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.
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It’s true that Insider trading injures the stock traders who buy from or sell to the insider
A final comment following Friedlander’s post above. Obviously we want securities and other asset prices to be efficient signals for capital allocation. Otherwise we would have too many servers being produced in 1999 or two many 3,000 square foot homes being built in 2005. But given the current technology for disseminating material information virtually instanteously it is beyond belief that IO and Law and Economics types are still justifying legalizing inside trading with a market efficiency argument rather than pushing for more perfect dissemination of material information.
This boils down to the same issue of whether market forces and efficiency are the only factor society needs to consider. I understand “fairness” irritates the author of the post however it is one of the reasons we outlaw sending hit-men to kill corporate opponents.
Mr. North Fork Investor: In your comment 1 above, you said that you suffered losses when trading on the market at the same time that insiders were trading on the other side. Could you confirm that you would not have entered into that trade if the insiders had abstained from trading? Was their trade the event that caused you to trade? If not, if your decision whether to trade was independent of whether or not the insider was trading, it’s hard to see how the insider caused your loss in any way, shape or form. There may (or may not) be other reasons to object to insider trading, but I don’t see how you can claim that insider trading causes the losses suffered by trading counter-parties. That’s the point that Dean Manne is making. If I’ve missed something in your explanation of your experiences, please clarify.
that is exactly what I am saying, on more than one occasions over the last 20 years I entered into trades and suffered losses because an inside trader created a market signal that caused me to enter a contra trade. That is the inside trader caused my losses and I am not unique. Option market makers get screwed like that lots of times. (although their limit order displays may be based on different algorithms than mine.) What did I say above that you didn’t understand? I can say it louder.
that is exactly what I am saying, on more than one occasions over the last 20 years I entered into trades and suffered losses because an inside trader created a market signal that caused me to enter a contra trade. I would not have entered an order otherwise and did not have an order entered prior to the inside trader entering a series of orders (it is never just one). That is the inside trader caused my losses and I am not unique. Option market makers get screwed like that lots of times. (although their limit order displays may be based on different algorithms than mine.) What did I say above that you didn’t understand? I can say it louder.
I don’t doubt what you are saying, but I don’t fully understand it. Specifically, how does an insider create a market signal that causes you to trade? Do you know who is on the other side of the trade or just that there is someone offering to buy or sell at a price? Why do you sell when you see a series of orders to buy? (or vice versa). Thanks for taking the time to explain.
For the record, my contraparty when I suffer a loss due to inside trading may be the inside trader or a momentum based tag-along trader. But that is fairly irrelevant.
Let me try to explain again. In this case the context is a merger and to keep it very simple a cash merger where a target company is being acquired for stock and there is a definitive merger agreement between the parties describing the terms thereof in fairly definite legal terms.
In that case the target stock will trade in a fairly narrow band at at discount to the cash merger price or pariety with the primary determinants of the discount being interest rates and the expected time to closing. People in my business calculate at what discount for a particular day they will add to positions or reduce positions. Not every trader of that stock has the same strategy as me. They may have strategies that cause them to trade that stock having nothing to do with merger arbitrage.
Almost all the time a non-arb seller causing a wider discount creates a signal for me to add to my positions. In the abscence of that seller having inside information, I can safely assume the discount is wide for no particular reason other than someone else’s selling program and I can safely add to positions. We (buyer and seller) have the same information set but just different trading programs.
But deals can also terminate and sometimes the parties leak the termination information maybe inavertently maybe not. In that case a selling program develops that is not based on informational pariety and as the discount widens my buy program turns out to be painful because I am buying into a terminating transaction but no annoucement has come from the companies and they have not held the stock. The longer they wait to release the bad news, if the discount doesn’t correct, the worse the losses from the insider traders can be.
The same kind of phenomenon can occur if the selling Company or another buyer leaks inside information about an overbid. In that case I might sell my position when I would have held it if the information about another bidder had been disseminated efficiently and the stock held until it was out.
Hope this is helpful.
Hope this
In my example the merger deal is cash from the buyer for stock of the seller. I think I miswrote that in my post.
