Decriminalize Insider Trading

by Don Boudreaux on October 24, 2009

in Crime, Financial Markets, Law, Prices, Property Rights, Regulation

In today’s Wall Street Journal I argue that insider trading should be decriminalized.

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{ 51 comments }

Name October 24, 2009 at 3:20 pm

Don is forgetting the self-serving behavior allowing insider trading would create in management teams. They would be incentivized to drive the stock price down before buying, including by means that would cause actual, as opposed to perceived, harm to the company.

BoscoH October 24, 2009 at 3:59 pm

And the BODs and shareholders would just accept that?

Anonymous October 24, 2009 at 4:24 pm

I don’t think Don is ‘forgetting’ this. On the contrary, this sort of behavior is sure to be punished in the market: management would loose credibility and the company will face a higher cost of capital/higher risk-premium. Moreover, the beauty of letting companies ‘regulate’ themselves is that this sort of behavior can be explicitly guarded against in the by-laws as Don points out if you bother reading the article.

Eric H October 24, 2009 at 4:38 pm

Are you talking about management teams that don’t work for the company whose stock they devalue? Who would want to drive down the stock price of the company they work for, if that company is well managed and productive? Doing so would put one’s own earnings at risk. One of the points Don makes is that individuals with inside information should be allowed to trade on it as they leave the firm. Laws against insider trading are essentially barriers to exit for workers and management of risky or badly-run enterprises. Allowing insider trading keeps management honest–they’d run a tighter ship if they knew risk to the crew of jumping overboard was lower.

Justin P October 24, 2009 at 8:21 pm

Why would a management team purposely try to devalue the stock of their own company?
Or do you mean try and devalue the price of the other company?

If they do the first, they are just plain dumb and should loose all their money.
The second, you forget the actions of the opposing management team, which would be trying to drive prices up! It’s called market Competition.

Anonymous October 24, 2009 at 4:01 pm

Beautiful – simply beautiful.
Too many talking-heads know little about the power, incentives and signals contained in the price system.

BoscoH October 24, 2009 at 4:02 pm

One wonders if the Enron debacle might have been prevented by some employee noticing that things didn’t add up and doing his best to profit from that information.

Eric H October 24, 2009 at 4:27 pm

From your piece it sounds like laws against insider trading do two things: 1) preserve bloated corporate interests already beholden to government through rent seeking and 2) satisfy populist status quo bias.

Think of GM. If only someone would’ve stepped up and insider-traded GM stocks years ago. GM has been poorly managed for decades–it’s been a tremendous drag on efficiency in that regard, and it’s been dependent on tariffs for almost 50 years. But keeping GM around–confirming the populist status guo (Chevy–”Like a Rock”)–helps people feel like things are okay. It boosts public complacency so corporatists in government and industry can belly up to the trough unnoticed.

hamilt0n October 24, 2009 at 4:57 pm

it takes bigger huevos to write this in the WSJ than to make a blog post about it. good job, don.

JP Koning October 24, 2009 at 5:10 pm

This is an excellent article.

I would like Prof Boudreaux to tackle an issue related to insider trading; whether stock market manipulation laws should be decriminalized, and if so (because I think he’ll say yes), how such a world would look like.

By market manipulation, I mean insider pools, washed sales, churning and more (see http://en.wikipedia.org/wiki/Market_manipulation). For instance, before the SEC’s introduction in 1934, it was common for insider “cliques” to pool their capital, slowly accumulate a stock, and then squeeze it with an avalanche of buy orders, finally selling into the frenzy for profit. The SEC criminalized this.

Anonymous October 24, 2009 at 5:11 pm

Bah! How could you possibly write this piece and never mention or point out the fact that the very people who make insider trading illegal are free to do it themselves, and do so very profitably.

The “legality” and “profitability” of Congressional insider trading has been discussed and documented on this very blog several times since this early spring.

By not mentioning what you must now well know, if you read your own blog, and making it part of your central thesis, you showed no courage or intestinal fortitude at all.

Furthermore you did no one any service at all by dodging the issue.

