An open letter on insider trading to Gene Fama and Ken French

Henry G. Manne —  17 May 2010

[Post bumped to the top, and cross-posted at Organizations & Markets, in light of our technical difficulties last week and in the hopes of eliciting a response — Eds]

Dear Gene and Ken:

I must say that I was totally flabbergasted when I read your recent blog posting on insider trading.  I know that your usual posts on investments, which I often cite to friends, are well-informed and empirically-supported; your work over the years on these topics is important and influential—and rightly so.  Unfortunately, in this post, you have deviated from your usual high quality.  Anyone current on the topic of insider trading will recognize that you have been careless in your selection of anti-insider-trading arguments and that you omitted from your brief note the major part of the argument about insider trading: whether and how much it contributes to market efficiency.  To say this is a strange omission coming from Fama and French would be an understatement.

Your first error is to assume that the insider trading debate is about informed trading only by “top management”.  I suspect that this error may flow from my original argument for using insider trading to compensate for entrepreneurial services in a publicly held company, a matter you do not mention and which I will not pursue here except to note that “entrepreneurial services” does not equate to top management.  Strangely no one seems to notice that most of the celebrated cases on the subject have not involved corporate personnel at all (a printer, a financial analyst, a lawyer and Martha Stewart).

I was more surprised, however, to see you repeating the oldest myth in the whole field, one that even the SEC gave up on as wrong many years ago and which frankly is no longer a part of the respectable debate on this topic: that a trade by an insider “disadvantages” the party on the other side.  (I will let pass the peculiar mistake of relating this by inference to a duty owed to existing shareholders when insiders are selling—how about insider sales to perfect strangers to the corporation?  Is there an inchoate fiduciary duty?).  I challenge you to show me any way in which the anonymous buyer or seller in an exchange transaction is harmed because that transaction just happens to involve an insider on the other side.  In fact, you cannot.  The specialist might be assumed to be vulnerable to losses from insiders’ being in the market, but careful research has shown that even they are totally unconcerned about the presence of insiders (other than as usurpers of their rents, and disclosure laws from the ’33 Act to Regulation FD have ensured that the specialists’ sphere of operation is well-protected) and that this so-called “moral hazard” argument is simply insignificant in the real world

Then you repeat another of the old myths surrounding the topic of insider trading:  that allowing it will create a further managerial moral hazard since it will give an incentive to top managers (who I presume are supposed to be able to manage this mischief without anyone else knowing about it—weird) to produce bad news rather than good news.  There is not, in the entire enormous literature on the topic, one iota of evidence for this statement, although some law professors, who are generally better at making arguments for a legal brief than they are at doing rigorous economics, may still mouth it. True, there could indeed be a small end-period problem with trading on bad news.  But, even if there is, it must be of little significance compared to the benefits to shareholders and other investors of allowing insider trading.  There are many forces, including reputation and market competition, operating to induce managers to produce good news, and there is no limit on the amount of this the market will continue to reward them for.  But there are no incentives other than this highly theoretical one encouraging managers to produce bad news.  A bit too much of this and the manager is ruined, while the possibility of making a gigantic killing to justify some once-in-a-lifetime malfeasance with inside information is all but non-existent.  This would be a very foolish bet for any corporate manager to make, and not surprisingly there is no evidence that they do so.

As for the idea that they will delay disclosure (a special form of the bad news/moral hazard argument), as Harold Demsetz pointed out over 40 years ago, the insider will have every incentive not to delay but to speed up disclosure so he can get the highest rate of return on his transaction.  Again there is not one bit of evidence suggesting that this delay ever occurs in the real world and some very strong evidence (the best is by Lisa Meulbroek) that insider trading of the illegal variety quickly moves stock price in the appropriate direction.

On this point, I can’t help but ask what is your theory of how stock market pricing came to be so efficient?  Surely it is not a result of the SEC and disclosure laws—a joke if it were not all so expensive (on which see, among other things, my son’s Hydraulic Theory of Disclosure article).  The studies that have looked have found a mixed result, at best, and the best of these (starting with Stigler’s in 1964 and Benston’s in 1973) find that the market was just as efficient before the SEC and the ’33 and ’34 Acts as it was after.  Gilson and Kraakman certainly did not supply a satisfactory answer to this question that they addressed many years ago, even though they were trying desperately to prove that something besides insider trading was making the market so efficient.

Obviously this is a much larger topic than I can address here, but I must admit to being most dismayed by your implication that the goal of instantaneous communication of new information to all market participants is a worthy ideal that in some way might be aided by disclosure regulation or a ban on insider trading.  We know very well who was pushing all along for a ban on insider trading: the market professionals who stood next in line for new information if they could just get those pesky insiders out of the picture.  They certainly were not interested in universal, equal access to information, nor was the SEC who aided and abetted them in this project.  Given this well-known history, do you really mean to stand with those rent seekers?

I have greatly admired your work for many years, as you know, and I hope I may have missed something in your short blog post.  But precisely because I admire your work—and because many others do, too—I felt an obligation to respond to your problematic comments on this point.  I look forward to your thoughts in response.

Yours cordially,

Henry Manne