In late 2019, the House of Representatives passed the Insider Trading Prohibitions Act with the intent of further restricting stock market trading based on nonpublic information, by seeking to clarify what constitutes “insider trading.” In a Wall Street Journal op-ed, Lyle Roberts recently criticized the bill for making the law more confusing ( “The Insider Trading Law is Bad. Will Congress Make It Worse?,” Jan. 10).
Maybe so. My concern is more general, that basic insider trading law maintains the distorting effect of a legal asymmetry that was pointed out years ago by my former colleague (and close friend) at Clemson University, the late Myles Wallace: Corporate officers can’t benefit legally from insider information through trading, but they can gain from nonpublic information through “insider nontrading” (which can be hidden from SEC scrutiny).
To understand the consequences of this non-coverage in the law, consider a Pfizer vice president who goes into a board meeting where she learns that the company has a wonderful, effective, and soon-to-be-released new drug in its development pipeline, Viagra. If Viagra is announced at the meeting and the VP leaves the boardroom to buy a thousand shares of Pfizer stock (with an investment of just over $40,000 at today’s closing price,) she can be dragged into court for insider trading and be fined and given a stiff prison sentence.
Suppose the same VP holds a thousand shares of Pfizer stock that she plans to sell when she has time after the board meeting. But during the meeting, she learns about the release of Viagra and decides not to sell. She has engaged in “insider nontrading,” and gains financially. However, she will have done so with little fear of a court date, understandably, because insider nontrading is not mentioned in insider trading law, mainly because it is very difficult to detect and prosecute. (Imagine the SEC hauling executives into court for not doing something.)
Nevertheless, as Professor Wallace pointed out, this legal asymmetry can have consequences. On an ill-defined hunch that some big product announcement will be made at the next board meeting, suppose our VP loads up on Pfizer stock (buys, say, a million shares) at some appropriately distant time prior to the meeting. If her hunch is realized, she can keep her Pfizer stock, reaping, potentially, a substantial increase in her portfolio’s value. If no announcement is made, she can sell her Pfizer stock, suffering on her “bet” only the cost of two buy/sell brokerage commissions, no more than $10 today.
No one should be surprised if the legal asymmetry causes corporate officers and board members to hold more (or less, depending on their companies’ future prospects) of their companies’ stocks than if both insider trading and nontrading were (or could be) treated the same in the law. Everyone should also be bothered by the potential differential justice meted out to insider nontraders who can enjoy their gains while insider traders are thrown in the slammer for doing the same thing.
In his unstated manner, Myles was a genius at coming up with oddball, simple, but insightful arguments.
Richard McKenzie is an emeritus economics professor in the business school at the University of California, Irvine. His current book project has a working title of The Brain on Economics, which will advance his brain-centric modification of neoclassical economic.
See our archive of McKenzie’s Econlib Articles here.
READER COMMENTS
RohanV
Jan 30 2020 at 4:36pm
What if her “hunch” is wrong, and the board meeting actually discusses a negative event which will tank Pfizer’s stock? Your executive is now screwed because she can’t sell.
Insider trading is basically betting on a sure thing. I think there’s enough risk in this scenario to differentiate it from insider trading.
Kevin Dick
Jan 30 2020 at 4:58pm
I don’t think this is the correct way to look at it.
Assume the insider otherwise has exactly the same priors as a well informed outsider.
So she’ll take the same a priori positions on the company as that outsider. But some non trivial fraction of the time, she’ll get inside information that improves her posterior expectation of non-trading.
This means her overall expected value of trading in the company’s stock is higher than for an outsider–even if she has the same priors. Yes, it’s lower than if she were also allowed to trade on insider information. But the asymmetry biases the market prices and may thereby reduce overall efficiency and market returns.
Matthias Görgens
Jan 30 2020 at 8:50pm
Insider trading is still far from a sure thing. Stock market prices are hard to forecast.
Robert Schadler
Jan 31 2020 at 11:03am
Have long wondered why corporate stock buybacks are not considered a form of “insider trading.” Surely those proposing and implementing these buybacks are “insiders.” One assumes their choices include higher dividends and investing the money elsewhere. They might well choose the option that benefits them the most.
The overall argument against insider trading is asymmetrical information. Neoclassical theory doesn’t clear to me on the matter of symmetrical (equal) information vs asymmetrical. Assuming equal information, or at least on all important aspects, seems silly. Yet the effort to guarantee equal information, or to police unequal information, seems unusually difficult and costly.
Thomas Eyssell
Jan 31 2020 at 2:55pm
To the buyback question – MBA students have asked me the same thing many times over the years (I’m a retired Finance professor). It’s a good question, but you need to recognize a few things. First, repurchased shares are held as “Treasury stock” by the firm, not by a (human) person. There are no votes while they are held, and no dividends are paid. Thus, if they are purchased on the basis of undisclosed positive information, no person at the firm gains directly. Arguably, the seller “loses”, but apparently, s/he was willing to sell at the then-current price.
Second, most of the empirical work in this area suggests that firms often buy at the “wrong” time – it’s not at all clear ex post that repurchases are well-timed, if the purpose is to “buy back on the cheap.”
Finally, from a financial management standpoint, the evidence suggests that management increasingly uses repurchases as an alternative to cash dividends – both constitute a mechanism for returning cash to shareholders, but repurchases are more flexible – investors generally view a dividend cut as bad news, because the quarterly payments have set up their expectations.
Phil H
Feb 3 2020 at 2:21am
I think this is a nice example of worrying too much. This argument by Wallace seems to be right, but will clearly be a lesser problem than insider trading itself. As companies, stockholders, and stockholding strategies become ever more sophisticated, there may come a day when the little unfairness of insider non-trading becomes a big exploitable loophole that is damaging in itself; and then perhaps the rules will have to be changed again.
But in the meantime, the important thing is not that some rule is perfectly fair. The important thing is that a rule effectively prevents 99.9% of harmful misconduct. If an imperfect rule or even an unbalanced nudge can achieve that, then they might be good market policies, despite not being perfectly fair.
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