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What's wrong with insider dealing?

Published online by Cambridge University Press:  02 January 2018

Harry McVea
Harry McVea*
Affiliation:
University of Bristol*
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Extract

If there is one fact about which critics (deregulators) and proponents (regulators) of anti-insider dealing laws are certain to agree, it is that rules designed to prohibit trading on inside information are popular. Virtually every country with a developed securities market has implemented legislation regulating insider dealing and in the vast majority of cases criminal sanctions have been imposed. Britain is no exception, and has recently reaffirmed its policy commitment in the Criminal Justice Act 1993, Part V (CJA). Regulators claim that legislation is justified on the basis of a range of different arguments, the most consistently cited of which is that insider dealing jeopardises the development of fair and orderly markets and by so doing undermines investor confidence. Other justifications include allegations that insider dealing is immoral, and contrary to ‘good business ethic’; that it hurts corporations (and their shareholders), investors, and market-makers;

Type
Research Article
Information
Legal Studies , Volume 15 , Issue 3 , November 1995 , pp. 390 - 414
Copyright
Copyright © Society of Legal Scholars 1995

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References

1. For the purposes of this paper insider dealing is defined as the use of material inside information on public stock exchange markets to make a profit or avoid a loss.

2. In some jurisdictions specific statutory civil penalties are also available. See, for example, Insider Trading Securities Fraud Enforcement Act 1988, s 5 (USA); and Companies Act 1990, s 109 (Ireland).

3. See, Preamble to EC Council Directive 89/592 EEC of 13 November 1989, OJ EC 18 November 1989 L334/30 Co-ordinating the Regulation of Insider Dealing in Member States.

4. See, K L Scheppele ‘“It's Just Not Right”: The Ethics of Insider Trading’ (1993) 56 Law and Contemporary Problems 123; W T Allen ‘Professor Scheppele's Middle Way: On Minimizing Normativity and Economics in Securities Laws’ (1993) 56 Law and Contemporary Problems 175; and R Schotland ‘Unsafe at Any Price: A Reply to Manne, Insider Trading and the Stock Market’ (1967) 53 Virginia Law Review 1425, pp 1438–39.

5. See, Justice Report on Insider Trading (London, 1972) para 3.

6. See, R J Haft ‘The Effect of Insider Trading Rules on the Internal Efficiency of the Large Corporation’ (1982) 80 Michigan Law Review 1051, pp 1051–1064; and D A Winslow & S C Anderson ‘From ‘Shoeless’ Joe Jackson to Ivan Boesky: A Sporting Response to Law and Economics Criticism of the Regulation of Insider Trading’ (1992–93) 81 Kentucky Law Journal 295, pp 311–315.

7. See, W Wang ‘Trading on Material Non–public Information on Impersonal Markets: Who is Harmed and Who can Sue Whom under SEC Rule 10b–5?’ (1981) 54 Southern California Law Rev 1217, pp 1234–1235.

8. See, C A E Goodhart ‘The Economics of “BigBang”’ (1987) Summer Midland Bank Review 6, p 10.

9. See, Schotland above, n 4, pp 1448–1449.

10. See, M Klock ‘Mainstream Economics and the Case for Prohibiting Inside Trading’ (1994) 10 Georgia State University Law Review 297 p 330.

11. See, M Mendelson ‘Book Review’ (1969) 117 University of Pennsylvania Law Review 470, pp 477–78; and V Brudney ‘Insider, Outsiders, and Informational Advantages Under Federal Securities Laws’ (1979) 93 Harvard Law Review 322, pp 355–356.

12. See, N Barry ‘Witchcraft and Insider Dealing’ pp 28–34, in Insider Dealing ed H L MacQueen (The David Hume Institute, Edinburgh, 1993) (hereinafter Barry I); Barry The Morality of Business Enterprises (Aberdeen University Press, Aberdeen, 1991) ch 3 (hereinafter Barry II); A Alcock ‘In Defence of Insider Dealing’ (1990) 140 NLJ 1470. And even those who are pro-regulation have shown a tendency to back-slide: ‘we have become less and less convinced that it is the heinous and immoral act that it is often represented to be.’ B A K Rider & M Ashe Insider Crime (Jordans, Bristol, 1993) preface.

