Insider trading and the regulations the stock market crash

It also should be noted that transactions based on unequally distributed information are common and often legal in labor, commodities, and real estate markets, to name a few. Nevertheless, many people still find insider trading in corporate securities objectionable.

One objection is that it violates the fiduciary duties that corporate employees, as agents, owe to their principals, the shareholders Wilgus A related objection is that, because managers control the production of, disclosure of, and access to inside information, they can transfer wealth from outsiders to themselves in an arbitrary and hidden way Brudney ; Clark Congress in the aftermath of the stock market crash, though aimed primarily at prohibiting fraud and market manipulation, also targeted insider trading.

However, the Securities Acts did not contain a broad prohibition of insider trading as such. Broader enforcement of restrictions on insider trading began only in the s, when the U. Securities and Exchange Commission SEC prosecuted the Cady, Roberts and Texas Gulf Sulphur cases using Rule 10b-5, a catch-all provision against securities fraud.

In those and subsequent cases that shaped the evolution of the general insider trading prohibition, the SEC based its justification for regulation on the unfairness of unequal access to information, the violation of fiduciary duties by insiders, and the misappropriation of information as a form of property. Nevertheless, federal legislators have never defined insider trading; in the s, the SEC actually opposed efforts to do so.

Supreme Court decided United States v.

As of , at least ninety-three countries, the vast majority of nations that possess organized securities markets, had laws regulating insider trading. Several factors explain the rapid emergence of such regulation, particularly during the last twenty years: At the same time, the effectiveness of the insider trading prohibition and the commitment to enforcing it have been low in most countries Bhattacharya and Daouk Who benefits from regulation of insider trading?

One group of beneficiaries is market professionals—broker-dealers, securities analysts, floor traders, arbitrageurs, and institutional investors. Regulation also, of course, benefits the regulators—that is, the SEC—by giving that agency greater power, prestige, and budget Bainbridge However, the benefits from insider trading laws to small shareholders, the alleged primary beneficiaries, have been extensively debated.

Manne popularized the economic analysis of insider trading Manne , although a similar book-length attempt by Frank P. Smith is dated a quarter century earlier Smith The major public policy questions economists and legal scholars have tried to answer are: How extensive should restrictions on insider trading be and should they be mandatory through the means of public regulation or voluntary by individual companies and securities exchanges?

Such studies have had one common methodological problem: Many researchers argue that trading on inside information is a zero-sum game, benefiting insiders at the expense of outsiders. But most outsiders who bought from or sold to insiders would have traded anyway, and possibly at a worse price Manne So, for example, if the insider sells stock because he expects the price to fall, the very act of selling may bring the price down to the buyer.

In such a case, the buyer who would have bought anyway actually gains. But this does not mean that no one loses because of insider trading, although such losses are likely to be diffuse and not easily traceable Wang and Steinberg The outsiders who lose in such a situation are buyers on the margin, who would not have bought unless the insider had sold and brought the price down slightly, and sellers who sold for less or could not sell at all.

Consequently, some commentators argue that such systematic diversion of wealth from outsiders to insiders may decrease the share price and raise the corporate cost of capital Mendelson However, long-term shareholders, as opposed to those speculating on short-term price movements, are rarely adversely affected by insider trading because the probability is low that such trading would affect the timing of their transactions and the corresponding market price Manne A controversial case is that of abstaining from trading on the basis of inside information Fried For example, an insider who had planned to sell stock but abstains on the basis of positive inside information thereby marginally prevents a potential buyer from getting a better deal on the stock.

Yet, it is clearly infeasible to monitor and prosecute insiders for not trading.

There is little disagreement that insider trading makes securities markets more efficient by moving the current market price closer to the future postdisclosure price. Accurately priced stocks give valuable signals to investors and ensure more efficient allocation of capital.

The controversial question is whether insider trading is more or less effective than public disclosure.

Empirical work demonstrates that insider trading does move prices in the correct direction Meulbroek Some researchers argue, though, that this additional price accuracy only redistributes wealth instead of making the process of capital allocation more efficient, because insider trading speeds up the process by only a few days or weeks without affecting the long-run attractiveness of a company as an investment Klock Probably the most controversial issue in the economic analysis of insider trading is whether it is an efficient way to pay managers for their entrepreneurial services to the corporation.

Their opponents contend that insider trading has some downside incentives and is likely to reward mere access to information rather than its production.

The argument is that allowing insider trading may encourage managers to disclose information prematurely Bainbridge or delay disclosure in order to arrange stock trades Schotland , to delay transmitting information to corporate decision makers Haft , to pursue excessively risky projects that increase trading profits but reduce corporate value Easterbrook , to increase tolerance for bad corporate performance by allowing insiders to profit on negative developments Cox , and to determine their compensation unilaterally Clark This controversy has not been resolved and is difficult to test empirically.

