On the face of it, prohibiting insider trading seems to be
fair and reasonable. 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 (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 with insider trading
laws which has been well articulated by Donald J. Bourdeaux over the years 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 unobservable. 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laws were repealed.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 personally 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 and SAC Capital Advisors.
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.
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