By Robert W. McGee and Walter E. Block
Reprinted from Business
Ethics and Common Sense, edited by Robert McGee,
Insider trading has gotten a bad name in recent years. News comentators and government officials often disparage inside traders as greedy, sinister people who would cut their own mother's throat if she got in the way of a deal. But while that may be true in a few cases, it is the exception rather than the rule. In fact, many of the transactions that might be considered insider trading result in no "harm" to anyone and may actually be beneficial to society.
Many commentators who disparage insider trading do so because they do not understand how it works, and they do not see that it can be beneficial. It should be pointed out that we are not trying to defend all forms of insider trading, because some kinds of insider trading are unethical. What we're attempting to show is that blanket statements like "insider trading in unethical" are not always true.
What determines whether insider trading is ethical or unethical? Basically, one must look to whether someone's rights have been violated. One example of insider trading resulting in a rights violation occurs when someone misappropriates property of another. But that does not mean that anyone who does something that results in economic harm to another has done something unethical. If a supermarket chain opens a new store across ' the street from a mom-and-pop grocery, Mom and Pop might lose business and thereby suffer economic harm, but that does not mean that the chain store people have done anything unethical. Mom and Pop have a right to sell groceries, but so does the chain store. Although Mom and Pop may be harmed economically, their rights have not been violated because there is no one preventing them from offering their goods for sale. If customers decide to do business with the chain store rather than with Mom and Pop, that is their business and their right.
Misappropriation is a different story. When someone misappropriates the property of another—and insider information is property—the misappropriation is a violation of the rights of the property owner. But when individuals use for their own benefit information that they have honestly acquired, there is nothing unethical about that. Let's take a look at some examples.
Let's say that Joe quits his low-paying job so that he can take advantage of another job opportunity a few blocks away. Does he have any obligation to tell his coworkers about the position first, before he applies for the position? Does it make any difference whether he learned about the position from a newspaper ad or from his brother-in-law? Regardless of how he learned of the job opportunity, he has the right to apply for the position without telling others about it first. Indeed, it is to his advantage to keep his mouth shut until he has the position locked up.
All Joe is doing is taking advantage of a position of superior knowledge, which is not much different than what a stock trader who spends fifty or sixty hours a week searching for information does. People who spend a great deal of time studying the market can gain information that others do not possess, not because they have stolen it but because they worked to acquire it. The information they gain is their property, and they should be able to do with it as they see fit--sell it, trade on it, give it away, or sit on it. They have no moral obligation to announce their findings to the world, just as Joe had no obligation to tell anyone about the job opportunity he discovered.
The method by which such information is acquired is irrelevant for purposes of determining whether using it is ethical or not, as long as it was acquired honestly, that is, without fraud or coercion. Whether Joe learned about the job by digging through want ads, by placing phone calls or going on numerous job interviews, or by receiving the information from an employment agency makes no difference. The fact that his brother-in-law might have dumped the information in his lap does not change anything. The brother-in-law has, in effect, given him a gift of property—information—that Joe is free to use as he sees fit. The only way that Joe could use this information unethically is if he obtained it from an employment agency under the stipulation that he not tell anyone else about the job. If he sells the information to another under this circumstance, he is misappropriating the employment agency's property. If he gives the information away rather than selling it, he is still acting unethically even though he might not have benefited personally, because he is breaching his contract with the employment agency not to tell others what he has learned. This situation is not unlike that of individuals who breach their fiduciary duty to their employer or client not to tell anyone that a merger (or bankruptcy) is right around the corner.
Is insider trading fraudulent? St. Thomas Aquinas said that fraud can be perpetrated in three ways, either by selling one thing for another or by giving the wrong quality or quantity.[1] A more modem definition is "intentional deception to cause a person to give up property or some lawful rights.''[2] A more general definition is that fraud is perpetrated when a person knowingly or intentionally makes a false representation of fact to another with the intent that the other party rely on the representation and when the other party actually did rely upon the false statement to his loss, detriment, or damage.[3] Some courts have extended liability to include negligent or inadvertent misrepresentation.[4] According to this theory, there is no fraud if there is no loss. And since much so-called insider trading does not involve any identifiable loss, the practice is not fraudulent. Even in cases where there is loss, it still has to be proven that all the elements of fraud are present before an inside trader can be found guilty of the offense.