13. See generally, J R Macey Insider Trading: Economic, Politics, and Policy (AIE Press, Washington DC, 1991), and B Bergmans Inside Information and Securities Trading: A Legal and Economic Analysis of Liability in the USA and the European Community (Graham & Trotman, London, 1991). especially pp 192–193 (challenging the necessity of a general rule prohibiting insider dealing).

14. Despite a great deal of recent literature on the subject, Henry Manne's 1966 book, Insider Trading on the Stock Market. (Free Press, New York, 1966), hereinafter ‘ITSM’, remains the most widely quoted statement of the case against prohibiting insider dealing. See also, Manne ‘In Defence of Insider Trading’ (1966) 44 (6) Harvard Business Review 113; Manne ‘Insider Trading and the Law Professors’ (1970) 23 Vanderbilt Law Review 547; and Manne ‘Insider Trading and Property Rights in New Information’ (1985) 4 Cato Journal 933.

15. See, Manne Vanderbilt Law Review, Ibid, p 552 et seq; and Manne Cato Journal, Ibid, p 936.

16. See, for example, Macey, above, n 13, p 3; and Bergmans, above, n 13, p 134 et seq.

17. See, W D Carlton and D R Fischel ‘The Regulation of Insider Dealing’ (1983) 35 Stanford Law Review 857. Initially Manne referred only to entrepreneurs, but subsequently this condition was relaxed to include managers as well. See, Manne Vanderbilt Law Review, above, n 14, p 582.

18. See, Schein v Chasen 313 So 2d 739 (Fla1975).

19. J D Cox ‘An Outsider's Perspective of Insider Trading Regulation In Australia’ (1990) 12 Sydney Law Journal 455, pp 457–8 (insofar as investors are harmed, harm is problematic and trivial).

20. See, M King and A Roell ‘Insider Trading’ (1988) April Economic Policy 163, at 168 et seq.

21. See, Manne ITSM, above, n 14, pp 101–102.

22. See, for example, C Tighe & R Michener ‘The Political Economy of Insider-Trading Laws’ (1994) 84 (May) American Economic Review 164 (modelling and developing Haddock and Macey's public choice theory explanation of US insider dealing legislation); H E Leland ‘Insider Trading: Should it be Prohibited?’ (1992) 100 Journal of Political Economy 859 (markets become less liquid when insider dealing occurs); R Benebou and G Laroque ‘Using Privileged Information to Manipulate Markets: Insider, Gurus, and Credibility’ (1992) 107 Quarterly Journal of Economics 921 (insiders can manipulate information through misleading announcements); L M Ausubel 'Insider Trading in a Rational Expectations Economy (1990) 80 American Economic Review 1022, especially pp 1025–27 (efficiency considerations justify ban on insider dealing).

23. See, for example, Macey, above, n 13; and Bergmans, above, n 13.

24. See, Barry I, above, n 12.

25. See, N Arshadi & T H Eyssell The Law and Finance of Corporate Insider Trading: Theory and Evidence (Kluwer, Boston, 1993) especially ch 7; Macey, above, n 13; Bergmans, above, note 13; and F C DiRusso ‘The Battle Against Insider Trading: Are we Paying too High a Price for Too Little Gain’ (1990) 14 Vermont Law Review 457.

26. See, Scheppele, above, n 4; J Moore ‘What is Really Unethical About Insider Trading?’ (1990) 9 Journal of Business Ethics 171 (restrictions necessary to protect the integrity of fiduciary relationships); and Klock, above, n 10 (favouring prohibitions solely as a matter of economic efficiency).

27. For seminal work in this area see generally, J Hirschleifer ‘The Private and Social Value of Information and the Reward to Incentive Activity’ (1971) 61 American Economic Review 561. See also, Klock, above, n 10, pp 321–323.

