Archives For securities regulation

Contemplating Disclosure-Based Insider Trading Regulation

Thom Lambert —  15 June 2012

TOTM friend Stephen Bainbridge is editing a new book on insider trading.  He kindly invited me to contribute a chapter, which I’ve now posted to SSRN (download here).  In the chapter, I consider whether a disclosure-based approach might be the best way to regulate insider trading.

As law and economics scholars have long recognized, informed stock trading may create both harms and benefits to society.  With respect to harms, defenders of insider trading restrictions have maintained that informed stock trading is ”unfair” to uninformed traders and causes social welfare losses by (1) encouraging deliberate mismanagement or disclosure delays aimed at generating trading profits; (2) infringing corporations’ informational property rights, thereby discouraging the production of valuable information; and (3) reducing trading efficiency by increasing the “bid-ask” spread demanded by stock specialists, who systematically lose on trades with insiders.

Proponents of insider trading liberalization have downplayed these harms.  With respect to the fairness argument, they contend that insider trading cannot be “unfair” to investors who know in advance that it might occur and nonetheless choose to trade.  And the purported efficiency losses occasioned by insider trading, liberalization proponents say, are overblown.  There is little actual evidence that insider trading reduces liquidity by discouraging individuals from investing in the stock market, and it might actually increase such liquidity by providing benefits to investors in equities.  With respect to the claim that insider trading creates incentives for delayed disclosures and value-reducing management decisions, advocates of deregulation claim that such mismanagement is unlikely for several reasons.  First, managers face reputational constraints that will discourage such misbehavior.  In addition, managers, who generally work in teams, cannot engage in value-destroying mismanagement without persuading their colleagues to go along with the strategy, which implies that any particular employee’s ability to engage in mismanagement will be constrained by her colleagues’ attempts to maximize firm value or to gain personally by exposing proposed mismanagement.  With respect to the property rights concern, deregulation proponents contend that, even if material nonpublic information is worthy of property protection, the property right need not be a non-transferable interest granted to the corporation; efficiency considerations may call for the right to be transferable and/or initially allocated to a different party (e.g., to insiders).  Finally, legalization proponents observe that there is little empirical evidence to support the concern that insider trading increases bid-ask spreads.

Turning to their affirmative case, proponents of insider trading legalization (beginning with Geoff’s dad, Henry Manne) have primarily emphasized two potential benefits of the practice.  First, they observe that insider trading increases stock market efficiency (i.e., the degree to which stock prices reflect true value), which in turn facilitates efficient resource allocation among capital providers and enhances managerial decision-making by reducing agency costs resulting from overvalued equity.  In addition, the right to engage in insider trading may constitute an efficient form of managerial compensation.

Not surprisingly, proponents of insider trading restrictions have taken issue with both of these purported benefits. With respect to the argument that insider trading leads to more efficient securities prices, ban proponents retort that trading by insiders conveys information only to the extent it is revealed, and even then the message it conveys is “noisy” or ambiguous, given that insiders may trade for a variety of reasons, many of which are unrelated to their possession of inside information.  Defenders of restrictions further maintain that insider trading is an inefficient, clumsy, and possibly perverse compensation mechanism.

The one thing that is clear in all this is that insider trading is a “mixed bag”  Sometimes such trading threatens to harm social welfare, as in SEC v. Texas Gulf Sulphur, where informed trading threatened to prevent a corporation from usurping a valuable opportunity.  But sometimes such trading creates net social benefits, as in Dirks v. SEC, where the trading revealed massive corporate fraud.

As regular TOTM readers will know, optimal regulation of “mixed bag” business practices (which are all over the place in the antitrust world) requires consideration of the costs of underdeterring “bad” conduct and of overdeterring “good” conduct.  Collectively, these constitute a rule’s “error costs.”  Policy makers should also consider the cost of administering the rule at issue; as they increase the complexity of the rule to reduce error costs, they may unwittingly drive up “decision costs” for adjudicators and business planners.  The goal of the policy maker addressing a mixed bag practice, then, should be to craft a rule that minimizes the sum of error and decision costs.

Adjudged under that criterion, the currently prevailing “fraud-based” rules on insider trading fail.  They are difficult to administer, and they occasion significant error cost by deterring many instances of socially desirable insider trading.  The more restrictive “equality of information-based” approach apparently favored by regulators fares even worse.  A contractarian, laissez-faire approach favored by many law and economics scholars would represent an improvement over the status quo, but that approach, too, may be suboptimal, for it does nothing to bolster the benefits or reduce the harms associated with insider trading.

