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In 1986, when I set out to develop a Law and Economics-oriented law school at George Mason University, I knew that I had a “secret weapon”, the list of about 450 law professors who had by then attended the Law and Economics Center’s Economics Institutes for Law Professors.  I did not have a large budget, but I did have a pretty good idea that some promising stars might be lurking in places I could raid.  Someone termed this the “powerball strategy”.  The very first person who fit the bill was Larry Ribstein.  He had made an impression on me in “summer camp” as someone with a natural proclivity towards the economic way of thinking, and I could just conjecture that he was not then receiving much support or encouragement for this more intellectual approach to law teaching.  I believe that he was the very first person I contacted to test his interest in joining a new kind of school.  As he demonstrated in everything he did for the rest of his woefully short life, he opted to take the more intellectually challenging opportunity, though he must have understood the tremendous risks that all of us were taking with our professional careers in those days.  Larry was the very essence of what became the George Mason style, intellectually fearless and forever mindful of the goals of law in a free society. He was a faculty mainstay in the task of developing the new curriculum and the new approach which we were all gambling on.  I suspect that he never would have left Mason (even for a chair and far more money) had he not felt that we had accomplished what we set out to do there.  He was crucial to the success that law school has enjoyed.

His work in recent years has been nothing short of spectacular, as he has almost single-handedly introduced the world to some peculiar disadvantages of the regulated corporate system we have evolved and opened our eyes to the benefits that can flow from the non-melliflous-named “uncorporation.”  That was still perhaps a work in progress when he died, and who knows whether a new enthusiast will step forward to champion the cause.  The same is true of his pioneering work in jurisdictional competition and capitalism in the movies.  But perhaps our greatest intellectual lacuna from his death will show in connection with his most recent work on the changing economics of legal services and legal education.  This work was of great importance, not merely because of the insightful substance, but also because he ventured into a very significant area most law professors fear to tread.  But that was Larry.

On a personal note, I have lost a delightful and valued friend, a professional and intellectual “son” who was not supposed to predecease his mentor, and my intellectual biographer (see his “Henry Manne: Intellectual Entrepreneur, in Pioneers Of Law And Economics (Lloyd R. Cohen and Joshua D. Wright, eds.,. Elgar Publishing, 2009)) who taught me that I had said far more than I ever understood.  I join the others who loved Larry in sending our deepest sympathy and condolences to Ann, Sarah and Susanna.

Henry G. Manne is Dean Emeritus of the George Mason University School of Law and Distinguished Visiting Professor at the Ave Maria School of Law.

The SEC is at it again, scandal mongering insider trading.  As usual this is the “biggest insider trading case yet,” as if they were trying for some Guinness record.  Since this story will be in the financial press for months and months to come, the well informed spectator – or participant – will want to understand that a lot of what is thought to be known about insider trading “ain’t necessarily so.”

1) Insider trading injures the stock traders who buy from or sell to the insider.

False: these outsiders are voluntarily transacting in an anonymous stock market and would be there and make or lose about the same amount regardless of the identity of the other party.

2) Legalizing insider trading would cause a great loss of confidence in the integrity of the stock market and thereby reduce capital investment, liquidity and trading.

False: Empirical studies strongly contradict this, and a robust stock market in the United States before the late 1960’s (when serious enforcement began) or in the rest of the world today (where serious enforcement has yet to begin) denies this.

3) Sensible enforcement of insider trading laws is feasible.

False: the ever larger, politically inspired, and inevitably unproductive SEC campaigns against insider trading demonstrate that significant enforcement is not only difficult, it is practically impossible.  And this is to say nothing of the logical impossibility of policing gains made by an insider’s knowing when not to buy or sell, a purely mental transaction that can never be policed.

4)  The SEC’s high-tech detection methods uncover illicit trading.

False: This claim has been made by the SEC from the beginning and is apparently not much more true today than it was fifty years ago.  Use of informants and wire tapping are the methods by which the SEC does most of its policing.

5)  There are no net social or economic costs to partial enforcement of these laws.

False:  The individuals who might be desirably motivated in their work by the right to trade on inside information are displaced (because they are so easily spotted and targeted by the SEC) by individuals with no claim to the value of the information but who are more difficult to identify and convict.

6)  We need regulation since the corporation itself has a property right in the information it produces, and the government can better protect this right than can the individual corporations.

False:  If the corporation had a real property right, then it could opt out of the regulation and allow its insiders to trade, something the SEC has steadfastly resisted.  And even if the government could enforce the rule more efficiently (highly dubious), there is no justification for this subsidy to certain companies.  (Even Steve Bainbridge gets this one wrong.)

