Time to Reassess Insider Trading Rules?
On the face of it, prohibiting insider trading seems to be fair and reasonable.
US insider trading laws, refined over time in court on a case-by-case basis, define “trading on the basis of inside information” as any time a person trades while aware of material nonpublic information (US Securities and Exchange Commissions Rule 10b5-1, which also creates an affirmative defense for pre-planned trades.) SEC regulation FD (“Fair Disclosure”) also requires that if a company intentionally discloses material non-public information to one person, it must simultaneously disclose that information to the public at large; in an unintentional disclosure, the company must make a public disclosure “promptly.” Lastly, the Williams Act gives the SEC regulatory authority over insider trading in takeovers and tender offers.
The intent of the insider trading laws is to prohibit a person with inside information from profiting at the expense of the public by trading on that information. As I said earlier, this seems fair enough. But there are at least two significant problems with a fair and reasonable application of the insider trading rules.
One issue, which has been well articulated by Donald J. Bourdeaux over the years and is that insiders could react to the
proprietary information by foregoing a planned purchase or sale of stocks. This “non-trading” reaction to inside information is inherently undetectable, rendering about half the distribution of all insider trading activity invisible. Bourdeaux argues that the insider trading laws are applied so capriciously that the markets would be better off and stock prices would reveal more accurate information if all insider trading laws were repealed.
I would not go that far. I do feel that there are clear instances where an individual who controls the flow of private information about a company could unfairly profit from delaying its release and trading in the interim. An unexpected earnings announcement comes to mind as a fairly clear example. This seems to be the case in the most recent insider trading allegations involving individuals at Galleon Group.
Just because someone has proprietary information about a company does not mean that that individual either knows or controls the public’s reaction to that information. Knowing the information is not the same as knowing the consensus market opinion about the company’s future stream of cash flows and risks! For one thing, the public may react differently than expected to the release of the information. Or, new information may become available that counteracts the inside information. Third, the inside information may be factually incorrect. Or, finally, the market may have already put two and two together and essentially inferred the essence of the so-called private information on their own, from other sources and developments, so that when the inside tip is released to the public there is no price reaction.
Recall that the stock price is nothing more, and nothing less, than the market’s consensus opinion about the value of the company’s future stream of profits or earnings. Investors and other market participants base their valuation of a stock on innumerable observations about the future prospects for a firm; when people trade on the basis of that information, their forecasts of profits and risks become incorporated into the new stock price. For example, suppose an investor learns something about a company which leads him to believe that the stock is now worth $11 a share. Another investor, who currently owns the stock, puts the stock valuation at $9 a share. If these two trade, they will strike a deal at somewhere between $11 and $9, say $10; this then becomes the new publicly reported stock price. When they trade on their forecasts, the information upon which those forecasts are based is now reflected in the stock price. If they did not trade, the stock price would have remained at $9 per share.
Let’s couch this example in terms of insider trading. Say a company executive overhears a dinner conversation by a judge presiding over a case. The judge, feeling good, observes that he thinks the jury will acquit company management in an on-going lawsuit. One would think that this is clearly good news for the company, which should make the stock price rise when it becomes public. The executive, acting on insider information, quickly buys up extra company stock in order to profit when the verdict is announced. If it turns out that the judge was wrong, or the stock price had already incorporated the probability of acquittal, easily gleaned from other, publicly available news reports, then the insider would have earned no abnormal profits.
Is this a case of illegal insider trading? I do not know and, to be blunt, neither do you; this issue is decided in court, literally on a case-by-case basis; the arguments are difficult and complex, hinging on the “quality” and “timeliness” of the information, whether the so-called information was available otherwise to the average investor, and whether the insider would have traded differently without the information. In other words, the court tries to rerun history as if the judge hadn’t had one too many cocktails that night.
The fact of the matter is that we rarely learn about such cases. Almost without exception, the only insider trading that generates enough attention to ever get to court are those in which someone makes enough profits to make the public stockholder feel hoodwinked; the many cases where the insider guessed wrong about the eventual impact of the information on the public stock price never see the light of day. Public stockholders do not bother to sue in cases where the insider loses money! And because we never hear about such cases, we are led to believe that trading on proprietary information necessarily creates an unfair advantage to the insider, which is not always so.
By Sherry Jarrell