FOR EDUCATIONAL USE ONLY

35 Stan. L. Rev. 857

Stanford Law Review

May, 1983

*857 THE REGULATION OF INSIDER TRADING

Dennis W. Carlton [FNa]

Daniel R. Fischel [FNaa]

Copyright © 1983 by the Board of Trustees of the Leland Stanford Junior

University; Dennis W. Carlton and Daniel R. Fischel

Imagine two firms, A and B, which are identical in all respects except that, in its charter, firm A prohibits the trading of its shares based on inside (nonpublic) information. The firm requires insiders (employees) to report their trades, which a special committee or an independent accounting firm then checks to ensure compliance with the charter provision. Firm B, by contrast, neither prohibits insider trading nor requires reporting. Insiders openly trade shares of firm B and regularly earn positive abnormal returns. In competitive capital markets, which charter provision will survive?

Despite the deceptive simplicity of this question, it has no obvious answer. [FN1] The consensus, to the extent that any exists, appears to be that firm A's charter will survive because it eliminates various perceived*858 harmful effects of insider trading. Thus, investors would pay less for shares in B. The managers of B, in order to maximize the value of B shares, would have to adopt a similar charter provision.

As for these harmful effects, many believe that insider trading is "unfair" and undermines public confidence in capital markets. [FN2] Other critics have argued that insider trading creates perverse incentives by allowing corporate managers to profit on bad news as well as good, [FN3] encourages managers to invest in risky projects, [FN4] impedes corporate decisionmaking, [FN5] and tempts managers to delay public disclosure of valuable information. [FN6] Some also have argued that insider trading is an inefficient compensation scheme because, in effect, it compensates risk-averse managers with a benefit akin to lottery tickets. [FN7] Still others have claimed that insider trading allows insiders to divert part of the firm's earnings that would otherwise go to shareholders and therefore raises the firm's cost of capital. [FN8] Under this "insider trading is harmful to investors" hypothesis, competitive capital markets would force firm B to prohibit insider trading.

The difficulty with this hypothesis is that it appears to be contradicted by the actions of firms. Although no one has conducted rigorous empirical research in this area, it is generally believed that firms have made little, if any, attempt to prohibit insider trading, at least until very recently and then perhaps only a response to regulation. [FN9] Today the area is federally regulated, [FN10] but the federal insider *859 trading prohibitions are limited, have rarely been enforced, and have had little observable effect on insider trading. [FN11] Indeed, numerous empirical studies have demonstrated that insider trading is widespread and is highly profitable-insiders systematically outperform the market. [FN12] Critics of insider trading have offered no explanation for why firms have made so little attempt to prohibit insider trading.

Critics of insider trading also should predict that insiders who outperform the market reduce their compensation in labor markets. Just as a manager who is known to shirk or to make poor investment decisions will consequently command lower compensation, so should a manager who is known to trade on inside information and earn abnormal positive returns, as revealed by his reported trades. [FN13] Yet no evidence even suggests that managers who report profitable trades thereby decrease the value of their human capital.

*860 Also puzzling is the common law which, in the main, permitted insider trading. [FN14] Because capital is highly mobile, firms, in order to attract investors, have strong incentives to incorporate in states that have efficient corporation laws. [FN15] Because incorporations are profitable to the state, the states in turn have strong incentives to provide a set of legal rules that maximize shareholders' welfare. If eliminating insider trading produced gains, states that prohibit insider trading would have a comparative advantage over other states, and firms that incorporated in such states would have a comparative advantage over other firms. Yet no evidence suggests that this has occurred.

Similarly, insider trading in the capital markets of many other countries historically has been subject either to regulations that have not been enforced or to no regulation at all. [FN16] This phenomenon, like the absence of domestic private and state prohibitions, suggests that the question of the desirability of insider trading is far more complex than commonly assumed.

Finally, insider trading in this country, despite the widespread perception to the contrary, is generally permitted. A fundamental difference exists between the legal and economic definitions of insider trading. Insider trading in an economic sense is trading by parties who are better informed than their trading partners. Thus, insider trading in an economic sense includes all trades where information is asymmetric. This definition includes all trades, whether or not in securities, where one of the parties has superior information. By contrast, federal law has focused on purchases or sales by certain insiders within a 6- month period or on trading on the basis of "material" *861 information by a broader, more amorphous group of insiders or their tippees. Insider trading in an economic sense need not be illegal. [FN17] The law never has attempted to prohibit all trading by knowledgeable insiders.

For purposes of analyzing whether insider trading is beneficial or detrimental, nothing turns on whether a particular trade is illegal. In assessing the arguments for and against insider trading, therefore, we will focus on trading by managers or other employees in securities of their own firms based on superior knowledge regardless of whether the trade is illegal. We emphasize, however, that the arguments for and against insider trading may apply equally to trading by others. [FN18]

We attempt in this article to analyze critically the arguments in favor of prohibiting insider trading and to suggest why allowing the practice may be an efficient way to compensate corporate managers. [FN19] Part I demonstrates that the insider trading debate is really a debate about whether the firm, as a matter of contract, should be able to allocate property rights in valuable information to managers or to investors. We argue that the parties' self-interest will lead them to reach by private agreement the optimal allocation of what is simply one element of a compensation arrangement. We discuss in Part II several incentive and information effects which suggest that there may be gains from allocating property rights in valuable information to managers as opposed to investors. These gains may explain the lack of pervasive private, common law, and foreign and domestic restraints on insider trading. Part III analyzes some of the numerous objections to insider trading. The various legal rules regulating insider trading are critically analyzed in Part IV. Part V is a conclusion.

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