28. See, J Dennert ‘Insider Trading’ (1991) 44 Kyklos 181, pp190–191.

29. See, Klock, above, n 10, p 323.

30. Macey, above, n 13, p 10; see also, R C Clark Corporate Law (Little, Brown, Boston, 1986) pp 269–270.

31. For a discussion of the market for corporate control and its problems see, J E Parkinson Corporate Power und Responsibility (Clarendon Press, Oxford, 1993) p 121 et seq.

32. For a discussion of the market for managerial talent and its problems see, Ibid, pp 116–118 (and sources cited therein).

33. See, Admission of Securities to Listings, s 5, ch 2, para 1. In certain circumstances the law permits a company to delay disclosure. See, Rider & Ashe, above, n 12, pp 10–12.

34. See, Carlton & Fischel, above, n 17, p 867.

35. Ibid, pp 867–868. See also, Easterbrook ‘Insider Trading, Secret Agents, Evidentiary Privileges and the Production of Information’ (1981) Supreme Court Review 309, p 326; and King and Roell, above, n 20, p 173)

36. See, Barry I, above, n 12, p 28; and Arshadi & Eyssell, above, n 25, p 132.

37. See, H Heller ‘Chiarella, SEC Rule 14e–3 and Dirks: ‘Fairness’ v Economic Theory’ (1982) 37 Business Lawyer 517, pp 539–540.

38. See, D Seligman ‘An Economic Defence of Insider Trading’ (September 1983) 108 Fortune 47, p 48.

39. Manne Vanderbilt Law Review, above, n 14, p 574.

40. J Cotterell ‘Insider Dealing in the United States–III: The De–regulation Issue’ (1986) 136 NLJ 150, p 151.

41. It is widely recognised that the stock market is one of the most (if not the most) efficient markets in existence. See generally, R Gilson and R Kraakman ‘The Mechanisms of Market Efficiency’ (1984) 72 Virginia Law Review 549. But note, Manne's suggestion that the stock market–in the US at any rate–is efficient despite anti-insider dealing laws because so much insider dealing continues to go undetected (Cato Journal, above, n 14, p 948).

42. As Manne acknowledges: ‘In time the truth will come, and the price will change accordingly whether insiders trade or not.’ Manne, ITSM, above, n 14, p 149 (footnote omitted).

43. See, above, n 35 and accompanying text. See also, F Easterbrook & D Fischel The Economic Structure of Corporate Law Harvard University Press, Cambridge, MA, 1991) v257.

44. King & Roell, above, n 20, p 173.

45. For this distinction between the private and social costs and benefits of information, see generally, Hirschleifer, above, n 27. See also, L K Meulbroek ‘An Empirical Analysis of Illegal Insider Trading’ (1992) 47 Journal of Finance 1661, p 1697.

46. S Bainbridge ‘The Insider Trading Prohibition: A Legal and Economic Enigma’ (1986) 38 University of Florida Law Review 35, pp 44–45 (and sources cited therein)

47. H Wu ‘Corporate Insider Trading in the Stock Market 1957–1961’ (1965) 2 National Bank Review 373 p 385.

48. If a small change in price causes a more than proportionate change in the amount demanded, the demand curve is said to be elastic.

49. See, Manne Cato Journal, above, n 14, p 938.

50. See, Gilson & Kraakman, above, n 41, pp 629–34; and Easterbrook, above, n 35, p 336.

51. Schotland, above, n 4, at 1446.

52. Ibid.

53. See, M Fishman & K Hagerty ‘Insider Trading and the Efficiency of Stock Prices’ (1992) 23 Rand Journal of Economics 106, p 107 and p 110.

54. See, Benebou and Laroque, above, n 22, p 921 et seq.; Ausubel, above, n 22, pp 1025–1027; and J Laffont & E S Maskin ‘The Efficient Market Hypothesis and Insider Trading on the Stock Market’ (1990) 98 Journal of Political Economy 70 (traders conducting large trades will find it advantageous to conceal their private information).

