Sunday, February 24, 2008

Should Insider Trading be Permitted?

An affirmative answer to this question will almost always be dismissed as outlandish. But, Henry Manne, who is considered the father of law and economics, has argued for deregulation of insider trading for the last 40 years.

His ideas have encountered a barrage of criticisms from other legal scholars. Further, as far as I am aware, there is no jurisdiction around the world that consciously adopts the policy of freely permitting insider trading. Manne makes the argument in true law and economics style: (i) insider trading allows persons with non-public information to trade in shares thereby driving prices of shares nearer to their real value (and supporting true price discovery), and (ii) insider trading is a form of compensation to insiders (primarily senior managers) and hence their monetary compensation can be reduced thereby saving cost to the company. Like most others, I find this line of reasoning unconvincing—although it may increase overall efficiency of the capital markets by encouraging price discovery and reduced compensation, it fails to recognize issues of distribution of gains among the different participants. In other words, insiders (who have an information advantage) will gain more than other investors who trade with insiders without parity of information.

However, that Manne and his ideas continue to engage attention is borne by the fact that his legacy is now being captured in a collection. Here is a foreword by Professor Stephen Bainbridge that sets out Manne’s line of reasoning. Although set in the US context, it makes interesting reading for those of you who are enthusiastic about the legal and economic aspects of insider trading and more generally in capital markets and securities regulation.

3 comments:

SUNDAR said...

Apart from the fact that Manne’s argument does not recognise the issue of distribution of gains, even the two fold reasoning he provides – price discovery and reduced director compensation – are not justified.

For instance, let us have a look at the TGS case. It may be recalled the price of the security had risen to $ 31 from $18 by the time the information was made public. This was, as Manne notes, the result of the trading by those with inside information. Thereafter as a result of further trading the price of the security further rises to $58. The reason why the security rose to $31 in the first place was because of trading by those with inside information. Thus, the security was already inflated. It was certainly not close to its correct price when further trading resulted in hiking its price.

Using insider trading as a form of directors’ compensation has been argued to reduce cost of the company. In a deregulated environment, however, just the opposite would happen. In a market riddled with insider trading, the investors would know that the market prices do not reflect the correct price. They would protect themselves by lowering the prices they would offer and increase the companies’ cost of capital. (See Gower & Davies Principles of Modern Company Law, 2003 p. 751-752)

Umakanth V said...

Sundar,

Thank you for your comments, which I agree with. However, since the points you raise are important, I will take the opportunity to clarify and elaborate on them.

On your first point, I return briefly to the facts of Texas Gulf Sulphur (TGS), which are as follows. When TGS discovered ore at the mining site, its stock was trading at $18. Subsequently, when TGS’ officers bought shares and options using this information (which was not yet public), the price rose to $31. This purchase is the crux of the insider trading action. Finally, when the ore discovery was announced to the public, the stock rose to $58 per share. Manne’s point here is that it was the price-discovery effect of insider trading that led the price to increase from $18 to $ 31 and finally to $58. Insider trading enabled a gradual increase in the price. If insider trading were prohibited, then upon announcement, the price would have shot up from $18 to $58 in one go, which is not desirable.

In this example, the real value of the stock (after ore discovery) is $58, and the question is when the market arrived at that price. Manne’s argument is that if insider trading is allowed, then the market will discover a price closer to $58, which in the TGS example was $31. Manne’s theory fails here to the extent that the price arrived at by the market was only $31, while it ought to have discovered the true price of $58. But, credit is also due to him on account of the fact that such pricing cannot be determined with mathematical accuracy, and that on an overall basis, insider trading may perhaps allow prices to be set closer to the real value than the market would set without insider trading. This is not to suggest that insider trading is desirable, but only to highlight this specific argument of Manne.

Your second point is a classical depiction of one part of the market for lemons, which is a problem in economics arising from asymmetric information. Let us apply this principle to insider trading. In a deregulated market, when some companies allow their employees to engage in insider trading, the market will discount the price of the stock of such company. But, the market has no way of knowing with certainty as to which companies allow insider trading and which do not. So, investors will discount values of companies across the board without distinguishing between companies that allow insider trading and those that do not. So, the companies that do not allow insider trading will refrain from accessing the markets as they will not obtain the true value for the securities. On the other hand, those that allow insider trading may continue to access the markets and realize whatever value the market provides, because the insiders will make their gains through insider trading. The resultant situation is that only companies that allow insider trading will access the markets and those that do not allow will not, thereby pulling down the quality of the entire market. Manne’s approach (like most others on deregulation) does not seem to have a neat solution to this problem.

Umakanth V said...

Following from my previous response, details regarding the "market for lemons" problem can be found here (http://en.wikipedia.org/wiki/The_Market_for_Lemons)