Should insider dealing be Prohibited?

Should insider dealing be prohibited?

There are advocates supporting both, prohibition and deregulation of insider trading. Since the fountainhead of majority of laws is the US law, this post will primarily discuss the US law, though insider trading is neither defined including all parameters nor are there clear regulations by the federal rules.[1] The most prominent argument against insider dealing mentions the unfairness of it ethically which may resultantly frighten away investors who contribute to the liquidity of the stock market.[2]  But in the absence of a clear definition of insider trading, enforcement of the regulations becomes a difficult task.

Moreover, the majority rule says that there is no such responsibility for the corporate insiders towards the shareholders. In the case of Carpenter v. Danforth[1] which is among one of the initial cases to deal with insider trading, it was held by the appellate division that the director™s duty which was owed to the corporation was not owed to the shareholders by reason of his holding shares.[2]

Giving all due respect to the decision of the court, the authors opines that  while conceding the fundamental duty of the directors towards the corporation also has to be accountable to the share holders who are in effect owners of the corporation. Shareholders will enhance/ continue their investments only if the corporation dealings are transparent and their investments bring them higher returns.

A point of view supporting insider trading justifies that it is acknowledged as a type of compensation for the corporate sector work force which can be kept at a subdued salary thereby benefiting the shareholders eventually. On the company value enhancement, academicians profess that it encourages innovations, due to the sheer quantum of rewards to be reaped, from creating products which add value and result in steep increment in the stock.[3]   However, strong the argument is, it does not explain the unfair act of keeping the general public from material corporate information and reaping the financial gains on their own at the shareholder™s cost. It also does not justify the issue of insiders getting into dicey business for quick profits.[1] Besides, due to acute competition there is no check on the managerial compensation, there by profits from insider trading augment the high managerial compensation rather than substitute lower compensations as envisioned.[2]

The compensation argument is one of the most common arguments which the proponents of insider dealing argue, however, they tend to forget the fact that, not only is insider dealing an ethically wrong instrument to compensate the management but the management is usually given higher salaries on the basis of their skills, experience and performance, the judgement for which is, in principle, made by the shareholders. If measures such as insider dealing are used to compensate the management, the shareholders inevitably lose to the insiders of a firm because of lack of the information, which, these insiders use to great advantage of their own.

Moreover, this cannot be a valid argument in support of insider dealing because the insider not only includes the management and executives but other secondary insiders such as lawyers, accountants as well, for whom this cannot be a valid justification.[3]

The fact that insider trading lacks a legal definition in place and the reliance by Americans on numerous anti-fraud provisions gives a base to the proponents of insider dealing to argue on the ground that regulating insider dealing might prove to be unfair to those traders who do not indulge in insider trading in it™s strict sense but their dealings are such that are borderline on insider trading.[1] However, this is not of much importance. The reason being that it is necessary to prove the intention of fraud.[2]

Critics of stringent insider trading regulations point out that securities analyst play a major role in assessment of companies and this would stifle their basis of analysis because of the absence of inputs from the company officials.[3] However, the empirical evidence shows that the analysts in the United States make their assessments within the ambit of permitted law.[4] Moreover, in a country like the US which has been highly cautious after the fall of ENRON, and the Sarbanes-Oxley Act which came in response to the Enron case, it is very difficult for the securities analyst to make any unfair or fake assessments.

There are also arguments on the basis that there is no sufferer of the so-called crime, insider trading and moreover, it would be highly expensive to impose restrictions on insider trading.[5] To enforce the restrictions against an offence like this is highly expensive as well as time consuming and whether directly or indirectly the cost is borne by the shareholders ultimately.

The parity of information is yet another reason given by the proponents for prohibiting insider dealing. However, the US Supreme Court rejected this argument contending that a truly efficient market is one in which the information possessed by all investors is not equal.[1] Moreover, the Court argued that a different level of possession of information encourages the investors to be more competitive and do more research thereby, improving market efficiency.[2]

With all due respect to the Supreme Court, competitiveness in the market place brings out the best and is a source of greater efficiency, but this is only true when the competition is healthy. In insider dealing, a person is privy to information by virtue of his being in that particular position. The question of research, competency and efficiency do not arise here because it amounts to possession of relevant information that might negate research about the future prospects of the company.

