The Case for Insider Trading

“Insider trading is a serious crime. Do you know what the penalty for doing it is? Nothing, if you’re a member of Congress.” - Jarod Kintz

The SEC mentions that insider trading is illegal. The SEC defines insider trading as, “When a person trades a security while in possession of material nonpublic information in violation of a duty to withhold the information or refrain from trading.” sec.gov. In other words, insider trading is when a person inside the company knows information that the public doesn’t know. Insider trading is considered unethical because it gives advantage to people with access to non-public information that the public doesn’t have. Insider trading allows people who know private information about the value of a company to buy and sell stocks of that company. For example, if people working in company A find out that company A will be taken over by company B and that this buy out will increase the value of company A, so the people in company A buy shares of stock in company A, this is an example of insider trading. The public doesn’t know that company A will be bought out and that the value of the firm will rise so the “insiders” benefit while the public isn’t able to.

While insider trading is currently illegal, should it be? Is insider trading economically inefficient and immoral? Insiders buying and selling stocks based on the information they know allow the prices of the stocks to reflect the reality that the company is facing. If insiders are allowed to benefit from the information they know, this is reflected in the company’s stock prices. As economist Henry Manne points out, if insider trading were allowed, the Enron scandal wouldn’t have happened. According to Manne, "I don't think the scandals would ever have erupted if we had allowed insider trading because there would be plenty of people in those companies who would know exactly what was going on, and who couldn't resist the temptation to get rich by trading on the information, and the stock market would have reflected those problems months and months earlier than they did under this cockamamie regulatory system we have." (http://www.washingtonpost.com/blogs/wonkblog/wp/2013/07/26/insider-trading-makes-us-richer-better-informed-and-could-prevent-corporate-scandals-legalize-it/) If insider trading was legal, the investors in Enron could have invested in more lucrative investments instead of waiting all those months until the Enron scandal broke out.

What Manne shows is that insider trading is economically honest and beneficial to both the insiders who are able to benefit by selling their stocks before they are worth less, as well as benefiting the public. Insider trading reveals information to the public that is reflected in the change of the stock prices. If people in the company are rushing to sell their stocks or are buying more shares this lets the public know how valuable the company is. By making insider trading illegal there is no incentive for insiders to act on the information they know so instead of revealing the information to the public (through buying or selling stocks), they keep valuable information of how the company is doing hidden, like in the case of Enron.

If the people working at Enron had inside information and were legally able to act on it they would want to sell their stocks. The fact that the Enron insiders would have sold their stocks this would make the price of the stocks lower, which signals to investors (and to the public) that the value of Enron is doing badly. It might be true that the people they sold stocks to got gypped but all this shows is that people should know more about the stocks they are buying. If insider trading were legal, people would be less inclined to invest in individual stocks since doing so is extremely risky. They would more likely invest in an index fund instead since insider trading reveals that thinking you know more about the company than the insiders is overly optimistic.

Insider trading rewards people who are knowledgeable about the value of a firm to benefit more than the people who lack such knowledge. Insider trading gives an incentive to people to become knowledgeable about what they are buying and selling. Insider trading rewards those with knowledge at the expense of those who lack such knowledge but isn’t this a good thing? Isn’t rewarding people for obtaining knowledge what you want instead of having them get no reward from the inside knowledge they possess? As Peter Engelen and Luc Van Liedekerke point out, “[the] reduction of insider trading will reduce, rather than increase market efficiency because it will slow down the speed with which information will be reflected in security prices.” (Engelen and Liedekerke 2007, 498).

The laws against insider trading are inconsistent. As Dylan Mathews points out, suppose you find out that The Post is about to suffer really big losses and so you decided to decide to sell your shares of The Post before news of such losses reach the general public. This would be an example of insider trading and illegal. But suppose you plan on buying more shares of The Post and then hear that the shares are going down so you refrain from buying more shares. This type of “insider-non trading” is legal, yet as Mathews says, “That kind of insider non-trading is totally legal, but basically equivalent to insider trading. Allowing one and not the other is bizarre and inefficient.” (http://www.washingtonpost.com/blogs/wonkblog/wp/2013/07/26/insider-trading-makes-us-richer-better-informed-and-could-prevent-corporate-scandals-legalize-it/).

