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What do the economists on the list think of his justification? He is published a lot on the von Mises institute as well. More to come. Shouldn't we know what is being said outside? REH Government Intervention and Insider Trading by Timothy D.
Terrell
Among all the supposed evils that capitalism has produced, insider trading
must be one of the worst and one of the most deserving of government
intervention. Certainly the stiff penalties and public display of animosity
toward insider traders would lead one to believe that it is a sinister crime
threatening the very underpinnings of our economy. Thus, to stamp out insider
trading, the federal government gave us the Securities and Exchange Commission
in 1933. However, a closer look at insider trading might reveal that, first of
all, contracts and other private-sector institutions can reliably control the
problems insider trading might cause, and, secondly, extensive business
regulation has actually exacerbated insider trading.
Insider trading occurs if a corporate �insider� (such as an employee of the
company) uses nonpublic information to make a profit trading securities. If Bob
knows that his employer is about to announce a merger with ABC Corp., most
likely producing an increase in the stock price of ABC, he can buy ABC stock and
make a huge profit after the merger is made public. Bob�s activity is illegal,
and some who have traded in this way have been sentenced to lengthy prison
terms, fines in the tens of millions of dollars, and banishment from their
occupations for life.
Most people would probably anathematize Bob for using his �unfairly� superior
knowledge about corporate events to enrich himself. Yet few people, it seems,
are able to adequately explain why this should be a crime. Where does the Bible
forbid this type of transaction? Has anyone been hurt by Bob�s insider trade?
Perhaps the person (Alex) from whom Bob purchased those shares of ABC stock
might claim harm. Yet, if Bob had not possessed any insider knowledge, Alex
still would have been willing to sell those shares for the same price (though
maybe to another person). Alex may envy Bob�s gains, but he has no justifiable
reason to complain. Bob�s employer may object, for reasons explained below, but
then some firms may decide to permit insider trading as a part of their
managers� compensation.
Unless Bob is breaking a contract with his employer by making use of his
special knowledge, why should Bob�s position as an insider illegitimize this
trade? After all, there are many people �outside� firms who make money on the
stock market by spending a great deal of time and effort gaining data about
firms. They are under no legal or moral obligation to share that information
with anyone. The egalitarian notion that suggests that Bob should not use
information that is not open to discovery by all others is insupportable.
Like the egalitarian ideas behind state welfare programs, the argument
against insider trading creates a false �injustice� out of inequality.
Avoiding the Principal�s Office
The more academic arguments against insider trading are based on the
so-called principal-agent problem. This problem arises when a principal (the
stockholder, in this case) enlists another person (here, the corporate manager)
to do a particular job on his behalf. If the principal cannot easily monitor the
behavior of the agent, the agent may pursue his own goals rather than the goals
the principal has assigned him. In the context of insider trading, this means
that corporate insiders could take steps to increase the ups and downs of the
company�s stock. Because profits can be made as stocks rise or fall (buying and
holding, or selling short), the insider has an incentive to create as many
fluctuations as possible. Theoretically, the insider could even profit from
driving the firm into bankruptcy!
Insiders could also lie about the firm in order to produce changes in the
stock price from which they could then profit. It would be as simple as selling
the stock short, then hinting around that the firm is about to release
lower-than-expected earnings reports.
Shareholders certainly want the firm to profit and they want accurate
information, so if this becomes a problem they will presumably do what they can
to prevent insiders from trading on their special knowledge. However, simply
forbidding the practice in a contract is not good enough unless the shareholders
can find and punish contract-breakers. If enforcement is too difficult, the firm
will be populated by those who are dishonest enough to break their contracts.
Insider trading, then, would seem to be such a serious problem that nothing
short of government intervention would be sufficient to solve it. What hope
would there be without the SEC to prosecute insider traders?
The Principal Has a Paddle
Several, in fact. There are at least four ways for stockholders to
effectively restrain or discipline would-be insider traders, if they wish to do
so. First, if the firm discovers that the employee has broken a contractual
agreement not to trade on inside information, the stockholders could sue that
person for breach of contract. The penalty might even be written into the
contract when the employee is hired. The task of discovering the breach of
contract might be contracted out to a third party. There is no reason this must
be a governmental body. Private firms such as the New York Stock Exchange or the
National Association of Securities Dealers could provide these services�in fact
these two organizations already do some monitoring for illegal transactions.