A typical case of insider trading occurs when a buyer with inside information calls his stockbroker and tells him to buy, knowing that the stock price is likely to rise as soon as the inside information becomes public. In this case, the buyer does not deceive the seller into giving up property. Indeed, the buyer does not even know who the seller is, and the seller would have sold anyway, anonymously. The seller's action would have been the same whether an inside trader was the other party to the transaction or not. If the inside trader had not purchased the stock, someone else would have. Yet this "someone else" would not be accused of reaping unjust profits, even if the identical stock were purchased for the same price the insider would have paid. Consequently, insider trading does not seem to fit the definition of fraud. Furthermore, according to Aquinas, there is no moral duty to inform a potential buyer that the price of the good you are trying to sell is likely to change in the near future.[5]
In the case Aquinas discusses, a wheat merchant
carries wheat to a place where wheat fetches a high price, knowing that many will come after him carrying wheat.., if the buyers knew this they would give a lower price. But... the seller need not give the buyer this information.., the seller, since he sells his goods at the price actually offered him, does not seem to act contrary to justice through not stating what is going to happen, If however he were to do so, or if he lowered his price, it would be exceedingly virtuous on his part: although he does not seem to be bound to do this as a debt of justice.[6]
A similar example is discussed by
An insider who knows the stock price is likely to change in the near future has no "moral" duty to inform potential buyers of this fact. Where there is no moral duty, certainly there should be no legal duty either. In fact, the U.S. Supreme Court has ruled at least twice that those in possession of nonpublic information do not have a general duty to disclose the information to the marketplace.[8] The Fourth Circuit Court of Appeals in 1988 held that a corporation has no duty to disclose tentative merger plans to stockholders before it buys their stock.[9]
Whose Rights Are Violated by Insider Trading?
Although the transaction of buying and selling stock by an insider does not meet either the dictionary's or Aquinas's definition of fraud, the question of justice still remains. If no one's rights are violated, the act is not unjust; if someone's rights are violated, the act is unjust. The obvious question to raise is: "Whose rights are violated by insider trading?"
The most obvious potential "victims" of insider trading are the potential sellers who sell their stock anonymously to an inside trader. But they would have sold anyway, so whether the inside trader buys from them or not does not affect the proceeds they receive from the sale. If the sellers are hurt by having an inside trader in the market, it is difficult to measure the damage, and it appears that there is no damage. In fact, the academic literature recognizes that insider trading does not result in any harm to any identifiable group.[10] As those who sell to inside traders may actually be helped rather than harmed because they received a better price, it appears illogical to allow them to sue for damage if in fact there are no damages. In any event, there appears to be no violation of anyone's rights in such instances of insider trading.
It has been argued that employers are harmed by insider trading because employees misappropriate corporate information for personal gain.[11] Yet employers whose employees misappropriate information for personal gain have a remedy at law already. If anyone sues, it should be the employer that sues the employee. Government should not be a party to such a lawsuit, since it is a private rights violation rather than a public harm that has been committed, if in fact any rights violation has been committed at all. Yet there has been little private restriction on trading on insider information,[12] and some authors have gone so far as to state that the gains derived from insider trading are equivalent to compensation that a corporation would otherwise pay to corporate officers for their entrepreneurial expertise[13] and that employers are not harmed at all by insider trading.
What are the Beneficial Effects of Insider Trading?
Insider trading serves as a means of communicating market information, which makes markets more efficient.[14] When insiders are seen trading, it acts as a signal to others that a stock's price will likely move in a certain direction. If a director of General Motors purchases a large quantity of General Motors stock, that act reveals evidence that the stock's price is likely to rise in the near future. Likewise, if the director sells, it is likely that the price will soon fall. A chain reaction will take place as the brokerage firm handling the transaction alerts other brokers and clients, and the stock price will start moving in the correct direction, closer to its true value. There is no need to make a public announcement, because the market reacts almost immediately. Even if the insider is anonymous, an increase (or decrease) in demand for a particular stock will be noticed by the market, and the price will move accordingly. Placing prohibitions on insider trading has the effect of blocking this flow of information. Insiders will attempt to hide their trades or perhaps not make them at all, thus preventing the market from learning this valuable information.