Legal, financial and institutional data researched across 33 countries show that if insider trading laws are strictly implemented in the stock markets, such markets have greater liquidity and the ownership of equity is dispersed making the stock prices more transparent.[3]

According to Carlton and Fischel, one of the benefits of insider trading is that it allows the stock prices to find its own legitimate level due to the inputs and settle to the firm™s proper value at earliest.[1] However, insiders do not trade for the benefit of others.[2] While on the other hand insider trading stigma may curb insiders their initiative to release relevant information in the market resulting the stock prices not having factored in the information and being less informative.(Kraakman, 1991). Also insider trading may act as a deterrent by reducing incentives to outside informed traders from researching and finding out relevant information about the firm thereby making the stock less informative.[3]   by: (1) Possibility of  sabotage by insiders (Morck, Yeung, and Yu, 2000); or by (2) Stemming the flow of stock information after reducing competitors. (Fishman and Hagerty, 1992)[4]

Though insider trading, if allowed to go on unchecked will lead to a different set of problems and open an avenue for higher cost of doing business. When insiders trade it is invertible that brokers and other market makers consistently lose money, to cover this additional cost they enhance their bid-ask value. This way they cover the higher cost and shift the onus of this enhanced cost to investors outside whom they deal with, resulting in creating insider trading tax.[5] Enhanced ownership may be a direct fall out of insider trading even if such trades are considered beneficial. Due to the large holdings it can be assumed that monitoring is professionally carried out and better (see, e.g., Bhide, 1993). With these large holdings (undiversified) the vulnerability factor is required to be offset through compensation. One such means is by allowing insider trading (Bhide, 1993; Demsetz, 1986). Enhanced valuation through insider trading encourages investors to hold large blocks of shares, however if insider trading is legally forbidden it is likely to dscourage investors investing in large blocks of shares. (Bhide, 1993; Demsetz, 1986). Various countries have different perspectives of pattern of share holdings, wherein countries promoting widespread equity ownership have put in place necessary regulations to prohibit insider trading.[1]

Insider trading regulations are not totally independent. They are influenced by various regulations among which is included the pattern of equity ownership. Research has further shown that if there are no regulations for insider trading then the small shareholders are at loss, as the large investors such as the institutional investors who have better resources and are by all means more powerful, join hands with the controlling authorities of the company in order to safeguard their interests.[2]

Some academicians argue that it is true that the insider dealers make striking profits from the inside information that they have access to, however, it is believed that these insiders are able to make these profits because of the information they have and not because of any kind of deception.[1] However this argument cannot be given credit as having access to information by virtue of being in a particular position and using it for the same transaction in which the other shareholders also participate, without disclosing that information to them, is itself a form of deception.

Moreover, regulations are to deter insiders from trading stocks of their own company but the regulations are silent about such trading of stocks of other companies.[2] Though the actual beneficiary of the insider dealing regulations are not clear. Small shareholders and general public do not greatly benefit from these regulations but it is usually the institutional investors, brokers, security analysts, floor traders. Moreover the regulators i.e. SEC gets more visibility and power which is accompanied with prestige and a larger budget. (Bainbridge 2002).[3]

The arguments as those given above by the proponents of insider trading are not consistent. Insider trading has to be regulated, this must have a rationale, only because there is nothing to stop the offenders from trading on the stock of other companies does not mean that the insiders should not be prohibited from trading on the stocks of their companies, the information of which they have easy access to on a quid pro quid basis. Moreover, even if the beneficiaries of the regulations are institutional investor or brokers it stands to reason. This is what makes the market efficient and competitive in its true sense, as these large investors may have more access to resources and may be more powerful but benefit purely on the basis of their research. Providing a level playing field to market professionals, small share holders and insiders by regulating insider trading will check volatility in the market.

Academicians Scott (1980), Herzel and Katz(1987), point out that insiders use information belonging to their organization for their personal gain.[4] Researchers have contested that insiders benefit at the expense of outsiders when inside information is the basis of initiating a trade, but outsiders trading their shares would have initiated the trades anyway and would have traded at a worse price (Manne 1970). That is to say if an insider is selling stock, he is doing so as his inside information informs him that the stock prices are likely to fall. As a consequence of selling pressure the stock prices fall, however a buyer of the stock in the market picks up the stock at a lower price consequent to the fall, thereby getting a better price for the stock he had set out to buy. As is evident that someone in the market has to bear the burden of the loss due to the insider trading, but such losses are generally spread out across buyers and sellers and cannot be easily traced. (Wang and Steinberg 1996 ). But insiders selling resulting in marginal fall in prices, goads the buyers on the margin to buy who actually loose, as well as the stock holders who sold at a lower price or persons who could not sell as there was no demand. In the instant case it is argued that transfer of wealth takes place from an outsider to an insider, the stock prices falling down erodes the valuation of the company thereby raising the cost of capital (Mendelson 1969). Insider trading rarely affects long term investors as opposed to short term speculators as the trades had been calculated and initiated for the long term projected value. (Manne 1966).[5]