Anonymous October 24, 2009 at 5:14 pm

Well sure this is the sort of thing Greenspan pushed during his tenure. Ignore fraud, deregulate, don’t enforce and hey it worked so good for the derivatives market. We need more Enron, Worldcoms and AIG’s.

see;

Frontline; The Warning

http://www.pbs.org/wgbh/pages/frontline/warning/

hamilt0n October 24, 2009 at 5:20 pm

insider trading would protect against those very scandals. if you had insider information about AIG wouldnt you sell? what kind of price signal would that send?

sandre October 24, 2009 at 5:37 pm

He trusts only that information which is certified true by the ministry of truth ( minitrue ), and it’s official mouth piece – Pravda.

Anonymous October 24, 2009 at 7:07 pm

As we are all aware any regulation is perfect and agencies are never captured.

Regulation in the abstract sounds like a great idea, but in reality, it is generally a far from ideal.

Justin P October 24, 2009 at 8:29 pm

Regulations are contingent on the regulators. People like Muir, seem to think the regulators are altruistic and omniscient at the same time thinking the market participants are the opposite. I don’t know if he just doesn’t realize that the regulators are just as corrupt and susceptible to bribery as the market participants or if he just chooses not to accept that information.

Justin P October 24, 2009 at 8:27 pm

Muir probably didn’t even read the article otherwise he would have known that Don addressed those very issues.

Muir, probably just read the headline and “inferred” the rest.

Anonymous October 24, 2009 at 9:00 pm

You are giving Yasafi way too much credit. You assume that:

(a) He can read. Or:

(b) He can comprehend what he reads.

Yasafi only knows this:

The State is my shepherd; I shall not want.

It maketh me to lie down in green pastures:
It leadeth me beside the still waters.

It restoreth my soul: It leadeth me in the
paths of righteousness for It’s name’s sake.

Yea, though I walk through the valley of the
Shadow of Liberty; I will fear no such evil: for thou
art with me; thy regulations and thy guns they
comfort me.

Thou preparest a table before me in the
presence of mine enemies: thou would never anointest
me with Evil Oil; my cup runneth over of subsidized corn.

Surely goodness and mercy shall follow me all
the days of my life; and I will dwell in the
house The State provideth for me for ever.

Justin P October 24, 2009 at 8:25 pm

Did PBS get their Offical Obama New Seal of Approval yet?

Name October 24, 2009 at 11:15 pm

Good grief, when people accuse you of just pretending that contrary arguments don’t exist, they’re not kidding, are they?

I’m just curious: did you read the article and simply ignore the part that argues THE EXACT OPPOSITE of what you’re saying, or do you not even bother?

Anonymous October 24, 2009 at 11:25 pm

Hey idiot, your freaking congressman never lost a dime on his/her insider trading, why would you?

Why would I……ooops, that’s right I don’t the real good inside information a congress person gets because I don’t have legislation to sell.

Gary October 24, 2009 at 5:42 pm

I have changed my mind. I’m all for insider trading.

iamse7en October 26, 2009 at 2:54 am

Jeff Miron’s recent post about it was the first time I’d heard the argument, and I was instantly intrigued. Upon further study, I’m convinced as well. I think the benefits outweigh the costs.

iamse7en October 26, 2009 at 2:54 am

Jeff Miron’s recent post about it was the first time I’d heard the argument, and I was instantly intrigued. Upon further study, I’m convinced as well. I think the benefits outweigh the costs.

Justin P October 24, 2009 at 8:24 pm

Excellent suggestion Don.
It might seem a stretch, but I think of this just like the anti-drug laws. They do more harm than good.

Name October 24, 2009 at 9:41 pm

A couple responses to those who argued in favor of allowing insider trading:

1. Management teams have power today in almost all situations over shareholders because shareholders are too dispersed/fragmented to band together efficiently. Members of the BoD are usually cronies of the management team, well-paid to go along with their, or their hired guns’ (bankers, consultants) suggestions. To expect them (or the by-laws) to be able to deter improper insider trading is naive; they certainly have not controlled backdating stock options, which is out-and-out theft from shareholders.

2. It was asked “why would management teams want to drive down their stock price?” Imagine a new product is coming out of R&D. Management announces that it is not that successful or will not be ready when anticipated. The stock drops. Management buys. The next quarter, the product is, amazingly, ready and management talks it up. This is just one example; there are many ways for management to manipulate the stock price and allowing insider trading would give them a greater incentive to do so.

3. Imagine a CEO sells stock because he knows a large customer has been lost. You were the ignorant patsy on the other side of the trade. Would you still favor insider trading?