The potential acquirer in a takeover attempt may also benefit by insider trading. The investment banker hired by the acquirer may leak information to arbitrageurs, who then accumulate shares in the target company with the intent of tendering them shortly thereafter. The result is that the takeover's chances of success are increased, and the acquirer may actually benefit as a result of the investment banker's alleged misconduct.[15]
The necessary separation of management from owners inherent in all large corporations has caused corporate management to be unresponsive to the wishes of corporate stockholders. Management can make decisions based on self-interest rather than shareholder interest with little fear of reprisal because it is easier for shareholders to sell their stock than to fight management decisions. This fact of corporate life is not new. It has been true ever since owners became separated from managers.
The (relatively) free market economy of the United States has found a way to pierce the protective veil that insulates unresponsive management from the wrath of small shareholders—the takeover. The corporate takeover is practically the only way that entrenched management can be shaken up and either forced to be responsive to shareholder interests or fired. This market for corporate control does not exist to any great extent in any other country, which gives the United States a competitive advantage because the threat of takeover gives U.S. corporate management an extra incentive to work for shareholder interests rather than their own. Thus, shareholders of U.S. companies receive a higher return on investment than can investors in companies that are not subject to a takeover threat, all other things being equal.[16] The attack on Drexel Burnham Lambert, and the threat of an attack on anyone else who tries to facilitate the market for corporate control with junk bonds, is bound to harm the market for corporate control and thus to decrease the already weak voice that shareholders have. Management of companies that do not have to fear a takeover will have less incentive to be efficient, and that hurts employees and consumers, too.
The shareholders who sell at the time the arbitrageurs are buying may also benefit. The increased demand generated by the arbitrageurs increases the price the sellers receive when they sell. Without the leakage of the insider information to the arbitrageurs, the demand for the stock in question would have been lower, thus the sellers (who would probably have sold anyway) would have received a somewhat lower price for their stock. Shareholders who do not sell also benefit, as the price of their shares rises as a result of insider trading.
A goal of most corporate managements is to increase shareholder wealth, in other words to increase the stock's price. As insider trading has a tendency to increase the stock's price, inside traders assist management achieve its goal. Inside traders may benefit the corporation in another way as well.
A decision by the board or its delegates to "tip" inside corporate information Co certain outsiders, to facilitate trading by them, could also be in the best interests of the corporation. For example, where the corporation has received valuable services from an outsider, one way of providing indirect compensation for those services is by providing the outsider with the authorized use of inside information owned by the corporation. Thus, if one accepts the notion that inside information is property of the corporation, even the tipping of that information to others ought not be regarded as improper, if the board of directors or other authorized corporate decision maker has determined that such tipping is in the best interests of the corporation .[17]
Who is Harmed by Prohibitions on Insider Trading?
Who is harmed by prohibitions on insider trading? The obvious answer is the inside traders themselves. If insider trading is not viewed as "immoral,'' then punishing insiders by preventing them from using their knowledge becomes an unjust act in itself.
There is a case to be made that the company's shareholders may be harmed by placing prohibitions on insider trading.[18] For example, the Williams Act, the part of the Securities Exchange Act of 1934 that requires anyone contemplating a tender offer to announce the intention well in advance (Sections 13d and e, Sections 14d, e and f), makes it easier for target managements to thwart a takeover. Several authors have argued that shareholders tend to benefit by takeovers, so that making it easier to thwart a takeover may be against the stockholders' interest.[19]
Outlawing or restricting insider trading may have long-term adverse effects on the economy. The market certainly will operate less efficiently, because insider trading increases market efficiency.[20] As hostile takeovers will be more difficult to make, shareholders will lose, as shareholders tend to benefit by hostile takeovers.[21]
Insider trading laws result in compliance and escape costs. The legal and accounting fees involved in complying with or circumventing the law can be fairly expensive, an expense that would not be incurred in the absence of insider trading laws. Using indirect means to accomplish what could otherwise be accomplished directly also leads to unnecessary costs.[22] The delay in disclosure that results from using indirect means of accomplishing the goal also increases market inefficiency. There may also be other transaction costs, such as using an obscure mutual fund or a foreign bank or broker, when a more direct purchase would be less costly.