My new book chapter proposes a disclosure-based approach that would help reduce the sum of error and decision costs resulting from insider trading and its regulation.  Under the proposed approach, authorized informed trading would be permitted as long as the trader first disclosed to a centralized, searchable database her insider status, the fact that she was trading on the basis of material, nonpublic in­formation, and the nature of her trade.  Such an approach would (1) enhance the market efficiency benefits of insider trading by facilitating “trade decod­ing,” while (2) reducing potential costs stemming from deliberate misman­agement, disclosure delays, and infringement of informational property rights.  By “accentuating the positive” and “eliminating the negative” conse­quences of informed trading, the proposed approach would perform better than the legal status quo and the leading proposed regulatory alternatives at minimizing the sum of error and decision costs resulting from insider trading restrictions.

Please download the paper and send me any thoughts.

In 10b-5, corporate law, disclosure regulation, error costs, financial regulation, insider trading, markets, regulation, securities regulation, SSRN
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A Decision-Theoretic Approach to Insider Trading Regulation

Thom Lambert —  19 January 2012

Regular readers will know that several of us TOTM bloggers are fans of the “decision-theoretic” approach to antitrust law.  Such an approach, which Josh and Geoff often call an “error cost” approach, recognizes that antitrust liability rules may misfire in two directions:  they may wrongly acquit harmful practices, and they may wrongly convict beneficial (or benign) behavior.  Accordingly, liability rules should be structured to minimize total error costs (welfare losses from condemning good stuff and acquitting bad stuff), while keeping in check the costs of administering the rules (e.g., the costs courts and business planners incur in applying the rules).  The goal, in other words, should be to minimize the sum of decision and error costs.  As I have elsewhere demonstrated, the Roberts Court’s antitrust jurisprudence seems to embrace this sort of approach.

One of my long-term projects (once I jettison some administrative responsibilities, like co-chairing my school’s dean search committee!) will be to apply the decision-theoretic approach to regulation generally.  I hope to build upon some classic regulatory scholarship, like Alfred Kahn’s Economics of Regulation (1970) and Justice Breyer’s Regulation and Its Reform (1984), to craft a systematic regulatory model that both avoids “regulatory mismatch” (applying the wrong regulatory fix to a particular type of market failure) and incorporates the decision-theoretic perspective. 

In the meantime, I’ve been thinking about insider trading regulation.  Our friend Professor Bainbridge recently invited me to contribute to a volume he’s editing on insider trading.  I’m planning to conduct a decision-theoretic analysis of actual and proposed insider trading regulation.

Such regulation is a terrific candidate for decision-theoretic analysis because stock trading on the basis of material, nonpublic information itself is a “mixed bag” practice:  Some instances of insider trading are, on net, socially beneficial; others create net welfare losses.  Contrast, for example, two famous insider trading cases:

  • In SEC v. Texas Gulf Sulphur, mining company insiders who knew of an unannounced ore discovery purchased stock in their company, knowing that the stock price would rise when the discovery was announced.  Their trading activity caused the stock price to rise over time.  Such price movement might have tipped off landowners in the vicinity of the deposit and caused them not to sell their property to the company (or to do so only at a high price), in which case the traders’ activity would have thwarted a valuable corporate opportunity.  If corporations cannot exploit their discoveries of hidden value (because of insider trading), they’ll be less likely to seek out hidden value in the first place, and social welfare will be reduced.  TGS thus represents “bad” insider trading.  
  • Dirks v. SEC, by contrast, illustrates “good” insider trading.  In that case, an insider tipped a securities analyst that a company was grossly overvalued because of rampant fraud.  The analyst recommended that his clients sell (or buy puts on) the stock of the fraud-ridden corporation.  That trading helped expose the fraud, creating social value in the form of more accurate stock prices.

