Reflecting on insider trading

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 InsiderTradinginformation” 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

Don Boudreaux
Don Boudreaux

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markets would be better off and stock prices would reveal more accurate information if all insider trading laws were repealed.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

5 thoughts on “Reflecting on insider trading

  1. There are good arguments to be made for a repeal of insider trading laws. Most of these hinge on the desirability of not interfering with the market; suggesting that unfettered trading activity is the most efficient way of conveying news to the market about a particular security. This kind of logic is very Milton Friedman, which probably explains its current cyclical unpopularity.

    The moral problem with abolishing insider trading rules is that the ultimate source of such information must always be an officer of the company or an advisor to the company – and they have a clear fiduciary duty both to the company and to its shareholders. At the heart of any insider trade there must inherently be a breach of fiduciary duty. The executor of an insider trade is either acting in direct breach of trust, or has been passed information by a party who is themselves in breach of trust.

    Repeal the insider trading laws and practically you have to abolish the notion of scheduled reporting cycles by issuers of listed securities – and there is no doubt that the market would be a more disorderly place if that were to happen.

    The argument in this article that insider trading can be tough to catch because sometimes the possession of inside information leads to a decision not to trade is valid, but ultimately unfulfilling. Nobody is going to legislate against “inaction with intent to defraud”. Every time we legislate, we create imperfections in the market – and this is an example to warm Prof. Friedman’s heart.

    The argument that the possessor of insider information may jump the wrong way is equally true in principle, but doesn’t really work in practice. The definition of insider information (US common law) refers to “Material” information, the impact of which on the value of a security will rarely be directionally ambiguous even if the size of movement is unknown.

    Finally, the argument presented here seems to be based on the view that insider trading actions are typically civil suits brought by shareholders. The fact is that the vast majority are SEC actions triggered by electronic analysis of trading activity and pursued under the Insider Trading and Securities Fraud Enforcement Act 1988. Substantial financial gain on the part of the perpetrator is not in and of itself a precondition for such an action being successful. Rather, it is enough to demonstrate that insider information was possessed, and utilised to make a relevant trade.

    We don’t read too much about the SEC’s successes because the vast majority of cases are settled out of court, saving the tax payer hard earned dollars that would otherwise line the pockets of many a struggling attorney.

    NJW

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  2. Thanks so much for your thoughtful and engaging comments. I am more informed because of each of your observations. And, if I were arguing for the repeal of insider trading laws, each of your points would be dead-on. But, in fact, I was not. My point is more subtle — perhaps even more subtle than I intended!

    What I had hoped to convey was the observation that insiders who are privy to proprietary information about a company do not unambiguously profit at the expense of the less-informed from trading on that information. This fact does not argue for the repeal of insider trading laws; on the contrary, it raises the bar for insider trading laws. It makes more difficult the task of designing insider trading laws that accomplish what they set out to accomplish — to help ensure that public stock prices are an unbiased estimate of relevant information — without going so far as to prohibit informed trading, which makes us all better off.

    I do in fact see that you’ve left a little room for my point in your responses. “No one is going to legislate for inaction,” is one, for it highlights the difficulty with drafting non-distortionary legislation, including the existing insider trading laws. Two, “insider information is material information, the impact of which on the value of a security is rarely directionally ambiguous.” In other words, it is unambiguous to prosecutors that a certain piece of inside information should either increase or decrease the price? How would prosecutors validate their assumption? Perhaps by observing the stock price movement when the information eventually became public? And if they were wrong, do they continue the prosecution or move on to another violation with clear victims and measurable damages? And doesn’t this help make my initial point: that the link between the piece of information and the eventual public stock price reaction is not always clear, is not always unambiguous, is not always as is presumed when reading between the lines of the insider trading code.

    A small, subtle, and dominated point, I agree. But the one I had hoped to make nonetheless.

    Thanks again for your nearly-impervious comments. They were a joy to read and contemplate.

    Sherry

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  3. A few further observations if I may based on your reponse:

    You write:

    “What I had hoped to convey was the observation that insiders who are privy to proprietary information about a company do not unambiguously profit at the expense of the less-informed from trading on that information.”

    We can argue that every time a security changes hands (on the secondary market at least), there is an ultimate winner and loser to the extent that one party realises a profit or avoids a loss that is missed or picked up by the other party. Clearly if one party has “insider” information, the chances of the winner being that party ought to be somewhat increased. Not necessarily, you seem to argue.

    I argue that Insider information is described in law as being “price sensitive information”. Insider Information that has no effect on the price of a listed security does not fall within the scope of the act(s). When you add that to the requirement for that insider information to be “material” before its misuse is actionable, the potential directional effect of that information on the price of a security is normally crystal clear.

    In the US the list of such price sensitive disclosures is taken to be those that must be declared on a form 8-K (this is subject to review at the moment).