Another economic argument for insider trading is that it provides efficient compensation to holders of large blocks of stock Demsetz ; Thurber Such shareholders, who provide valuable corporate monitoring and sometimes cannot diversify their portfolios easily—and thus bear the disproportionate risk of price fluctuations—are compensated by trading on inside information.

However, proponents of regulation point out that such an arrangement would allow large shareholders to transfer wealth from smaller shareholders to themselves in an arbitrary fashion and, possibly, provoke conflicts between these two groups Maug A common contention is that the presence of insider trading decreases public confidence in, and deters many potential investors from, equity markets, making them less liquid Loss Empirical comparisons across countries do not clearly demonstrate that stricter enforcement of insider trading regulation has directly caused more widespread participation in equities markets.

Another argument is that insider trading harms market liquidity by increasing transaction costs. The alleged reason is that market makers—specialized intermediaries who provide liquidity by continuously buying and selling securities, such as NYSE specialists or NASDAQ dealers—consistently lose from trading with insiders and recoup their losses by increasing their bid-ask spread the differential between buying and selling prices Bagehot Yet, the lack of actual lawsuits by market makers, except in options markets, is strong evidence that insider trading is not a real concern for them.

Moreover, econometric attempts to find a relationship between the bid-ask spread and the risk of insider trading have been inconsistent and unreliable Dolgopolov Empirical research generally supports skepticism that regulation of insider trading has been effective in either the United States or internationally, as evidenced by the persistent trading profits of insiders, behavior of stock prices around corporate announcements, and relatively infrequent prosecution rates Bhattacharya and Daouk ; Bris Even in the United States, disclosed trading by corporate insiders generally yields them abnormal profits Pettit and Venkatesh Thus, insider trading regulation may affect the behavior of certain categories of traders, but it does not eliminate profits from trading on private information.

SEC Speech: Insider Trading - U.S. Perspective (T. Newkirk, M. Robertson)

For these reasons, some scholars doubt the value of such laws to public investors; moreover, enforcement is costly and could be dangerously selective. Several researchers have proposed that market professionals notably, securities analysts be allowed to trade on inside information Goshen and Parchomovsky These researchers reason that such professionals enjoy economies of scale and scope in processing firm-specific and external information and are removed from corporate decision making.

Therefore, allowing market professionals to trade on inside information would create more liquidity in securities markets and stimulate competition in the acquisition of information. Thus, the proponents of regulation argue that unrestricted insider trading would adversely affect the process of gathering and disseminating information by the securities industry, and this point of view has some empirical support Bushman et al.

On the other hand, permitting insiders to trade on inside information may allow companies to pay managers less because they have insider-trading opportunities.

In fact, there is evidence from Japan and the United States that the cash portion of executive salaries is lower when potential trading profits are higher Hebner and Kato ; Roulstone If market professionals could trade legally on private information but insiders could not, public shareholders would still lose, while being unable to recoup their trading losses in the form of higher corporate profits because of lower managerial compensation Haddock and Macey Despite numerous and extensive debates, economists and legal scholars do not agree on a desirable government policy toward insider trading.

On the one hand, absolute information parity is clearly infeasible, and information-based trading generally increases the pricing efficiency of financial markets. Information, after all, is a scarce economic good that is costly to produce or acquire, and its subsequent use and dissemination are difficult to control.

On the other hand, insider trading, as opposed to other forms of informed trading, may produce unintended adverse consequences for the functioning of the corporate enterprise, the market-wide system of publicly mandated disclosure, or the market for information.

It also should be considered that individual firms have an incentive to weigh negative and positive consequences of insider trading and decide, through private contracting, whether to allow it. Stanislav Dolgopolov is a John M. Olin Fellow in Law and Economics at the University of Michigan Law School.

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Articles EconLog EconTalk Books Encyclopedia Guides Search. Insider Trading by Stanislav Dolgopolov. Home CEE 2nd edition Insider Trading. Texas Gulf Sulphur Co. Although insider trading typically yields significant profits , these transactions are still risky. Much trading by insiders, though, is due to their need for cash or to balance their portfolios. Such trading on information originating outside the company is generally not covered by insider trading regulation.

About the Author Stanislav Dolgopolov is a John M.

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Further Reading Introductory Brudney, Victor. Hu, Jie, and Thomas H. Insider Trading and the Stock Market. Bagehot, Walter [pseudonym for Jack L. Corporation Law and Economics. Bhattacharya, Utpal, and Hazem Daouk. Piotroski, and Abbie J. A Critical Evaluation of Adverse Selection in Market Making. Goshen, Zohar, and Gideon Parchomovsky. A Private Interest Model, with an Application to Insider Trading Regulation. Evidence from the U. A Reply to Manne, Insider Trading and the Stock Market. Rule 10b-5, Disclosure and Corporate Policy.

Stock-Market Prices and Profits. Yale University Press, The cuneiform inscription in the Liberty Fund logo is the earliest-known written appearance of the word "freedom" amagi , or "liberty. Insider Trading by Stanislav Dolgopolov About the Author.