These are just two examples of how insider trading may reduce or enhance social welfare.  In general, instances of insider trading may reduce social welfare by preventing firms from exploiting and thus creating valuable information (as in TGS), by creating incentives for deliberate mismanagement (because insiders can benefit from “bad news” and might therefore be encouraged to “create” it), and perhaps by limiting stock market liquidity or reducing market efficiency by increasing bid-ask spreads.  On the other hand, instances of insider trading may enhance social welfare by making stock markets more efficient (so that prices better reflect firms’ expected profitability and capital is more appropriately channeled), by reducing firms’ compensation costs (as the right to engage in insider trading replaces managers’ cash compensation—on this point, see the excellent work by our former blog colleague, Todd Henderson), and by reducing the corporate mismanagement and subsequent wealth destruction that comes from stock mispricing (mainly overvaluation of equity—see work by Michael Jensen and yours truly).

Because insider trading is sometimes good and sometimes bad, rules restricting it may err in two directions:  they may acquit/encourage bad instances, or they may condemn/prevent good instances.  In either case, social welfare suffers.  Accordingly, the optimal regulatory regime would seek to minimize the sum of losses from improper condemnations and improper acquittals (total error costs), while keeping administrative costs in check.

My contribution to Prof. Bainbridge’s insider trading book will employ decision theory to evaluate three actual or proposed approaches to regulating insider trading:  (1) the “level playing field” paradigm, apparently favored by many prosecutors and securities regulators, which would condemn any stock trading on the basis of material, nonpublic information; (2) the legal status quo, which deems “fraudulent” any insider trading where the trader owes either a fiduciary duty to his trading partner or a duty of trust or confidence to the source of his nonpublic information; and (3) a laissez-faire, “contractarian” approach, which would permit corporations and sources of nonpublic information to posit their own rules about when insiders and informed outsiders may trade on the basis of material, nonpublic information.  I’ll then propose a fourth disclosure-based alternative aimed at maximizing social welfare by enhancing the social benefits and reducing the social costs of insider trading, while keeping decision costs in check. 

Stay tuned…I’ll be trying out a few of the paper’s ideas on TOTM.  I look forward to hearing our informed readers’ thoughts.

In 10b-5, error costs, insider trading, law and economics, markets, regulation, securities regulation
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Bainbridge on the SEC’s Conflict Minerals Disclosure Getting Business Roundtabled…

Josh Wright —  5 January 2012

As in, “If the SEC doesn’t pull up its socks and do a serious cost-benefit analysis, it may discover that Business Roundtable has become a verb. As in, the court Business Roundtabled yet another SEC rule.”

Here.

In business, disclosure regulation
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The Twitter campaign for the STOCK act

Larry Ribstein —  20 December 2011

Professor Bainbridge is urging his readers to pressure Eric Cantor into dropping his opposition to pending legislation that would ban Congressional insider trading.  But before you Twitter Cantor, please read Todd Henderson and my Politico column, in which we make the following point, among others:

A prohibition on trading would be impossible to enforce because congressmembers have so many opportunities to use information without trading on it. They could trade tips or exchange them for political favors. Given the pervasiveness of political events, the Securities and Exchange Commission would face an impossible task of identifying the trading from market movements — its usual tool for tracking insider trading.

If the SEC did try to enforce the ban, it could chill legitimate information flows on Capitol Hill and create a powerful tool for political parties to deploy against their enemies. Moreover, the SEC itself would be exposed to accusations of political favoritism — which could undermine its market-policing role. Conflict-of-interest allegations, like those during the Madoff investigation, would become routine.

The SEC is already embroiled in more politics than you want a market regulator to be.  Does it really need to start regulating Congress?  I think this Act needs more thought and less Twittering.

In insider trading, politics
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Preempting state securities laws

Larry Ribstein —  14 December 2011

States can be a wonderful laboratory and platform for jurisdictional competition.  But sometimes the laboratory seems to belong to Dr. Frankenstein and then federal law must step in to bring order.

Biff Campbell thinks Reg D has failed its intended purpose and the reason is state law.  Here’s part of the abstract:

Regulation D * * * offers businesses — especially businesses with relatively small capital requirements — fair and efficient access to vital, external capital.  * * * The data show that Regulation D is not working in the way the Commission intended or in a way that benefits society. The data reveal that companies attempting to raise relatively small amounts of capital under Regulation D overwhelmingly forego the low transaction costs of offerings under Rule 504 and Rule 505 in favor of meeting the more onerous (and more expensive) requirements of Rule 506. Additionally, these companies overwhelmingly limit their relatively small offerings to accredited investors, which dramatically reduces the pool of potential investors. This unintended and bad outcome is the result of the burdens imposed by state blue sky laws and regulations, and this has to a large degree wrecked the sensible and balanced approach of the Commission in Regulation D.  Congress. . . could solve the problem by expanding federal preemption to cover all offerings made under Regulation D.