My numbers correspond to Dean Manne’s. As an aside I am a private investor, a seasoned risk arb who thinks regulation FD is the best think Arthur Levitt did at the SEC. Over the last thirty years I have worked with or gone to school with many prosecuted insider traders who have spent some time behind bars. They all knew that what they were doing was ethically and legally wrong and were simply greedy pigs. Those biases being stated, I have the greatest respect for Dean Manne.
I’m a Chicago School kind of a guy who thinks this is one place Milton Friedman errred terribly.
1. This is written by someone who has never been on the other (losing) side of an inside trade. I do not know how Prof Manne can say my potential losses would be the same whether the other side had material inside information or not. All I can say is that I trade against what I perceive to be market inefficiencies and if my trading counterparties have inside information what I deem to be inefficiencies turn out to be informational disadvantages. I’d prefer more efficient regulation of FD and stronger criminal penalties on trading on rather than disclosing material inside information.
2. Please cite some of these studies and please tell me how you measure a robust stock market–because my studies of the 60’s indicate terrible misallocation of capital and the formation of the bubbles like we alway do. I measure market efficiency by price spreads and know very clearly that our markets are more efficient today because of technological change (both in market quotation dissemination and trade execution) and regulatory changes (decimalization.)
3. Patently absurd. What do you mean by sensible? It’s like any crime fighting strategy. Deterence works to some degree. When the SEC stops working hard at deterrance you get more people taking shots. We have great technology for detecting inside trading and at the worst just pick up the phone because all professional traders know when they are on the other side of an inside trade (or tagalong trader).
4. Can’t comment. But I do know that the technology exists that is far better today than in the 80s to detect inside trading. If it isn’t being used by the SEC that is an easy fix.
5. Agree with conclusion but not with reasoning.
6. Don’t agree with the premise of the question. We need regulation because our securities laws demands that material information be promptly disclosed publically and trading before that occurs by insiders is patently unfair not to the company whose information he has misappropriated but to the contraparty in the trade who should be given the information before agreeing to the trade.
7. yada yada yada
8. this is the first I’ve heard of this strawman argument but agree with conclusion.
9. can’t disagree
10. ditto.
11. While not quite on point, please see “option grant timing” and “option backdating” and “Mozilo” for situations where executives grant options prior to good news and backdate option grants to periods following disclosures of bad news and allow third parties to execute their option exercises while in possession of material negative inside information. Executives have been known to respond to and or exploit regulatory inefficiencies when they can to use inside information for private gains.
12. that research you kind of cite is the worst statistical work to come out of the academic community in some time.
13. Of course that is true but so what. Another strawman argument
14. Noone has.
Henry Manne has been so right for so long about insider trading. The government’s pursuit of insider traders is just a cat chasing its own tail. *Someone* is going to profit from new information — why should the government benefit outsiders and send insiders to jail? As a shareholder, I would want my insiders, not total strangers, to be the beneficiaries.
There is also a free speech issue.
Price is a fundamental statement of economic information in a capitalistic society. Any government restrictions on incorporating available, accurate information in prices are an abridgment of speech. There is also an element of fraud (although technically, I would guess governments do not commit fraud). Any buyer or seller of the stock or asset, after material information is available to insiders, is trading without that information and at prices that do not incorporate that information. If not for the government insider trading restrictions on that material information, the information, and the pricing reflecting trades with that information, would be available to non-inside buyers and sellers. Later release of that information does not help buyers and sellers who trade between the time the information becomes known to insiders and the later time that it is released. A buyer or a seller is involuntarily aggrieved by the unavailability of the insider information to determine their price of a trade and accept the trading price as is. With the earlier release of the information, directly or through trades based on that information, parties voluntarily make trades with the information, accept the price as is and are not aggrieved.
It would seem to me that SEC and other legal restrictions on trading on inside information are prior abridgments of speech. It is then a question of whether there is sufficient governmental interest to allow a prior restraint of information by prohibiting insider trades and whether that interest overrides the rights of buyers or sellers to trade on complete available information during the period prior to release and after the information is known by insiders.