him a few times last millennium, and found him to be knowledgeable, engaging, and thoughtful. His reports to constituents about the budget set a standard that many in his party followed. Cox is a stand up guy, but his reputation will take a bigger hit with this Cuban thing than with the bailout.

It is interesting to watch all the IANALs comment on Cuban's "Blog Maverick" blog. Comments are running 2:1 against him on his own public forum that he doesn't need to provide. But one commenter knowledgeable about insider trading pretty much nailed it by citing letter and verse about how Cuban had to agree to keep the information given to him confidential. Cuban is a savvy guy. The SEC isn't so much accusing him of a crime as they are accusing him of being a moron. Good luck with that.

chanceH writes:

also :

Scenario C:

You decide you'd like to diversify your portfolio, by selling 50% of your holding of XYZ and parking the funds in a money market account. On the way into work, an insider tells you something bad about XYZ. The information he gives you is correct and confidential. Now just because some new information has been transmitted into your noggin, you aren't allowed to sell stuff you supposedly own. In effect, the insider has temporarily deprived you of full control of your own property.

Something just isn't right about that.

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