Anonymous October 27, 2009 at 1:25 am

These are my thoughts as well. I think there are countless possible scenarios for management teams, or members of those teams, to take advantage of insider information at the expense of individual shareholders.

While I agree with Don that it is impossible to police insider trading, legalizing insider trading would create a very large loophole for a management teams to benefit greatly at the expense of their employees and company shareholders.

What do you suppose the economic waste would be if a CEO “earns” a 500m dollars from investors by manipulating non-public market information, consequently letting go 40% of their workforce or bankrupting the company?

I find the economic argument compelling, but there’s a moral element that I don’t think economists can address.

Anonymous October 24, 2009 at 9:58 pm

Good article Don. Note that the insider charges against Mark Cuban were dismissed, as he had no fiduciary obligation not to trade the stock in question. Of course, they never should have been brought against him in the first place.
Flag, how exactly are insiders supposed to drive their stocks down? By short selling? I don’t think so.

Name October 24, 2009 at 11:04 pm

billstepp – tons of ways. even a negative tone at a conference or on an earnings call can drive out a stock price. management teams already work to drive down stock prices before option grants. never underestimate the ability of someone in power to advance his own interests!

Anonymous October 24, 2009 at 11:14 pm

Given that Congress permits insider trading for Congress, I would never underestimate the ability of those with the ultimate power to job the system in their favor.

Anonymous October 24, 2009 at 10:02 pm

First we have to recognize that insider trading is impossible to stop. Like most regulation, the regulation here simply creates a thriving black market in insider trading, thus making the situation worse.

Gil October 25, 2009 at 3:29 am

Aren’t you making a presumption that insider trading is a bad thing?

muirgeo October 24, 2009 at 10:32 pm

WE just did this.

Here Wall Street. You want to combine commercial and investment banking sure go ahead. You want to invent new investment products sure and gets some physicist to help.. they have nothing bette rot do then solve are energy problems. Oh and you want to be able to trade those new fancy products outside of regulation… sure go right ahead. We won’t bother with silly things like fraud. Will call off the dogs at the CFTC and the SEC and the Fed… you guys know best. Oh what ? You say you want to create a new insurance product that can skirt standard insurance regulations…SOUNDS GREAT go right ahead. What’s that Wall Street? You want us to loosen lending standards and increase leverage limits. Sounds like a GRAND IDEA. Us free market guys are right behind you. We won’t get in your way. You want to be able to hide your assets offshore, get communist slave labor, ship capital overseas, loosened rules for CEO stock, options… sure… you want to make it easier for predatory buy outs, tax cuts for the wealthy… you got it. You want us to ignore the Sherman act… YOU GOT IT.

10 years 15 years pass….

Hows it going Wall Street guys?

Well it looks like we have made some complex opaque products mixed them in a blender using the physicist formula for brownian motion and now we have 1 trillion dollars leveraged to $100 trillion dollars with a lot a shit gluing it all together. We are filthy rich. So I think it’s going good but I think the rest of the world is fucked but we’ll be OK. We have some good inside information of the whole thing. They’ll be out of work and we’ll still be taking million dollar bonuses… not to worry.

We’ve even got some new ideas. Do you think you can get rid of rules against insider trading?

Nathan October 25, 2009 at 2:47 am

Coherence isn’t your strong suit, is it?

Anonymous October 25, 2009 at 2:20 pm

No it’s quite coherent what happened regardless of my poor ability to put it into words. We let Wall Street devise it’s own financial products and let them use these products outside of regulation. They blew up the global economy with literally more then $50 trillion dollars of bad assets. It’s THAT simple!

But you want to ignore this fact. It is you who is lacking coherence of thought preferring ideology over reality. If communism failed over the course of a century we just saw free market capitalism self destruct in less then 30 year. Yet the true believers push on.

Anonymous October 24, 2009 at 11:36 pm

Don Boudreaux erred in this article. He should have said ‘legalize’ instead of ‘decriminalize.’ The latter word can mean legalize, but it also can mean reducing criminal penalties or replacing criminal laws with bureaucratic government regulations. Based on the article, he wants insider trading legalized with no government regulation, only corporate regulation.

Gil October 25, 2009 at 3:32 am

Crap! You beat to it! I going to point out that too. Awww.

Yeah, I concur – be hardcore, use the term ‘legalise’!