Some academicians such as Manove (1989) have argued that due to insider trading selling pressure, the stock prices may be depressed thereby depreciating the value of the firm. But Manne 1996 points out agency problem may be actually reduced due to insider trading. Also Harold Demsetz concluded that shareholders who hold large chunks of controlling stocks instead of diversified portfolios need to be compensated for the risk, this can be taken care of by allowing them access to valuable trading information.[6] Bhattacharya further argues that outsiders also may benefit from insider trading.[7] Though, even if law ensures a level playing field and information is available to all participants, it is not necessary that they arrive at the same conclusion after analysis. In all probability different analysts would arrive at different conclusions and trades initiated will be as per varied opinions of the best analysis of the information available. [8]

Analysis and interpretation is directly proportional to the competence of the analyzer, however analysis is secondary. Firstly it is mandatory to follow the source of information. Information per se cannot be the same with all interested parties as market players compete and research credible information and have to at times wade through misinformation. However, this source of information seeking and analysis takes an unfair preponderance if the information is available to a select few to act upon, by virtue of their position giving them easy access to important information, denied to others.

Manager™s incentives compensating them through insider trading can hurt the corporate performance, as in the zeal to garner insider trading profits through substantial price swings, managers may engage in risky projects and expose the company to undue risk.[9]  Insider trading also tends to make managers complacent not exercising themselves to their full potential as they are able to generate profits even faced with bad news.[10] Besides these managers exploit inside information by hoarding and trading this information before revealing it, thereby interfering with the natural flow of information within the firm which may be counter productive.[11]

As a natural consequence the innovators who create valuable information are the ones who actually profit from the information and this can go unchecked as it is not possible to ensure otherwise.[12]    The  real innovators of the firm would prefer to hoard information to enable them to monopolize on the insider trading profits, but the fact that this is discouraged, would possibly allow other insiders to take advantage of this without any contribution from them. The inability to hold back information by the true innovators of the firm to take maximum advantage of insider trading, acts as a deterrent as it ultimately reduces their initiative, as their advantage from insider trading is diluted , thereby ultimately adversely affecting corporate performance due to lack of incentive. Conversely curbing free flow of information within the firm and having access by a select few could jeopardize organizational efficiency of the firm[13]

The problem of free riding is age old. However it is suggested that there should be a body in place to decide on certain information which can be kept confidential by the innovators, just like certain official information which cannot be made public, other than that there should be an equal distribution of information to one and all.

[1] Swanson, C.B. (2003). Insider Trading Madness: Rule 10b5-1 and the Death of Scienter. Kanas Law Review, [online] vol.52, p.147. Available from: <https://litigation-essentials.lexisnexis.com/webcd/> [accessed 3 July 2011].

[2] Huang, H.H. (2007). Substitute Trading and the Effectiveness of Insider Trading Regulations. [online]. Available from: <http://www.ryerson.ca/economics/seminars/seminar071211.pdf> [accessed 12 July 2011].

[3] Dolgopolov, S. (2008). Insider Trading. [online]. Available from: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1305210> [accessed 19 July 2011].

[4] Maug, E. (2002). Insider trading legislation and corporate governance. European Economic Review, [online] 46(9), pp.1569-1597. Available from: < http://www.sciencedirect.com/science/article/pii/S001429210200243X>

[5] Dolgopolov. S. (2008). Insider Trading. [online]. Available from: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1305210> [accessed 19 July 2011].

[6] Demsetz, H. (1986). Corporate Control, Insider Trading and Rates of Return. The American Economic Review, [online] 76(2), pp.313-316. Available from: < http://www.jstor.org/pss/1818787> [accessed 3 July 2011].

[7] ibid.

[8] Miller, M. (n/d). The Inside: Parasite or Legitimate Profit-Maker? [online]. Available from:

< http://ccsindia.org/ccsindia/policy/money/studies/wp0029.pdf> [accessed 26 July 2011].

[9] Easterbook, F.H. (1981). Insider Trading, Secret Agents, Evidentiary Privileges, and the Production of Information. The Supreme Court Review, [online] vol.1981, pp.309-365. Available from:

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[10] Cox, J.D.(1986). Insider Trading and Contracting: A Critical Response to the Chicago School. Duke Law Journal, [online] 1986(4), pp.628-659. Available from: < http://scholarship.law.duke.edu/cgi/ > [accessed 24 July 2011].

