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A Note On Corporate Rule-Making and Insider Trading

In the comments section of this EconLog post by David Henderson (a post that highlights Charley Hooper’s excellent case against government restrictions on insider trading) I offered the following comment:

Regarding an exchange above [in the EconLog-post’s comments section] between Zeke and David Henderson —

David argued (as did the pioneering scholar on this matter, Henry Manne) that proscriptions against insider trading should be left to corporations and not be hijacked or otherwise overridden by politicians or government bureaucrats or courts. Zeke then responded that such decision-making would likely have to be made at the level of shareholders, but that, practically speaking (because many large corporations have many shareholders), any efficiency-enhancing rule to proscribe insider trading would not be made because of collective-action problems among the shareholders.

David then suggested an opt-out rule: have a general prohibition on insider trading until and unless a majority (or supermajority) of shareholders votes to allow insider trading for their firm.

Two points (and forgive me if I missed if these points were made elsewhere in the comments):

First, Zeke and David presume that the best default rule is against insider trading. Why? David’s rule would be desirable only if corporations generally would prefer that their insiders be prohibited from trading on inside information. It’s not at all clear to me that such a presumption is justified. If collective-action problems really do plague shareholder decision-making, and if insider trading is generally in the best interests of shareholders – then David’s rule would be harmful, not helpful.

Of course, if my second “if” above were different, then David’s rule would be helpful, not harmful. My only point here is that we shouldn’t be too quick to presume that insider trading is generally so undesirable that a default rule against it is justified.

Second, and more importantly, this discussion (including my own in the paragraphs above) overlooks another of Henry Manne’s profound insights – namely, the operation of the market for corporate control.

At the risk of summarizing too bluntly Henry’s nuanced explanation of the operation of that market, an active market for corporate shares – through, for example, mergers or hostile takeovers – solves the collective-action problem that would otherwise afflict owners of shares of large, publicly held corporations. Outsiders to the corporation – such as corporate raiders – specialize in monitoring the performance of corporations and mustering the financing and carrying out the activities that are necessary to assemble a controlling block of shares if and when incumbent managers are likely managing the corporation incompetently. The controlling block of shares is then used by those entrepreneurs who assembled it to oust the incumbent managers and to replace them with better managers. The corporation’s new controlling owners can, and presumably will, also change whatever by-laws and policies are thought to work against the best interests of that company’s shareholders.

So, if Acme Corp. ‘should’ prohibit its insiders from trading on nonpublic information but, for collective-action reasons (or due to the incompetency of incumbent managers), does not do so, Acme’s share prices will be lower than what they would be if such a prohibition were in place. The market for corporate control will then kick in to inspire a takeover of the corporation and a change in its by-laws and policies. Acme will then start to prohibit insider trading by its executives and other agents. Likewise, of course, if Acme Corp. ‘should’ allow its insiders to trade on nonpublic information but doesn’t currently do so.

I recently, by the way, re-read nearly all that Henry Manne wrote on insider trading.  (You can find it all collected in the second volume of Henry’s Collected Works.)  This work by Henry – spanning four decades, from 1966 through 2006 – displays his remarkable genius as an economist, his deep knowledge of law and legislation, as well as his impressive devotion to scholarship and truth.  (If you purchase this volume, don’t overlook Stephen Bainbridge’s excellent introductory essay.)

UPDATE: David Henderson, in a follow-up comment, clarifies what I already knew but failed to make clear in my own comment, namely, that David doesn’t really believe that a default rule against insider trading is optimal.  David was merely, and quite sensibly, attempting to offer to Zeke a compromise position.