The taste for insider trading law

Larry Ribstein —  13 June 2011

Steve Bainbridge responds to my post about insider trading as compensation with a suggestion that rules against insider trading are an example of a case “where mandatory rules are appropriate.”

I was about to sputter about laws against insider trading are really about property rights, and surely property should be alienable — right?  And about how this is really about fiduciary duties, and behind that agency costs, which is the heart of corporate law.  So how much of the rest of corporate law should be made mandatory and federal?

Then I realized Steve was really talking about lawyers trading on clients’ information.  Well, that’s different. Clients rarely authorize this, so it’s usually theft and therefore bad.  But I still wonder why clients shouldn’t be allowed to authorize it.  And who knows whether that might happen as lawyers’ roles evolve?  (You knew I was going to stick that one in again, didn’t you?)

But after calming down I got riled up by the last line: “If investors have a taste for prohibiting insider trading, it thus does no good to say that the world would be a more efficient place if insider trading were allowed.”

Um, well, where does that sort of reasoning stop?  People ought to be able to indulge a lot of seemingly goofy tastes.  But that’s a long way from a normative argument that these tastes should be imposed on society.

Larry Ribstein

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Professor of Law, University of Illinois College of Law

4 responses to The taste for insider trading law

  1. 
    northfork investor 14 June 2011 at 8:35 am

    The notion that inside trading would improve economic efficiency is a nonsensical outdated notion not shared by many economic theorists.

    And even if you disagreed with me you must admit that technology has made nearly instantaneous disclosure of material information possible and that must be more efficient that allowing for insider trading (because more people have the information and could assess what it means which should produce a better assessment than just the insiders.

    If you could get behind that all your frustrations with Bainbridge’s post would dissolve.

    Try it grasshopper.

    • 

      I do not think even Bainbridge agrees with your description of the economic literature on insider trading, be it theory or empirics, which is much more of a mixed bag than you suggest. And FWIW, the point of the comment above is not to delve into that particular debate, but highlight the link between revealed preference, the sort of subjective distaste for insider trading that Steve raises, and economic efficiency. Alas, I’m afraid I’m doomed to frustration regardless of whether I agree with you.

      • 
        northfork investor 14 June 2011 at 10:48 am

        I was not commenting on your reply Josh (I actually didn’t read it and meant to only comment on the original Ribstein blog) and agree that Bainbridge would not necessarily agree with my characterization of the literature (actually the only comment I made that might be about the literature is quite true–many economists do not buy the efficiency argument which is quite old and does not take into account technological improvement in information dissemination).

        I understand the concept of incorporating “distaste for insider trading” into consumer preferences in measuring economic efficiency but choose not to use that to justify my belief that the argument that insider trading leads to improved economic efficiency is absurd.

  2. 

    Aside from the slipper y slope issue Larry highlights, there is a tension in Steve’s position that “tastes must be incorporated into the concept of efficiency.” That’s not objectionable as a matter of economic theory. The “if only people were different” fallacy Bainbridge attributes to Demsetz was priginally raised in a context that reveals the tension. Demsetz (1969) was critiquing Arrow’s treatment of risk and insurance, and particularly the claim that efficiency commanded that risky activities “[should be undertaken if the expected return exceeds the market rate of return, no
    matter what the variance is.” Demsetz’s critique was that if the economic agents exhibit actual risk averse preferences than there is good economic reason to prefer the less risky project — and that the economist has no basis for concluding that the economic agent should be risk neutral. In other words, Demsetz argued that the “if only people were different fallacy” was substituting one’s view of what the individual’s preferences should be for those expressed through revealed preference. It is for that reason Demsetz concludes that “the taste for risk reduction must be incorporated
    into the concept of efficiency.”

    Applied here, I suspect that Professor Bainbridge is arguing that because there is a popular distaste to insider trading those preferences should be incorporated into any notion of efficiency. But notice that the popular distaste for insider trading is one exhibited by revealed preference — or by a “would-be” party to the contract allowing insider trading between a firm and its lawyers. This is not revealed preference in the economic sense at all as I understand it — but rather invoking a sense that folks don’t like insider trading (and of course, that general sense is influenced by their perception of its effects on them, if any). There is also likely a general sense that Wal-Mart should sell at lower prices and pay higher wages, a distaste for large horizontal mergers, payday loans, and so forth — but our notion of efficiency derives from how economic agents reveal those preferences through their choices in the market, not general distaste. This circles back upon Larry’s slope point I suppose. Of course, a prohibition could be efficient under some circumstances in theory; but my limited point here is that I do not think the “tastes” argument does the work Steve would like it to do here.