55. See, for example, Mendelson, above, n 11, pp 473–476; S Levmore ‘In Defense of the Regulation of Insider Trading’ (1988) 11 Harvard Journal of Law and Public Policy 101, p103.

56. See, Cox 'Insider Trading and Contracting: A Critical Response to the “Chicago School” (1986) Duke Law Journal 628, p 636; and Benebou and Laroque, above, n 22, p 923.

57. The argument that there is little empirical evidence to support the conclusion that insiders manipulate corporate disclosures misses the point, since it is questionable whether reliable evidence could be obtained.

58. See, Parkinson, above, n 31, pp 147–151.

59. Ibid, p 121 (and sources cited therein).

60. Ibid, pp 122–123.

61. See, Ausubel, above, note 22, p 1023; and M Manove ‘The Harm From Insider Trading and Informed Speculation’ (1989) 104 Quarterly Journal of Economics 823 (insider dealing may dampen shareholder support for corporate investment and reduce the efficiency of corporate behaviour).

62. The bid-ask spread is the difference between the price at which market makers are prepared to buy shares and that which they are prepared to sell.

63. See, King & Roell, above, n 20, p 166.

64. See, Mendelson, above, n 11, pp 477–478; Brudney, above, n 11, pp 355–356; and Klock, above, n 10, p 330.

65. See, Cox, above, n 56, pp 635–642; and H Schafer & C Ott ‘Economic Effects of EEC Insider Trading Regulation Applied to Germany’ (1992) 12 International Review of Law and Economics 357, p 364.

66. Cox, ibid p 638.

67. Cox, above, n 19, p 460.

68. See, G Lawson ‘The Ethics of Insider Trading’ (1988) 11 Harvard Journal of Law and Public Policy 727, p 759.

69. See, Klock, above, n 10, p 331, interpreting Ausubel, above, n 22.

70. See, Carlton & Fischel, above, n 17, p 881, for a similar point.

71. See, Ibid, pp 866–872; Manne Harvard Business Review, above, n 14, (insider dealing is ‘the only effective compensation scheme for entrepreneurial services in large corporations’) p1 16; Macey, above, n 13, pp 45–47; Barry I, above, n 12, pp 30–31; and Arshadi & Eyssell, above, n 25, pp 138–139.

72. Carlton & Fischel, above, n 17, p 870. It may be questioned whether this is really a significant cost.

73. Ibid, p 871.

74. See, for example, below n 89 and accompanying text.

75. See, Manne, ITSM, above, n 14, p 78.

76. See, Companies (Tables A–F) Regulations 1985, SI 1985, No 805, Reg 85.

77. But see, V Brudney & R Clark ‘A New Look at Corporate Opportunities’ (1981) 94 Harvard Law Review 997.

78. See, Cox, above, n 56, p 654. In any case, the societal interests involved in a (private) conflict of interest between a director and his company should not be comparable to the societal interests involved in relation to an insider and the (public) stock market.

79. See, Ibid, pp 654–659. The suggestion that standardised contractual terms will resolve the high transaction costs associated with a large number of passive shareholders entering into contract with managers is flawed, since in the bargain struck, managers will tend to write in terms which suit their own interests. As it is, there is no evidence to indicate that companies are lobbying for repeal of insider dealing laws in order that they may better compensate their managers. See, Levmore, above, n 55, p104.

80. See, Cox, above, n 56, p 654.

81. Ibid.

82. Ibid.

83. Macey, above, n 13, p 38.

84. Manne, ITSM, above, n 14, p 110.

85. H Garten ‘Insider Trading in the Corporate Interest’ (1987) Wisconsin Law Review 573, p 582 and n 41.

86. See, Manne Harvard Business Review, above, n 14, p 115.

87. See, Cox, above, n 56, pp 652–653.

88. The suggestion made by Manne (see, ITSM, above, n 14, pp134—138) and endorsed by others (see, eg. DiRusso, above, note 25, p 488) that existing forms of compensation are inadequate is improbable. See, Clark, above, n 30, p 278; and N L Georgakopoulos ‘Classsical and Cross Insider Trading: Variations on the Theme of Rule 10b–5’ (1990) 28 American Business Law Journal 109 p 123.