He has a point.  Permitting the states to regulate national securities transactions enables individual states to impose regulatory costs outside their borders for the benefit of local interest groups.  This can have perverse effects — in this case, by letting individual states impede national capital formation and entrepreneurship .Indeed, a key economic rationale for federal law is to address this problem.  See Easterbrook & Fischel, Mandatory Disclosure for the Protection of Investors, 70 Virginia Law Review 669 (1984).  

But we don’t have to eliminate state securities laws, along with state law’s potential advantages of competition and experimentation, to deal with this problem.  There’s an alternative:  apply state law only to intrastate transactions, or to corporations that have contracted for the securities law of a particular state (e.g., by incorporating in the state).  In other words, apply the same choice-of-law rule to state securities law as to state corporate governance law.  I discuss this approach in Dabit, Preemption and Choice of Law and Preemption and Choice-of-Law Coordination (with O’Connor).

In federalism, securities regulation
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Let Congress trade!

Larry Ribstein —  2 December 2011

I have previously discussed here and here the policy arguments against a broad ban on Congressional insider trading (this is apart from Steve Bainbridge’s serious problems with the proposed legislation).  

Now Todd Henderson and I have weighed in on Politico with more on why we should let Congress trade (while imposing strong disclosure duties).  It’s obviously not a popular position these OWS and politician-bashing days. But we think it’s a sensible one that deserves serious consideration.

Update:  Bainbridge responds.  He focuses on the perverse incentive problem, which Todd and I acknowledge.  Unfortunately, he ignores our argument for disclosure as a way of dealing with that issue, and the serious problems of having the SEC enforce a Congressional insider trading ban.  Consideration of these issues caused me to change my views on banning Congressional insider trading.  I think it’s inconsistent to focus on enforcement problems in banning private activity (as both Bainbridge and I do) and not do so in banning public conduct, where enforcement is even trickier.

In insider trading, politics
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Why do insiders trade illegally?

Larry Ribstein —  17 November 2011

Not, as economic theory would predict, because they need the money, according to Bhattacharya and Marshall, Do They Do it for the Money?  Here’s the abstract:

Using a sample of all top management who were indicted for illegal insider trading in the United States for trades during the period 1989-2002, we explore the economic rationality of this white-collar crime. If this crime is an economically rational activity in the sense of Becker (1968), where a crime is committed if its expected benefits exceed its expected costs, “poorer” top management should be doing the most illegal insider trading. This is because the “poor” have less to lose (present value of foregone future compensation if caught is lower for them.) We find in the data, however, that indictments are concentrated in the “richer” strata after we control for firm size, industry, firm growth opportunities, executive age, the opportunity to commit illegal insider trading, and the possibility that regulators target the “richer” strata. We thus rule out the economic motive for this white-collar crime, and leave open the possibility of other motives.

One hypothesis:  the need for more money is not necessarily perfectly correlated with how much you have.  Insider traders are rich because they really want to be rich (some would call this “greed”). The higher demand for money offsets the risks. This doesn’t mean you can “rule out the economic motive” for insider trading. 

There may be broader implications here for executive compensation, executive misconduct generally, and for reconciling this data with evidence of executives’ willingness to trade off insider trading and other compensation.

In insider trading
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Crowdfunding

Larry Ribstein —  17 November 2011

Should you have to do a costly SEC registration and work through a registered broker-dealer just to raise a little money for your start-up? 

Today’s WSJ covers so-called “crowd-funding.” It tells of a guy who raised $41,000 from 17 investors.  The business has done well, but the website it used was ordered to stop doing this because it wasn’t a licensed broker-dealer.  

Supporters of a crowd-funding exemption are rallying near the SEC in Washington today (Occupy the SEC!).

The House has voted an exemption that would allow sales of up to $2 million in equity online to investors whose crowdfunding investments are up to $10,000 year or 10% of their annual income.  A Senate bill would limit these amounts to $1 million and $1,000.

Opponents of crowdfunding exemptions cite the potential for fraud.  But surely there’s a balance between fear of fraud and permitting what could be a significant jobs-generator.