Taxpayers are adversely affected by insider trading laws, as enormous resources must be placed at the disposal of the police power to do any kind of policing. The resources used to police the insider trading laws might be better used to prevent some real criminal activity from being committed. For any use of government resources, there is a cost and a benefit. Because insider trading can be regarded as a victimless crime, if indeed it is a crime at all, an argument can be made that the resources government uses to enforce the insider trading laws can be better employed elsewhere.
Information can be an asset. Where the owner of an asset uses that information for gain, there should be no complaint, as long as there is no fraud or coercion. But where such asset is used for gain without the owner's permission, any gain belongs to the owner.
Financial analysts generally obtain information about a company by analyzing public information and interviewing company officials, who are often all too eager to provide whatever information is requested. In such cases, it can hardly be said that the financial analyst misappropriated information belonging to the company, and there should be no prohibition on using the information for profit. Such property is in the public domain, and the company therefore has relinquished whatever claim it once had. Whatever information a financial analyst obtains in this manner is earned by considerable effort, and the analyst acquires a property right in that information, which can then be sold to clients, published in a newsletter to clients, or used for personal gain.[23] There is no ethical duty to give this property to the world, just as there is no ethical duty to give any other property to the world. The property can be kept for personal use or given to any persons of the owner's choosing, either for profit or for free. Forcing an analyst to give this information to the world before being allowed to trade on it would eliminate the incentive to develop the information in the first place, and the market would suffer as a result.[24] Such coercive actions would also be unjust to the analyst, whose property rights are being impinged upon.
Insider trading has been viewed as evil, and inside traders have been seen as unethical individuals. As we have tried to point out, these views are often incorrect. Insider trading can be beneficial to a number of groups. Whether or not the practice is unethical depends not on the effects—who is "harmed"—but on property rights and fraud (or the absence of fraud). If the transaction is not fraudulent and the inside trader is not violating anyone's property rights in information, there is nothing unethical about the practice. The fact that an inside trader can make millions of dollars, seemingly with little effort, is completely irrelevant as far as determining whether the practice is unethical.
[1] G. Dalcourt, The Philosophy and Writings of St. Thomas Aquinas
(1965), at 105;
[2] Webster's New World Dictionary of the American Language, college edition (1964).
[3] Kaufman Inv. Corp. v. Johnson, 623 F.2d 598 (9th Cir. 1980), cert. den. 450 US 914; Meader v. Francis Ford, Inc., 286 Or. 451,595 P.2d 480 (1979); Metal Tech. Corp. v. Metal Techniques Co., Inc., 74 Or. App. 297, 703 P.2d 237 (1985); 2 Restatement 55, et. seq., Torts Second § 525 ff., cited in Foley, "Insider Trading: The Moral Issue," The Freeman 37 (November 1987): 409, at note 7.
[4] Weiss v. Gumbert, 191 Or. 119, 227 P.2d 812, 228 P.2d 800 (1951); 3 Restatement 126-45, Torts Second §§ 552-552C, cited in Foley, "Insider Trading: The Moral Issue," Freeman 37 (November 1987): 409, at note 8.
[5] St.
Thomas Aquinas, Summa Theologica, II-II, Q.77, art.
3(4); Barath, "The Just Price and the Costs of
Production According to St. Thomas Aquinas," New Scholasticism 34 (1960):
420; Bartell, "Value Price, and
[6] St. Thomas Aquinas, Summa Theologica, II-II, Q.77, art. 3(4).