89. Indeed, Macey recognises this. See, Macey ‘Ethics, Economics, and Insider Trading: Ayn Rand Meets the Theory of the Firm’ (1988) 11 Harvard Journal of Law and Public Policy, 785, p 800. But what he fails to recognise is that harm is defined in relation to what is and what is not socially acceptable conduct.

90. See, Carlton & Fischel, above, n 17, p 873.

91. See, Schotland, above, n 4, p 1453; and Easterbrook, above, n 35, p 332.

92. See, Cox, above, n 56, pp 651–652.

93. Where managers pursue interests different from those of shareholders, agency costs arise. Examples include, shirking, non–profitable growth, and excessive compensation. See generally, M C Jensen & W H Meckling 'Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure (1976) 3 Journal of Financial Economics 305.

94. See, Benebou & Laroque, above, n 22, p 947.

95. See, Ibid, p 921.

96. See, Manne Cato Journal, above, n 14, p 937.

97. Ibid. Again, this will depend not merely on the risk of detection but also on the penalty imposed when prosecuted.

98. See, Alcock, above, n 12. The dearth of convictions in the UK for insider dealing would seem to support the view that insider dealing legislation is unenforceable.

99. It is important therefore to build into the existing legal disincentives a heavy penalty to compensate for the difficulty of detection.

100. See, I Ayres & J Braithwaite Responsive Regulation: Transending the Deregulation Debate (Oxford University Press, Oxford, 1995) p 19 et seq.

101. See, Manne Cato Journal, above, n 14, p 938; and Barry I, above, n 12, p 33.

102. Ibid. (emphasis added).

103. See, Demsetz ‘Perfect Competition, Regulation, and the Stock Market’, in Manne (ed) Economic Policy and the Regulation of Corporate Securities (American Enterprise Institute, Washington DC, 1969) p 14.

104. See, Macey, above, n 13, p 40.

105. See, Winslow & Anderson, above, n 6, p 320.

106. See, Schein v Chasen 313 So 2 d 739 (Fla 1975), and Freeman v Decio 584 F 2d 186 (7th Cir 1978). See also, Carlton and Fischel, above, n 17, pp 857–859.

107. Rider & Ashe, above, n 12, pp 3–4.

108. Justice Report on Insider Trading, para 2; and Arshadi & Eyssell, above, n 25, p 132.

109. See, King and Roell, above, n 20, p 169.

110. Above, n 25, pp 133–136.

111. See, B Cornell & E R Sirri ‘The Reaction of Investors and Stock Prices to Insider Trading’ (1992) 47 Journal of Finance 1031, pp 1040–1055.

112. See, Macey, above, n 13, pp 7–12.

113. See, Haft, above, n 6, pp 1651–1664.

114. See, Macey, above, n 13, pp 36–37.

115. See, above, n 79 and accompanying text.

116. See, Macey, above, n 13, p 37. See also, H N Seyun ‘The Effectiveness of the Insider-Trading Sanctions’ (1992) 35 Journal of Law and Economics 149, p 151.

117. See, Easterbrook ‘Insider Trading as an Agency Problem’ in J W Pratt & R J Zeckhauser (ed) Principals and Agents: The Structure of Business (Harvard Business School Press, Boston, 1986) 81, pp 93–94.

118. Ibid, pp 94–5.

119. See, above, n 107 and accompanying text.

120. See, R Byrne and W Binchy Annual Review of Irish Law (The Round Hall Press, Dublin, 1990) p 85.

121. See, R Keane Company Law in the Republic of Ireland (2nd edn 1991, Butterworth (Ireland), Dublin) para 36.08.

122. See, A Berg ‘Sec 62: the Full Extent of Exposure’ (1988) August International Financial Law Review 26, p 29.

123. See, Klock, above, n 10, p 307; and M P Dooley ‘Enforcement of Insider Trading Restrictions’ (1980) 66 Virginia Law Review 1, p 33.