Chris Meisenzahl October 25, 2009 at 12:01 am

OUTSTANDING piece!!! ;-)

DG Lesvic October 25, 2009 at 12:07 am

Congratulations,

I’ts good to see the best writer on political economy today get his due, even if only once in a while.

Anonymous October 25, 2009 at 12:40 am

Flag,
A negative tone is in the eye of the beholder. Corp. execs usually try to put a positive spin on bad news, at least on the conference calls I have heard. As for options grants, that works both ways, as they exercise their options too and sell stock them.
I don’t think they try to advertise bad news as such in general.

Anonymous October 25, 2009 at 1:46 am

The more regulation the government puts on insider trading, the less likelihood you are going to see newer companies go public. It’s just not worth it AND it will have the effect of reducing economic output and employment. Thanks socialists.

Gil October 25, 2009 at 4:08 am

Are you sure? If anything if insider trading was totally legal then the public market might all but disappear. This is due to the fact that insiders will get the best deals and reap the profits whereas outsiders will only hear about the deals only after the dust has settled and any lucrative opportunities are gone.

It’d be akin to young Bert driving a quality secondhand car he bought at a private sale. If Bert shows it offs to Phil and Phil complains:

“No fair! I didn’t hear about! If I had have heard of the deal I would have jumped at the chance but I didn’t see the car being advertised in the local classifieds.”

“Yeah well it wasn’t exactly an open sale – the seller was my uncle Kurt. He wanted to sell this perfectly roadworthy car basically as a trade-in because he wants to buy a new car. The deal was struck at my cousin’s Gert birthday party.”

“That’s bullcrap! He should been obliged to put an ad in the classifieds so everyone gets a chance at such a deal.”

“I beg to differ – it was inside family deal.”

“That’s unfair! Inside trading sucks!”

“Whatever.”

However will companies be better off private? It is said that since public companies have disinterested shareholders they risk long-term growth failure by pandering to the short-term interests of the shareholders. Doesn’t that sound similar to Hoppe’s criticism of Democracy?

Toby DiPasquale October 25, 2009 at 4:42 am

This WSJ article made the front page of Hacker News and there’s a discussion going on there about it: http://news.ycombinator.com/item?id=901138 (I’m trying to hold the natives down over there as ‘codeslinger’)

Daniel Earwicker October 25, 2009 at 9:47 am

AT LAST! Why isn’t this argued more often? The insider trading laws must serve the interests of powerful people, because they make so little sense, how else do they survive?

As Don points out, for a frequent trader, deciding not to trade right now based on private information is as important as deciding to trade, and yet is impossible to detect.

But even more ridiculous, if information wasn’t distributed unevenly, the stock market would have no function at all. Its very purpose is the buying and selling of information. If the only information that could be traded was that which was already available to everyone, all prices would be permanently zero, and no one would show up to trade.

In reality, there would still be fluctuations because there are some things that no one can predict; so some people would still win more due to pure dumb, ignorant luck. Perhaps that would be “fairer”!

Compare with laws regulating pure gambling – it’s illegal to know too much about which horse is going to win, but the ideal is that everyone knows nothing, so it’s pure luck and everyone has fun.

But investment isn’t a game; it’s important. Does the government really want it to only be about gambling on the unknown?

Therefore I would go further: the only useful, meaningful, functional kind of trading is trading on information with restricted availability, and hence is a form of insider trading.

Anon October 25, 2009 at 12:47 pm

See http://www.professorbainbridge.com/professorbainbridgecom/2009/10/learning-to-love-insider-trading-lets-not.html

“All of which seems perfectly plausible, but for the inconvenient fact that a given security represents only a particular combination of expected return and systematic risk, for which there is a vast number of substitutes. The correct measure for the supply of securities thus is not simply the total of the firm’s outstanding securities, but the vastly larger number of securities with a similar combination of risk and return. Accordingly, the supply/demand effect of a relatively small number of insider trades should not have a significant price effect. Over the portion of the curve observed by individual traders, the demand curve should be flat rather than downward sloping.”

————-

An interesting opposing view. I think the core difference of opinion b/w Profs. Boudreau and Bainbridge come down to whether individual stocks are close substitutes — i.e., Prof. Bainbridge suggests that I might be just as happy with stock in ACME, Inc. as Zenith, Inc.