[11] Haft, R.J. (1982). The Effect of Insider Trading Rules on the Internal Efficiency of the Large Corporation. Michigan Law Review, [online] 80(5), pp.1051-1071). Available from: < http://www.jstor.org/stable/i255020> [accessed 3 July 2011].

[12]Cox, J.D.(1986). Insider Trading and Contracting: A Critical Response to the Chicago School. Duke Law Journal, [online] 1986(4), pp.628-659. Available from: < http://scholarship.law.duke.edu/cgi/ > [accessed 24 July 2011].

[13] Haft, R.J. (1982). The Effect of Insider Trading Rules on the Internal Efficiency of the Large Corporation. Michigan Law Review, [online] 80(5), pp.1051-1071). Available from: < http://www.jstor.org/stable/i255020> [accessed 3 July 2011].

[14] Luberti, F.P. (1983). An Outsider looks at Insider Trading: Chiarella, Dirks and the duty to disclose non-public information. Fordham Urban Law Journal, [online] 12(4), pp.777-806. Available from: <http://ir.lawnet.fordham.edu/cgi/> [accessed 6 August 2011].

[15] Jaffe, J.F. (1974). The Effect of Regulation Changes on Insider Trading. The Bell Journal of Economics and Management Science, [online] 5(1), pp.93-121. Available from: < http://www.jstor.org/pss/3003094>

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[16] Li, D. and Zhang.Y. (2010). Internal Control Effectiveness and Insider Trading. [online]. Available from: <http://www.isb.edu/AccountingResearchConference/File/LiZhangICDIT2010.pdf> [accessed 26 July 2011].

[17] Jaffe, J.F. (1974). The Effect of Regulation Changes on Insider Trading. The Bell Journal of Economics and Management Science, [online] 5(1), pp.93-121. Available from: < http://www.jstor.org/pss/3003094>

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[18] Fisch, J.E. (1991). Start Making Sense: An Analysis and Proposal for Insider Trading Regulation. Georgia Law Review, [online] vol.26, p.179. Available from: <http://heinonline.org/> [accessed 29 July 2011].

[19] Prentice, R.A. (1999). The Internet and its Challenges for the Future of Insider Trading Regulation. Harvard Journal of Law and Technology, [online] 12(2), pp.265-360. Available from:

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[20] Padilla, A. (n/d). The Regulation of Inside Trading as an Agency Problem. [online]. Available from:

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[21] ibid.

[22] ibid.

[23] Li, D. and Zhang.Y. (2010). Internal Control Effectiveness and Insider Trading. [online]. Available from: <http://www.isb.edu/AccountingResearchConference/File/LiZhangICDIT2010.pdf> [accessed 26 July 2011].

[24] Fried, J. (1997-98). Reducing the profitability of Corporate Insider Trading through Pretrading Disclosure. S. Cal.L. Rev., [online] vol.71, pp. 303-392. Available from:< https://litigation-essentials.lexisnexis.com/webcd/ > [accessed 28 July 2011].

[25] Miller, M. (n/d). The Inside: Parasite or Legitimate Profit-Maker? [online]. Available from:

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[26] Connor, M.A.O. (1989). Towards a More Efficient Deterrence of Insider Trading: The Repeal of Section 16(b). Fordham Law Review, [online] 58(3). pp.309-381. Available from: <http://ir.lawnet.fordham.edu/cgi/>

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[27] Miller, M. (n/d). The Inside: Parasite or Legitimate Profit-Maker? [online]. Available from:

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[28] Bris,A. (2005). Do Insider Trading Laws Work? European Financial Management, 11(3), pp.267-312.

[29] Beny, L.N. (2005). Do Insider Trading Laws Matter? Some Preliminary Comparative Evidence. American Law and Economics Review, [online] 7(1), pp.144-83. Available from: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=623481>

[accessed 21 July 2011].

 

[30] Maug, E. (2002). Insider trading legislation and corporate governance. European Economic Review, [online] 46(9), pp.1569-1597. Available from: <http://www.sciencedirect.com/science/article/pii/S001429210200243X>

[accessed 4July 2011].

 

[31] ibid. (Moreover, as per Manne (1966) and Carlton and Fischel (1983) argue that insider trading is less expensive than traditional means of information disclosure).

[32] Avgouleas,E. (2005). The Mechanics and Regulation of Market Abuse: A Legal and Economic Analysis.Oxford: OxfordUniversity Press.

[33] Beny, L.N. (2005). Do Insider Trading Laws Matter? Some Preliminary Comparative Evidence. American Law and Economics Review, [online] 7(1), pp.144-83. Available from: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=623481> [accessed 21 July 2011].