124. When insiders have inside information, they will hold no shares in bad periods and as many shares as they can acquire in good periods. See, Schafer & Ott, above, n 65, p 363.

125. See, Goodhart, above, n 8, p 10; and King & Roell, above, n 20, p 169.

126. See, Cornell & Sirri, above, n 111, p 1055.

127. See, D Haddock & J R Macey ‘Regulation on Demand: A Private Interest Model, with an Application to Insider Trading Regulation’ (1987) 30 Journal of Law and Economics 311; and Tighe & Michener, above, n 22.

128. Haddock & Macey, Ibid, p 319.

129. See, J Suter The Regulation of Insider Dealing in Britain (1989, Butterworths, London) p 49.

130. See, Georgakopoulos, above, n 88, pp 124–125.

131. See, Ausubel, above, n 22, pp 1025–1026.

132. See, B A K Rider & H L French The Regulation of Insider Dealing, (Macmillan Press, 1979) p 3.

133. See, Easterbrook, above, n 35, p 330.

134. Macey, ‘From Fairness to contract: The New Direction of Rules Against Insider Trading’ (1984) 13 Hofstra Law Review 9, p 10.

135. See, Harvard Business Review, above, n 14, p 113.

136. Ibid.

137. Contrast Macey's statement that ‘[i]nsider trading appears to involve purely economic issues’. See, Macey, above, n 13, at 802.

138. See, Stock Exchange Practices, Hearings before the Committee on Banking and Currency, US Senate, 73rd Congress, 1st session.

139. US v Chiarella 445 US 222, pp 248–50.

140. See, Easterbrook, above, n 35, pp 323–324.

141. Ibid.

142. J A Boyle ‘A Theory of Law and Information: Copyright, Blackmail and Insider Trading’ (1992) 80 California Law Review 1415, p 1495.

143. Easterbrook & Fischel, above, n 43, pp 253–254.

144. See, Easterbrook, above, n 35, p 326.

145. Vanderbilt Law Review, above, n 14, p 551.

146. 401 F 2d 833 (2d Cir 1968).

147. Ibid p 848.

148. See, D D Prentice ‘Insider Trading’ (1975) Current Legal Problems 83, p 92.

149. See, Memorandum of the Securities and Exchange Commission in support of the Insider Trading Sanctions Act of 1984, H R Rep No 355, 99th Cong, 2d Sess 21 (1984).

150. See, United States v Carpenter, 791 F 2d 1024 (2d Cir 1986) p 1031.

151. See, Brudney, above, n 11, pp 353–368.

152. Easterbrook & Fischel, above, n 43, pp 241–242.

153. Ibid, p 241. But see, Klock, above, n 10, p 310, who challenges the suggestion that analysts have valuable information.

154. Ibid, pp 241–242.

155. See, Easterbrook, above, n 35, p 330.

156. See, Boyle, above, n 142, pp 1495–1496 (an attack on one inequality should not be mistaken for an attack on all inequalities).

157. For a variation on this point see, Ibid, p 1495.

158. See, above, n 4.

159. See, Allen, above, n 4, p 182.

160. Ibid, p182.

161. Ibid.

162. See, Preamble to EC Council Directive 89/592 EEC of 13 November 1989, OJ EC 18 November 1989 L334/30, Co-ordinating the Regulation of Insider Dealing in Member States.

163. See, H Kripke ‘Manne's Insider Trading Thesis and Other Failures of Conservative Economics’ (1985) 4 Cato Journal 945, pp 954–955.

164. See, Seligman, above, n 38, p 47.

165. In addition, see, arguments outlined in text accompanying n 70, above.

166. See, above, n 106 and accompanying text.

167. See, Allen, above, n 4, p 180.