[7] Cicero, De Officiis Bk. III, ch. xiii (W. Miller trans. 1968). G. Lawson discusses this passage in "The Ethics of Insider Trading," Harv. J.L. & Pub. Pory 11 (1988): 727, at 738-39. This passage is also mentioned in Barry, "The Economics of Outside Information and Rule 10b-5," U. Pa.L. Rev. 129 (1981): 1307, at 1361 n. 206. For a critique of the Lawson article, see J. R. Macey, "Comment: Ethics, Economics, and Insider Trading: Ayn Rand Meets the Theory of the Firm,"' Harv. J.L. & Pub. Pol'y 11 (1988): 785.
[8] Chiare!la
v.
[9]
[10] Henry Manne, "Insider Trading and Property Rights in New Information," Cato Journal 4 (Winter 1985): 933 reprinted in Dom and Manne, eds., Economic Liberties and the Judiciary~(1987) at 317-27; Morgan, "Insider Trading and the Infringement of Property.-'l~ights," Ohio St. L. J. 48 (1987): 79.
[11] Scott, "Insider Trading: Rule 10b-5, Disclosure and Corporate Privacy," J. Legal Stud. 9 (December 1980): 801; Martin, "Insider Trading and Misappropriation Theory: Has the Second Circuit Gone Too Far?" St. John's L. Rev. 61 (1986): 78; Morgan, "Insider Trading and the Infringement of Property Rights," Ohio St. L.J. 48 (1987): 79.
[12] Dooley, "Enforcement of Insider Trading Restrictions," Virg. L. Rev. 66 (February 1980): 1; Easterbrook, "Insider Trading, Secret Agents, Evidentiary Privileges, and the Production of Information," Sup. Ct. Rev. (1981): 309.
[13] Manne, "Insider Trading and the Stock Market," JSD
riss.,
[14] Wu,
"An Economist Looks at Section 16 of the Securities Exchange Act of
1934," Colurn. L. Rev. 68 (February 1968): 260;
Kelly, Nardinelli, and Wallace, "Regulation of
Insider Trading: Rethinking SEC Policy Rules," Cato J. 7 (Fall 1987): 441,
at 442;
[15] Herzel and Katz, "Insider Trading: Who Loses?" Lloyds Bank Review 15 (July 1987).
[16] Manne and Ribstein make this
point in "The SEC v. The American Shareholder," National Review,
[17] Morgan, "Insider Trading and the Infringement of Property Rights," Ohio St. L.J. 48 (1987): 79, at 98.
[18]
[19] A
number of authors have addressed this point in recent years. See Johnson,
"Antitakeover Legislation: Not Necessary, Not
Wise," Cleve. St. L. Rev. 35 (198687): 303; Manne,
"The Real Boesky-Case Issue," New York Times (November 25, 1986),
A-27, col. 1; Bandow, "Curbing Raiders Is Bad
for Business," New York Times (February 7, 1988); D. Prychitko,
"Corporate Takeovers and Shareholder Interests," Issue Alert no. 13
(Washington, D.C.: Citizens for a Sound Economy, April 16, 1987); Coffee, Grundfest, Romano, and Weidenbaum,
"Corporate Takeovers: Who Wins; Who Loses; Who Should Regulate?"
Regulation 88 (1988): 23; Bubb, "Hostile
Acquisitions and the Restructuring of Corporate
[20] Finnerty, "Insiders and Market Efficiency," Journal of Finance 31 (September 1976): 1141.
[21] Jarce!l, Brickley, and Netter, "The Market for Corporate Control: The Empirical Evidence Since 1980," J. Economic Perspectives 49 (Winter 1988).
[22] H. Demsetz, "Perfect Competition, Regulation, and the Stock Market," in H. Manne, ed., Economic Policy and the Regulation of Corporate Securities (1969); H. Manne, "Insider Trading and Property Rights in New Information," Cato J. 4 (Winter 1985): 933 reprinted in Dom and Manne, eds., Economic Liberties ~md the Judiciary (1987), 317-27.
[23] Fleischer, Mundheim, and Murphy, "An Initial Inquiry into the Responsibility to Disclose Market Information," Univ. Pennsylvania L. Rev. 121 (1973): 798.
[24] Fama and Laffer, "Information and Capital Markets," J. Business (July 1971): 289; Ronen, "The Effect of Insider Trading Rules on Information Generation and Disclosure by Corporations," Accounting Review (1977): 438.