[34] ibid.

[35] Manne, H.G. (2005). Insider Trading: Hayek, Virtual Markets, and the Dog that Did Not Bark. Journal of Corporation Law, [online] 31(1), pp.167-185. Available from: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=679662>

[accessed 23 July 2011].

[36] Gilson, R.J. and Kraakman, R.H. (1984). The Mechanics of Market Efficiency. Virginia Law Review, [online] 70(4), pp.622-26. Available from: < http://www.jstor.org/pss/1073080> [accessed 28 July 2011].

[37] Langevoort, D.C (1992). Theories, Assumptions, and Securities Regulation: Market Efficiency Revisited. University of Pennsylvania Law Review, [online] 140(3), pp.851-920. Available from:

< http://www.jstor.org/stable/i273487> [accessed 18 July 2011].

[38] Beny, L.N. (2005). Do Insider Trading Laws Matter? Some Preliminary Comparative Evidence. American Law and Economics Review, [online] 7(1), pp.144-83. Available from: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=623481>

[39] Baltic, C.V. (1992). The Next Step in Insider Trading Regulation: International Cooperative Efforts in the Global Securities Market. Law and Policy in International Business, [online] 23(1), P.167. Available from: <http://heinonline.org/> [accessed 20 July 2011].

[40] Newkirk, T.C. and Robertson, M.A. (1998). Insider Trading-A U.S. Perspective. 16^th International Symposium on Economic Crime. Jesus College, Cambridge. 19^th September 2003. Available from:

< http://info.worldbank.org/etools/docs/library/157390/securities/images/insider_newkirk.pdf>

[accessed 2 august 2011].

[41] Anon. (1998). Nanny Discovers Abusive Squeezes, The Daily Telegraph, 30 July,p.27 as given in Newkirk,T.C. and Robertson, M.A. (1998). Insider Trading-A U.S. Perspective. 16^th International Symposium on Economic Crime. Jesus College, Cambridge. 19^th September 2003. Available from:

< http://info.worldbank.org/etools/docs/library/157390/securities/images/insider_newkirk.pdf> [accessed 2 august 2011].

[42] SEC v. Stevens 91 Civ. 1869 (S.D.N.Y. March 19, 1991), Litig. Rel. No. 12813.

[43] Butler, H.N. (1989). Can the SEC Change?. Corporate Board, [online] 10(56), p.6. Available from: <http://business.highbeam.com/412274/article-1G1-7251056/can-sec-change> [accessed 15 July 2011].

[44] Newkirk, T.C. and Robertson, M.A.(1998). Insider Trading-A U.S. Perspective. 16^th International Symposium on Economic Crime. Jesus College, Cambridge. 19^th September 2003. Available from:

< http://info.worldbank.org/etools/docs/library/157390/securities/images/insider_newkirk.pdf>

[accessed 2 august 2011].

[45] Fried, J. (1997-98). Reducing the profitability of Corporate Insider Trading through Pretrading Disclosure. S. Cal.L. Rev., [online] vol.71, pp. 303-392. Available from:< https://litigation-essentials.lexisnexis.com/webcd>

[accessed 28 July 2011].

[46] Alexander, R.C.H. (2007). Insider Dealing and Money Laundering in the EU: Law and Regulation. [e-book]. Hampshire: Ashgate Publishing Limited. Available from: http://books.google.co.in/books [accessed 3 August 2011].

[47] Carpenter v.Danforth 19 Abb. Pr. 225 (N.Y. Sup.  Ct. 1865), rev™d, 52 Barb. 581 N.Y. App. Div. 1868.

[48] Dalley,P.J. (1998). From horse trading to insider trading: the historical antecedents of the insider trading debate. William & Mary Law Review, [online] vol.39, pp. 1289-1353. Available from:

<http://works.bepress.com/cgi/viewcontent. > [accessed 2 August 2011].

[49] See, e.g., Henry B. Manne, Insider Trading and the Stock Market (1966) (insider trading increases market efficiency because it produces desirable incentives on corporate managers.

[50] Swanson, C.B. (1997). Reinventing Insider Trading: The Supreme Court Misappropriates the Misappropriation theory. Wake forest L.Rev., [online] vol.32, 1157,1167-68. Available from:

< http://heinonline.org/HOL/ > [accessed 31 July 2011].

[51] Bainbridge, S.M. (2000). Inside Trading: An Overview. [online]. Available from:

< http://papers.ssrn.com/sol3/papers.cfm?abstract_id=132529> [accessed 12 July 2011]