So I’ve been a little absent from the blog lately. Sorry about that. I have a decent excuse.
As our law prof readers know, but others might not, this is prime article submission season. The conventional wisdom is that it’s best your get your article into the hands of newly minted law review editors right after they take over, which usually happens around the first of March. Hence, there’s a mad dash to submit journal articles around this time of year.
Saturday afternoon, I submitted (via ExpressO, a true godsend!) an article entitled, “Overvalued Equity and the Case for an Asymmetric Insider Trading Regime.” The article was inspired by a talk Professor Michael Jensen gave at the U of Missouri last year on the “agency costs of overvalued equity.” Jensen argued, as he does in this paper, that stock overvaluation leads managers to do all sorts of things that reduce the value of, and may ultimately destroy, their corporations. At the end of his talk, Jensen stated that he didn’t really know what to do about the problem of overvalued equity. My first thought was that Jensen had given us yet another reason to be skeptical of the insider trading ban, which prohibits insiders who know a firm is overvalued from signaling that information to the market via their trading behavior.
That got me to thinking about whether there is a principled basis for distinguishing insider trading that decreases stock price from that which increases stock price. The central claim of my article is that there is such a basis — that the net investor benefits occasioned by “price-decreasing insider trading” (i.e., sales, put purchases) exceed those resulting from “price-enhancing insider trading” (i.e, purchases of stock or call options). I further argue that shareholders and managers would likely bargain for an insider trading policy that would generally permit price-decreasing insider trading while generally banning price-enhancing insider trading, and that current insider trading doctrine would permit regulators to posit such an asymmetric approach as the default rule.
The full paper is now available on SSRN. Here’s the abstract:
The forty-year debate over whether insider trading should be regulated has generally proceeded in all-or-nothing terms: Either all insider trading should be permitted (subject only to private restrictions imposed by issuers themselves), or none should. This Article argues for an asymmetric insider trading policy under which insider trading that decreases the price of an overvalued stock is generally permitted, but insider trading that increases the price of an undervalued stock is generally prohibited. Concluding that the net investor benefits of price-decreasing insider trading exceed those of price-enhancing insider trading, the Article argues that an asymmetric insider trading regime likely represents the bargain that shareholders and corporate managers would strike if they were legally and practically able to negotiate an insider trading policy. Current insider trading doctrine would permit regulators to impose such an asymmetric insider trading policy as the default rule.
Comments are encouraged!
Under my proposal (legalize insider trading that tends to correct overvaluation), we don’t really need to do either. Basically, insider trading that would tend to drive stock prices down (i.e., selling, short-selling, and buying puts) would be permitted, whereas insider trading that tends to enhance prices (i.e., buying stocks or calls) would remain prohibited. To facilitate the price effect, the proposal further calls for price-decreasing insider trades to be disclosed when executed. (Like the disclosure requirements under Sec. 16(a), but immediate and for all corporate employees, not just statutory insiders.)
The idea is to encourage the “reporting” of overvaluation via insider trading. This would help prevent significant overvaluation and the agency costs that accompany it.
Undervaluation is less of a problem, for it tends to be self-correcting (managers and analysts are more likely to take steps that would prevent it) and creates fewer investor harms when it does occur.
How do you plan to establish causation between insider trading and stock price movements, and how do we measure the magnitude of the impact? The reverse causation problem (insider trading is triggered by price changes, not the other way around) seems insurmountable.