Secondly, if corporate insiders are damaging the company and lowering its
value, they are setting the firm up for a takeover. The new owners may do what
the old owners failed to do�fire the managers responsible for the firm�s decline
and replace them with managers of their own choosing. As economist Alexander
Padilla argued recently, �If managers . . . mismanage the firm, one or several
raiders will come to take over control of the firm and they will purely and
simply lose their jobs and be replaced by other managers that the raider
believes are more competent to manage the firm�s . . . resources� (Alexander
Padilla, �Can Agency Theory Justify the Regulation of Insider Trading?� in
Quarterly Journal of Austrian Economics, Spring 2002, forthcoming). The
consequences to insider traders may not be immediate or well-focused on those
particularly responsible�but the takeover remains a threat.
Thirdly, the competition among managers within the firm can be an effective
restraint. Lower-level managers have an incentive to �blow the whistle� on their
superiors if they believe they can convince the stockholders that a breach of
contract has occurred. Higher-level managers can only progress if the firm,
particularly their division, is profitable, so they have an incentive to filter
out lower-level managers who undermine that goal. This internal monitoring may
be much more effective than any inspection from the �outside� by stockholders.
Fourthly, shareholders may react to a manager�s breach of contract by
spreading the word to other firms that the manager is not to be trusted. As
Padilla notes, unless blacklisting is forbidden by the law (and there is no
reason it should be, since none of us have a right to the opinions others hold
of us), it can be a powerful restraint on a manager considering breaking a
contract. What firm would hire this manager if his previous employers made clear
that they were nearly driven bankrupt by his insider trading?
Interventionism and Insider Trading
If intervention prevents stockholders from effectively disciplining errant
managers, insider trading could become a serious problem. First, anti-takeover
regulations tend to reduce the threat to bad managers of losing their job. For
example, the SEC requires those who buy five percent of outstanding shares on
the open market to disclose their action, thus giving managers enough warning to
take countermeasures. Secondly, the extensive regulations governing hiring and
firing can make it very difficult for firms to take legal action against
contract-breakers or to affect their public reputations.
We should dispense with one final argument for insider trading regulations
before closing this column. Small shareholders do not typically have the same
motivation to watch corporate insiders that large shareholders do. Insider
trading, then, would produce a tendency for shares of stock to be concentrated
in the hands of a few individuals who watch their firms carefully. This means
that it might be more difficult for someone to buy and sell in this market;
i.e., the market would become less liquid.
This problem is a bit over inflated, however. What is lost in liquidity is
gained in control of management by the stockholders. Financial analyst Jeff
Scott argues that �concentrated ownership and less-than-perfectly liquid markets
(like real estate or fine art) are neither evil nor undesirable. Market makers
on the exchanges can create liquidity independent of the government; what they
cannot create on private exchanges, they should not ask the state for� (Jeff
Scott, �Is the Market Too Big to Drop?� in The Free Market, February 1998, p.
3). Many securities laws, Scott suggests, are really an effort to boost the
securities industry by promoting high levels of trading. Perhaps. But what
becomes clearer, as one looks carefully at insider trading, is that our current
batch of regulation to deal with the problem is redundant at best. If no
contract is being violated, there is nothing morally wrong with using privileged
information to make a profit. Furthermore, firms that wish to prohibit the
practice have excellent private sector means to stop it, if the government does
not hinder them with regulations. Finally, if problems with insider trading
persist even in a free market, that is not enough to justify government
intervention. The Bible limits the state to rewarding those who do good and
punishing those who do evil (according to the summary of the state�s duties in
Romans 13) and says nothing of favoring particular industries, stabilizing the
economy, or solving the principal-agent problem. There is plenty of real
immorality to contend with�let�s not create another phony sin. Timothy Terrell is an assistant professor of economics at Wofford College in Spartanburg, South Carolina.
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