    You also assert that:

    “insider trading laws…set out… to help ensure that public stock prices are an unbiased estimate of relevant information —”

    Whilst it is certainly true that the Insider Trading Laws are there to protect the market from manipulation by the unscrupulous, I suspect that few practitioners would view stock prices as an “unbiased estimate of relevant information”. Many would see them as a highly biased store of old information, updated with rumours, hopes and expectations. Once you get away from the market leading stocks and into the pinksheets, values are often reflective more of liquidity considerations than fundamentals.

    And long may it be so. If the market represented rational buyers and sellers trading around a shifting equilibrium based on each new disclosure, the world would be a dull place.

    Finally, on the subject of prosecuting the offenders in the light of my observations, you write:

    “In other words, it is unambiguous to prosecutors that a certain piece of inside information should either increase or decrease the price? How would prosecutors validate their assumption? Perhaps by observing the stock price movement when the information eventually became public? And if they were wrong, do they continue the prosecution or move on to another violation with clear victims and measurable damages?”

    In practical terms, the SEC is most commonly alerted to Insider trading by material volumes of directional trading in a security front-running an announcement. By the time the SEC moves to prosecute (and this is quite quickly usually), both the directional trading and the announcement are a matter of record. Often the perpetrator will have gone to extraordinary lengths to conceal the transaction (use of nominees etc) and this further implicates them as/when the transaction(s) are detected. There is no question of the SEC commencing proceedings for “insider trading” ahead of the public disclosure of the information alleged to have prompted the transaction.

    The real issue for prosecutors in this area is in demonstrating that the insider information was in the possession of the alleged perpetrator, and determining if the information was acted upon in the reasonable knowledge of it falling under the insider definition. Those are tougher challenges than first meet the eye – unless as in the case of Galleon, you happen to have a whistle-blower on the inside of the perpetrator: the ultimate insider information…

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  4. Very interesting discussion. There is still something swirling around in our comments that seems to me to be fundamentally contradictory. I haven’t quite got it to the point where I can articulate it clearly and sharply — maybe you can help me with that. But here is where I think I see the contradiction, not in your thinking, per se, but in the whole of the pro and con arguments on the topic, for which I use specific selections of your comments to illustrate:

    One, you say “I argue that Insider information is described in law as being ‘price sensitive information’. Insider Information that has no effect on the price of a listed security does not fall within the scope of the act(s). When you add that to the requirement for that insider information to be “material” before its misuse is actionable, the potential directional effect of that information on the price of a security is normally crystal clear.”

    So prices do respond predictably and in a timely manner to new material information.

    But then you note: “I suspect that few practitioners would view stock prices as an ‘unbiased estimate of relevant information.’ Many would see them as a highly biased store of old information, updated with rumours, hopes and expectations.”

    “A biased stock” — i.e., the stock price is either systematically “too high” or “too low” relative to some true intrinsic value (determined by whom and how is quite the trick!) — “of old information” — i.e., the stock price is stale, slow to react.

    “Updated with rumours” …rumours about something material? Then the price should react. Or rumours about something immaterial? Essentially misinformation. Then the price shouldn’t react and, if it does, it would have to be systematically positive or negative misinformation to generate biased prices.

    ….”with hope or expectations…”

    All stock prices are forecasts of future cash flows and risks. Is “hope” supposed to imply that those forecasts are foolish, or too optimistic? Again, we’d have to have some universally accepted measure of the true value of the stock or its cash flows and risks to be able to dismiss the forecasts as flawed. And “expectations” is just another word for “forecasts.”

    One other point I’d like to clarify, if I may. I did not mean to imply that each trade produces a loser and a winner — someone who profits and someone who loses. At any given point in time, there is an entire distribution of forecasts of the prices or returns of (frequently traded — not pink sheet or penny) stocks made by investors; imagine a bell curve populated by a distribution of investors at each expected value. I personally can be anywhere in that distribution at any point in time, depending on my information set and existing portfolio (because of the impact of diversification on risk). My risk preferences will determine what price or return is “enough;” what represents a return sufficient to compensate me for risk. If I trade, by definition I am accepting a price below what another demands for their own purposes; there is no reason we cannot both “gain” on our own personal accounts. For example, if I think a stock is worth $10 and I pay $9, and the seller thinks the stock is worth $8 and gets $9, we are both better off.

    I don’t know about you, but this thread requires me to think very deeply and very carefully about these complex issues. It is intellectually challenging to try to articulate the core issues, to keep drilling down until we get to the meat of the question of whether stock prices are meaningful and fair. If doesn’t get more fundamental that that, and there are experts from both Wall Street and academia firmly planted on either side of the issue. I am keeping an open mind, and have learned valuable information from you, and would love to keep the dialogue going as time permits.

    Thanks.

    Sherry

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