Economist Robert Murphy explains how insider trading is a victimless crime in the following scenario: Support a Wall Street Trader is at a bar and overhears an executive talking about how when the Acme Corporation becomes public the value of the stock will rise from $10 to $15 a share. Upon hearing the news, the Wall Street trader rushes to buy 1,000 shares of Acme stock in order to make a profit of $5,000. Who has this trader hurt with his profit of $5,000? The people who sold him the stock wanted to sell anyway (since they didn’t know the value would increase by 50%). Perhaps if they didn’t sell the stock to the Wall Street trader they would have sold it to someone else and for less than $10 a share. The sellers didn’t loose anything and the Wall Street trader was able to profit by the information he overheard. The only people who lost were people who wanted to buy shares before the news went public but were unable to buy as many shares since some of them were already bought by the Wall Street Trader. If the Wall Street Trader didn’t by the stock then those who weren’t privy to the inside information would have made a profit instead of the Wall Street trader. No matter what someone would have profited. Either those who just managed to get lucky by having the stock they bought increase in value or the Wall Street Trader who, based on the information he heard, would have profited. Why is it more just for people who didn’t know the value of the stock was going to increase and just took a gamble more deserving than the person who heard that he value of the stock was going to increase before he bought it? In either case is an example of “dumb luck.” All that allowing insider trading does is allow those who know the value of the company to gain than those who lack such knowledge.

Insider trading is economically efficient and part of what the market is about. Insider trading might give an added advantage to someone who is inside the company to benefit more than an outsider but this should be expected. It makes sense than a person who works for a firm would know and be able to acquire more information than those who don’t. If one doesn’t like the fact that they are not privy to such information they can try to become an insider by working for the firm. According to Henry Manne, “insider trading will release information early into the market and make prices stick closer to their real value. By allowing insiders to cash in on their private information, a more creative productive, risk-taking breed of managers will be attracted to the firm.” (Engelen and Liedekerke 2007, 499). By having insiders being able to cash in on the information they are privy to will benefit shareholders by attracting those who are better at acquiring information to enter the firm. Insider trading makes the market more efficient since it attracts those who are better able to obtain information about how the firm is doing than those who aren’t rewarded for the knowledge they get. While obtaining knowledge about the company’s future might be based on some luck there is also skill involved in being productive, creative and ambitious enough to be able to acquire information in the first place. It’s better for the firm, the shareholders and the economy at large to add incentives for requiring knowledge and acting on it than having people who don’t reveal how the company is doing since there aren’t rewards for doing so.

Insider trading is often viewed as being unfair since it gives advantage to those inside the firm to benefit from knowledge that the public isn’t able to acquire. This is seen as being unfair. The problem with such a view is that the market isn’t about equity; it’s about having those who produce value being rewarded and weeding out those who are inefficient. People who are more physically attractive may have lucky DNA but they shouldn’t be penalized for their genes. There is nothing wrong with rewarding people who are better looking to have the modeling jobs at the expense of those who are less physically attractive so what’s wrong with rewarding someone who instead of having lucky DNA, received lucky information?

There is no moral requirement to provide others with information that you possess. It is considered standard practice in journalism that if a journalist discovers some important news the reporter is under no obligation to share the findings with their colleagues, but rather to take advantage of the new information and be the first one to report it on it. Such competition in journalism is considered “professional behavior and might even you a Pulitzer Prize.” (Engelen and Liedekerke 2007, 502). As Tibor Michan observes, “To take advantage of such special opportunities is a sign of good judgment, not of unfairness or deception.” (Machan 2003, 2).