A Middle Ground on Insider Trading: Allowing Price-Decreasing Insider Trading Could Signal When Equities Are Overvalued
Lambert, Thomas A., Regulation
For more than four decades, corporate law scholars have debated whether government should prohibit insider trading, commonly defined as stock trading on the basis of material, nonpublic information. Participants in this long-running debate have generally assumed that trading that decreases a stock's price should be treated the same as trading that causes the price to rise: either both forms of trading should be regulated or neither should. I argue for a middle-ground position in which "price-decreasing insider trading" (sales, short sales, and purchases of put options on the basis of negative information) is deregulated, while "price-increasing insider trading" (purchases of stock and call options on the basis of positive information) remains restricted.
The reason for the proposed asymmetric treatment is that price-decreasing insider trading provides significantly more value to investors than price-increasing insider trading. Price-decreasing insider trading provides an effective means of combating the problem of overvalued equity--i.e., a stock price so high that it cannot be justified by expected future earnings. As Harvard's Michael Jensen has argued, overvalued equity increases the probability that corporate managers will engage in value-destroying actions. Deregulation of price-decreasing insider trading would allow corporate insiders--those in the best position to know when a stock is overvalued--to signal the market that the price is too high. Deregulation of price-increasing insider trading could similarly remedy undervalued equity, but undervaluation causes fewer problems than overvaluation and there are numerous other mechanisms for addressing that sort of mispricing. Moreover, the potential investor losses resulting from price-increasing insider trading are higher than those caused by price-decreasing trading.
THE INSIDER TRADING DEBATE
Ever since Henry Manne published his classic book Insider Trading and the Stock Market, scholars have debated whether insider trading has net benefits. Critics of insider trading attribute to it both distributional and efficiency costs. The main distributional claim is that there is something fundamentally wrong with traders using an informational advantage to profit at the expense of other traders, particularly when the advantaged traders are corporate insiders who are supposed to be acting as agents for those who lack the informational advantage. As for efficiency costs, the critics make several claims:
* Insider trading discourages equity investment by uninformed outsiders because they fear trading with informed insiders, which reduces the liquidity of capital markets.
* Insider trading encourages insiders to delay disclosures and to make management decisions that increase share price volatility but do not maximize firm value.
* Insider trading increases the "bid-ask" spread of stock specialists, who systematically lose on trades with insiders (whom they cannot identify ex ante) and who will thus tend to "insure" against such losses by charging a small premium on each trade.
* Banning insider trading protects the corporation's property rights over valuable information regarding firm prospects.
Proponents of deregulating insider trading discount those arguments. Regarding the normative claim that insider trading is simply wrong, they argue that insider trading cannot be "unfair" to investors because they trade with full knowledge of the possibility of insider trading. The proponents dismiss the efficiency criticisms with a mixture of empirical evidence and theory. With respect to concerns that insider trading increases bid-ask spreads, empirical evidence suggests that any increases are small. While in theory the ability to engage in insider trading might encourage managers to delay disclosures or make management decisions aimed solely at increasing share price volatility, deregulation advocates contend such mismanagement is unlikely. …