Maybe I’m an odd duck of an investor, but my preference in stock is very idiosyncratic. I don’t buy a share unless I understand the business very well and feel comfortable with that specific company’s business model and ability to execute. For example, I don’t see DO and RIG (two oil drillers that are often discussed as competitors), as being close substitutes.

I suppose Prof. Bainbridge would say that my voice is drowned out by the millions of day traders, but I don’t think so. They’re a constant baseline of noise –albeit liquidity-providing noise — spread across the spectrum of stocks. Just as many sales as buys (tautology intended). The marginal difference in demand over a long enough run (i.e., weeks, not seconds or minutes) are professional investors and individuals like me. Or so I think.

dscofield October 25, 2009 at 1:07 pm

This makes a lot of sense but how would it really play out given how much ‘emotion’ affects the market, most management (and investors) are stock ‘renters’ not stock ‘owners’ which affects the long-term health of a company and the comments made by “Name” on the fragmentation of shareholders, BOD ‘friends of management’ etc. Any change such as this should require changes in executive compensation that limit the risk of ‘gaming’ the system.

Anonymous October 25, 2009 at 2:19 pm

It is a hypocritical piece that Don wrote. He has to be aware of the Elephant in the room, but he avoided saying one thing about it.

I speak of Congressional insider trading done with impunity and perfectly legal for them, but criminal for you, me and Raj, et. al.

It is a bad joke to talk about insider trading in any form without making an issue of that.

RedSt8r October 25, 2009 at 5:45 pm

Proponents of insider trading must not own anything of value. Would Prof. Don be happy with a grad student assistant selling questions and answers to his exams? Oh, sorry would that be proprietary?

“At bottom all insider trading robs information from the rightful owners for the personal gain of the employee insider.”

“Professor Boudreaux’s failure to protect the ownership rights of shareholders is a significant and substantive failure on the part of one who otherwise champions individual rights and freedoms.”

A more detailed post is at: http://redst8r.wordpress.com/2009/10/25/insider-trading-hooey/

bonerici October 25, 2009 at 6:02 pm

back in the bad old days, there were a large variety of schemes to make gigantic profits by illegal means, because at the time they were not illegal, so you could form trusts, corner markets, pump and dump, and of course, if you were a corrupt manager of a company you could find ways to bankrupt the company and in the meantime make a gigantic profit by selling and buying the stock of this same company with insider trading.

Naturally this was bad. It was bad for the stock holders, bad for the companies, bad for the states who held the charters to the companies, and it was only good for corrupt managers, CEOs and boards. The Modern Corporation and Private Property by Adolph Berle explained how stock holders no longer have any control over their own corporations, way back in 1932, and things indeed have changed, CEO’s have much more power now.

So what was the point of the rule against insider trading, I mean historically? The point is that current regulations back in 1935 had no way to punish corrupt managers. None. A CEO could pump and dump his corporate stock, buy and sell until he personally had all the wealth that the company used to have, and then it’s all IBG, “I’ll Be Gone” and there wasn’t a law that could touch him. The reasons for this is that when insider trading is legal it’s impossible to tell the difference between a bad manager and a corrupt manager.

That is why the insider trading laws were passed. Without the ability to nail corrupt CEO’s due to insider trading corrupt CEO’s will never ever be caught. Is that what we want? For CEO’s to destroy their very companies in order to make quick buck and leave a ruined husk, and never be punished?

You can’t count on the good nature of mankind for them to be decent human beings. We do need laws for that you know.

In the fantasy world that boudreaux seems to live in, the shareholders have the ability to fire corrupt managers. In the real world, where I live, we only find out that a CEO is corrupt after a company has been bankrupted, and even then the CEO leaves with all the money.

There is one reason and one reason only that CEO’s do not do this all the time, and that is because of the insider trading laws, which would put them in jail. Without that, the entire system would come crumbling down as CEO’s sucked dry the husks of our corporation in the pursuit of personal profits.

Anonymous October 26, 2009 at 9:52 pm

I’m puzzled that the WSJ article states insider trading is “impossible to police” but is accompanied by pictures of several people who have been arrested for insider trading. Isn’t that contradictory?

Toro October 31, 2009 at 12:36 pm

As a professional investor who is occasionally privy to inside information, I think this is a terrible idea.

I would refer you this article by Jeff Matthews explaining why.

http://jeffmatthewsisnotmakingthisup.blogspot.com/2009/10/how-to-solve-crime-let-criminals-decide.html

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