Insider Trading: The Law, the Economics, and the Debate (Chapter 29)
Most people think insider trading is straightforwardly evil. Rich executives cheating the system by trading on secret information. Easy call, right?
Chapter 29 of Trading and Exchanges complicates that picture significantly. Harris walks through the legal definitions, the enforcement challenges, and then presents a genuine debate with strong arguments on both sides. Whether you end up supporting or opposing insider trading restrictions, you will think about the issue very differently after reading this chapter.
What Actually Counts as Insider Trading
Inside information is material information about the value of a security that is not publicly available. Material means it would move prices if widely known. In equity markets, corporate managers control most inside information.
The key thing to understand: inside information retains its status no matter how many people pass it along. If your barber tells you a stock tip he got from another client who got it from a corporate insider, and that tip is based on material nonpublic information, trading on it is illegal. The chain of transmission does not matter. Inside information loses its special status only when it becomes available to the public through a press release or public filing.
It gets even broader than corporate secrets. A printer who reads the contents of a takeover prospectus while operating the presses has inside information. Government employees who know the contents of an economic report before it is released cannot trade on that information. Anyone who obtains material information by misappropriating it is potentially liable.
Harris tells the story of Vincent Chiarella, who worked at a financial printing press in the 1970s. The documents he handled had the names of acquiring and target companies blanked out, but Chiarella figured out the identities from other details in the documents. He made about 30,000 dollars in 14 months. He was initially convicted, then the Supreme Court reversed the conviction because he had no fiduciary duty to the companies involved. But the law subsequently changed. Under today’s misappropriation doctrine, he would be convicted.
How Insiders Actually Trade (and Get Caught)
Corporate insiders, which include senior managers, directors, large shareholders, and key employees, are allowed to trade their own company’s stock. But they cannot trade on nonpublic material information. How a CEO could make trading decisions completely uninfluenced by confidential information in their possession is, as Harris puts it, “hard to imagine.”
To handle this contradiction, the SEC allows insiders to set up prearranged trading programs. They cannot establish these programs specifically to profit from nonpublic information, but the programs let them trade even when they possess such information. Insiders also face restrictions on short-swing profits (any gains from positions opened and closed within six months must be returned) and cannot take short positions in their own companies.
Detection works through exchange surveillance. Officers look for suspicious patterns, typically large price changes on high volume, especially before corporate announcements. When they find unusual trading, they call the listed company and ask if anything is going on.
The investigation process is fascinating. Regulators compile two lists: everyone who knew the inside information, and everyone whose trades benefited from its revelation. They look for connections between the two lists. Harris mentions that computer programs can mine databases of addresses, email contacts, college yearbooks, and family records to find “degrees of separation” between insiders and traders.
The Colt Industries case is a perfect illustration. A lawyer at the firm handling the company’s recapitalization apparently leaked the information. Between July 11 and 18, someone called 40 friends and relatives who together bought 1,400 deep out-of-the-money options for 38,000 dollars. After the announcement, those options were worth 1.5 million. The Philadelphia Stock Exchange surveillance unit caught them, and investigators solved it by putting pins in a map. All the buyers lived within a few blocks of each other in Brooklyn.
The Arguments for Restricting Insider Trading
Fairness and investor confidence. The most intuitive argument. People avoid markets they think are unfair. If insiders can freely profit from information nobody else has, regular investors lose trust and pull their money out. Less investment means higher costs of capital for companies.
Liquidity. Insider trading, like all informed trading, hurts liquidity providers. Dealers widen their spreads to compensate for the risk of trading with someone who knows more than they do. Wider spreads mean higher transaction costs for everyone. This is not theory. It follows directly from the adverse selection framework Harris developed earlier in the book.
Corporate control. This is the argument Harris seems to find most compelling. When insiders can trade on inside information, they become reluctant to share information with the board of directors or shareholders. Sharing information destroys their trading advantage. So directors know less about what is actually happening at the company, making it harder to oversee management.
Even worse, insiders might make business decisions that maximize their trading profits rather than shareholder value. They might choose projects based on how much informational advantage the projects create rather than their actual business merit. They might front-run trades their own companies make, diluting shareholder value.
The Arguments for Allowing Insider Trading
Informative prices. Insider trading pushes prices toward fundamental values. If insiders know the company’s prospects are better than the market thinks, their buying pushes the price up toward the correct level. More informative prices mean better resource allocation across the economy.
Harris presents a rebuttal to this: the value depends on how much sooner prices adjust. If insiders trade on information that will be public tomorrow, the benefit is tiny. And enforcement only works against trading on information that will soon be released anyway. So in practice, restrictions do not prevent the kind of insider trading that would actually make a big difference to price efficiency.
Enforcement costs. Insider trading laws are extremely hard to enforce. Only a few countries even try seriously. When laws are routinely broken without consequences, respect for authority suffers. And selective enforcement creates its own injustices, with some people prosecuted while most go free.
Entrepreneurial incentives. This is the most intellectually interesting argument, credited to Henry Manne. Insider trading lets managers become entrepreneurs within their own firms. A manager with a great idea can buy stock before implementing it and profit when the stock price reflects the idea’s value. This is a self-selecting compensation scheme. Only employees who genuinely believe in their ideas will take the risk. The company does not need to evaluate every employee’s claim of having a good idea.
Harris points out a critical flaw in this argument: insider trading as compensation only provides proper incentives when insiders establish their positions before they know outcomes. If they can trade after learning results, there is no penalty for failure and too much incentive to take risky bets. Also, any argument for insider trading must distinguish between long positions (insiders want to create value) and short positions (insiders want to destroy value). Destroying value is always easier than creating it, so virtually everyone agrees that insiders should not be able to short their own companies.
The Compensation Connection
One of the most interesting observations in the chapter involves CEO pay across countries. In countries where insider trading is effectively restricted (like the US), direct compensation must be higher because managers cannot supplement their pay through trading. In countries where enforcement is weak (like Japan or Germany at the time), CEO salaries are lower because insider trading profits are effectively part of the compensation package.
So when people compare American CEO pay to CEO pay in other countries and claim Americans are overpaid, they might be missing a huge piece of the picture. The comparison is only fair if you add insider trading profits to the compensation in countries where enforcement is lax.
Where This Lands
Harris does not take a strong side in the debate, though his analysis of the corporate control argument suggests he leans toward supporting restrictions. The chapter ends by noting that insider trading laws are popular and there is no chance of repeal. The real question is how much money regulators should spend on enforcement, given how difficult detection is.
For practitioners, the takeaway is straightforward. Insider trading makes markets less liquid because it adds informed traders that liquidity providers must protect against. Whether you think it should be legal or not, you need to understand its effects to understand bid/ask spreads, dealer behavior, and transaction costs.
This post is part of a series on Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris (Oxford University Press, 2003, ISBN: 0-19-514470-8). This retelling covers Chapter 29.