Saturday, December 29, 2012

An outsider's view of insider trading

As an investment professional, I follow the insider trading laws. And as a CFA charterholder, I follow the more rigorous ethics required by the CFA Institute. But I don't believe in insider trading restrictions. That is I don't subscribe to the theory of justice underpinning insider trading prohibitions. I would like to see these prohibitions largely changed to the extent of elimination generally. I believe this would be an improvement to our society's justice and economic/market efficiency.

The idea of prohibitions on insider transactions hinges on the idea that profiting from knowledge is good but profiting from too much knowledge is bad. Those supporting insider trading restrictions would probably say I've got that wrong. That it isn't too much knowledge but rather unfair knowledge. My answer to that is there is no principled concept of "fair" that allows one to draw a line in the way insider trading laws do making the distinguishment between fair knowledge and unfair knowledge. It takes logical magic tricks to make the distinction. Simply put, the distinction is arbitrary, which is antithetic to logical principals. The arbitrariness can be seen in how ridiculously vague the insider laws are. This makes for dangerous risks--it puts arbitrary power in the hands of already powerful people.

Let's make clear a couple of points. In my opinion insider trading prohibitions are not about prohibiting fraud or misrepresentation. Hence, reducing or eliminating them would not be any sort of condoning of fraud or misrepresentation. They are about making illegal a victimless crime that has in the general public opinion a very negative perception (people benefiting from too much information).

Prohibiting insider trading has several very real negative effects:

  • It violates property rights--the right to freely buy and sell in the market.
  • It reduces economic/market efficiency by limiting who can bring knowledge into the price system.
  • It promotes a false sense of security (moral hazard) by promising that securities transactions are between generally equally equipped traders--this illusion as well as the above problem with market efficiency is mitigated by the next effect.
  • It drives some market transactions (insider transactions) into the dark and gives pause to other transactions for fear of raising insider suspicions. This is very much like the negative effects an onerous, complicated tax system brings--wasted resource allocation in compliance and reduced otherwise beneficial activity in avoidance.
My solution is disclosure-based insider trading rules. I am not alone in this idea. Basically I would like to see insider trading laws replaced by a rule requiring open disclosure of any "significant" transactions from an "insider". I would let the courts decide what a "significant" transaction would be, but as a guidance perhaps a trade over $10,000 in notional or exercise value. I would expand the definition of an "insider" to include any employee of a firm (not just the current definition which includes a company's officers, directors and any beneficial owners of more than 10% of a class of the company's equity securities) and as with the current definition any individual who trades shares based on material non-public information in violation of some duty of trust whether inherent or imputed (e.g., getting a tip from the CEO one could reasonably expect was material non-public information). Now more truly if you're not "inside", you're "outside". Failure to properly disclose an insider trade would result in a fine equal to say 25% of the gross profit from the alleged trade. Any employee trade not properly disclosed would also result in the same fine incurred by the employer unless the employee was acting with malicious intent. 

The reason companies would find this change to be largely in their interest is the same reason why companies would want restrictions on insider trading in many cases. Companies have at least two reasons why they don't want their officers making some kinds of insider trades: 
  1. It makes for very negative PR for a CEO to sell (buy) the company stock on insider knowledge that negative (positive) news is forthcoming. 
  2. A company wants a CEO's incentive to be with the long-term interest of the company whereby he gains (looses) as the firm gains (looses). (Unfortunately, we continue to allow insiders to avoid losses their firms incur generally at tax-payer expense. But that is a problem for another blog post.)
I would anticipate greater popularity of agreements between corporations and their insiders that allow for clawback of earnings or outright damages for insider trades not in company interest.