7)  Insider trading does not contribute to the efficiency of stock market pricing.

False:  All trading has some marginal effect on price, and by definition any informed trading pushes the price in the correct direction, some of it quite noticeably and very quickly.  There are conflicting findings in the empirical literature on the strength of the short-term price effect of insider trading. But this probably reflects  differences in the pricing process resulting from varying trading and market conditions.  Further, nearly all empirical studies in this field are based on data representing legal and reported insider trading, a decidedly inappropriate way to measure the effect of illegal insider trading.

8)  If insiders are trading, market makers will have to broaden their bid-ask spreads and thus charge more to all traders.

False:  Careful research on this point concludes that market makers on stock exchanges do not feel harmed by the presence of insiders in the market and do not adjust their spreads in response.

9)  There is a clear definition of “insider trading” and of the level of “materiality” required for a violation of the law.

False:  Neither the SEC nor Congress has ever defined “inside information”, nor has either succeeded in specifying the level of significance the information must have to be the subject of a criminal violation.

10)  It is easy to distinguish the information insiders use illegally from that analysts secure in the legitimate course of their work.

False:  This line is so grey and the potential rewards so great that the line is easily and regularly overstepped, either inadvertently or intentionally.  The present prosecution is apparently based to some extent on the notion that assembling many small pieces of non-material information into a single “mosaic” of valuable information is illegal. Just what is it that the SEC wants analysts to do?

11)  Allowing trading on bad news as well as on good will create an incentive for executives to create bad news.

False:  All the motivating vectors in the market for managers point them in the direction of trying to increase their company’s stock price not lower it, and these pressures would overwhelm any slight increase in adverse motivation from insider trading.

12)  The criminalization of insider trading has no effect on the compensation of corporate employees.

False: Recent research demonstrates that when the right to trade on information is denied to executives, they must be paid additional compensating sums to substitute for this loss.  This must partially account for the enormous increases in executive salaries, bonuses and stock options we have witnessed in the past thirty years.

13)  Individuals within the company who were not responsible for the good news may profit from the knowledge and, therefore, insider trading serves no valuable reward function.

False: While it is very difficult to design an efficient compensation scheme to encourage innovation, allowing insider trading by everyone aware of new developments will create a corporate culture of innovation and risk taking without requiring the enormous option plans and bonuses currently used, which incidentally, and unlike insider trading, come out of the shareholders’ pockets.

14)  The SEC has studied the economics of insider trading and applied rigorous economic analysis to the phenomenon.

False:  If they have, they have certainly failed to disclose this significant bit of information to the public or to make any intellectual sophistication apparent.

15)  Fuzzy notions of fairness have a place in serious discussions of the economic costs and benefits of regulation.

False.

Henry G. Manne is Dean Emeritus at George Mason University School of Law

Behavioral Economics, like so many efforts previously to upend the hegemony of the neo-classical market model, will leave some footprints on the intellectual sands of time.  However, there is no way that it can accomplish what many of its disciples seem, subliminally at least, to believe:  that we should abandon the traditional model with (because of?) all its implications about private property, competitive markets and individual freedom.  That dream is, of course, ridiculous for one obvious and frequently mentioned reason: Behavioral Economics does not even attempt to offer an integrated theory of resource allocation, the ultimate and necessary mission of any economic theory.  All it does is putter around some select edges of the traditional theory (mainly the very weakly held – and, as we shall see, unnecessary – rationality assumption) and, again like its predecessors in the intellectual history of economics, it claims far more damage to the received model than it actually delivers.

My first observation about the present state of affairs in Behavioral Economic theory is that it builds too ambitiously on the findings of psychology and does not pay enough attention to what economists already well understand.  I don’t know of any respectable economist of the last 80 years or more who has pushed a fundamentalist notion of the rationality assumption in descriptive or analytical economics.  To the extent that some of the more dedicated Behavioralists do accuse devotees of the market model of something like this, they are clearly misunderstanding the heuristic nature of the perfect competition model.  I won’t take the opportunity to try to reeducate them in what economics is all about and what economists do.  Suffice it to say that the model is valuable enough if it does nothing more than paint an idealistic picture of a perfect market – else what’s a heaven for?

What I would like to point out, however, is the irrelevance of much of the substance of Behavioral Economics for “doing” economics.  My principal (as a matter of fact my sole) authority for this proposition (though some of Gary Becker’s work also comes to mind) is the magnificent classic article by Armen Alchian, Uncertainty, Evolution, and Economic Theory, 58 JPE 211 (1950). Continue Reading…

[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

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