For some academic coverage of crowd-funding see Heminway and Hoffman (arguing that “the offer and sale of crowdfunding interests under certain conditions should not require registration” and suggesting “principles, process, and substantive parameters of a possible solution in the form of a new registration exemption adopted by the SEC under Section 3(b) of the Securities Act”); Steve Bradford (proposing to exempt certain crowdfunding sites from federal regulatory requirements but not antifraud rules); and Hazen (reviewing proposed crowdfunding exemptions and arguing that “the proposals to date do not adequately justify an exemption”).

In disclosure regulation, securities regulation
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Congressional insider trading

Larry Ribstein —  14 November 2011

CBS is all hot and bothered about insider trading by Congress.  Steve Bainbridge is not so sure it’s illegal. Neither am I, and I question whether it should be on policy grounds (see here, first published here).  I suggest more disclosure, and reducing the opportunity for all kinds of corruption by having less law.

In insider trading
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Illinois Corporate Colloquium: Choi on SEC backdating investigations

Larry Ribstein —  5 October 2011

Yesterday at the Illinois Corporate Colloquium Steve Choi presented his paper (with Pritchard and Weichman), Scandal Enforcement at the SEC: Salience and the Arc of the Option Backdating Investigations.  Here’s the abstract:

We study the impact of scandal-driven media scrutiny on the SEC’s allocation of enforcement resources. We focus on the SEC’s investigations of option backdating in the wake of numerous media articles on the practice of backdating. We find that as the level of media scrutiny of option backdating increased, the SEC shifted its mix of investigations significantly toward backdating investigations and away from investigations involving other accounting issues. We test the hypothesis that SEC pursued more marginal investigations into backdating as the media frenzy surrounding the practice persisted at the expense of pursuing more egregious accounting issues that did not involve backdating. Our event study of stock market reactions to the initial disclosure of backdating investigations shows that those reactions declined over our sample period. We also find that later backdating investigations are less likely to target individuals and less likely to accompanied by a parallel criminal investigation. Looking at the consequences of the SEC’s backdating investigations, later investigations were more likely to be terminated or produce no monetary penalties. We find that the magnitude of the option backdating accounting errors diminished over time relative to other accounting errors that attracted SEC investigations.

As readers of this blog, and Ideoblog before it, will appreciate, this paper particularly resonated with me.  As I wrote in a large number of posts (e.g.) backdating was a molehill the media blew up into a mountain.  Now come Choi et al with evidence that while the SEC was spending its scarce resources on this overblown molehill it was ignoring real mountains (e.g., Madoff).

I found the paper overall quite persuasive.  I wasn’t entirely convinced by the evidence that the backdating cases were getting weaker.  In particular, stock price reactions may just indicate the market was learning about the which companies were involved before the investigations were brought, and was gradually figuring out that backdating was not such a big deal.  But I was convinced of the evidence of the opportunity costs of the SEC’s backdating obsession — the otherwise inexplicable decline in investigations of serious non-backdating accounting problems.

As we discussed in the Colloquium, the paper reveals that there are agency costs not just in the backdating companies that were investigated but also in the agency that was doing the investigating.  Although it’s not clear exactly what moved the SEC to follow the media, there is at least some doubt about whether the SEC’s resource allocation decisions were in the public interest.

This calls attention to another set of agents — the ones in the media.  Why did the media love backdating so much?  As discussed in my Public Face of Scholarship, there are “demand” and “supply” explanations:  the public demands stories about cheating executives and/or journalists like to supply these stories.  David Baron, Persistent Media Bias, presents a supply theory emphasizing journalists’ anti-market bias.

Whatever the cause of media bias, when the media is influential its bias can result in bad public policy. SEC enforcement isn’t the only example. As I discuss in my article (at 1210-11, footnotes omitted):

Where interest groups are closely divided, the outcome of political battles may depend on how much voter support each side can enlist. This may depend on how journalists have portrayed the issue to the public. For example, the press is an important influence on corporate governance. One factor in the rapid passage of the Sarbanes-Oxley Act, the strongest federal financial regulation in seventy years, may have been the overwhelmingly negative coverage of business in the first half of 2002: seventy-seven percent of the 613 major network evening news stories on business concerned corporate scandals.

It’s not clear what can be done to better align SEC enforcement policy with the public interest.  Incentive compensation for SEC investigators?  Perhaps the only thing we can do (as with corporate crime) is to try to keep in mind when creating regulation that even if corporate agents may sometimes do the wrong thing, people don’t stop being people when they go to work for the government.

In disclosure regulation, executive compensation, journalism, securities regulation
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