Trading and Exchanges Chapter 29: The Truth About Insider Trading

This is the last chapter of the book, and Harris saved a spicy one for the end. Chapter 29 is about insider trading. You might think it is simple: insiders trade on secret info, SEC catches them, they go to jail. But Harris shows that the whole topic is way more complicated than that. There are actually serious economists who argue insider trading should be legal. Let me explain.

What Counts as Insider Trading?

Insider trading happens when someone trades based on material nonpublic information. “Material” means the info would move the stock price if everyone knew it. “Nonpublic” means it has not been released through official channels like press releases or SEC filings.

The important detail: it does not matter how many hands the info passed through. If your barber tells you a tip he got from another client who got it from a CEO, and you trade on it, you are still guilty. Inside information stays “inside” until the company officially publishes it. That is the law.

Corporate insiders are senior managers, directors, large shareholders, and key employees. They can trade their own company stock, but supposedly not based on nonpublic material info. Harris points out the obvious problem here: how can a CEO make a trading decision about their own company that is NOT influenced by what they know? It is basically impossible. That is why the SEC lets insiders set up prearranged trading programs. They plan their trades in advance, so when they actually execute, it does not look like they are reacting to fresh secrets.

The Famous Cases

Harris tells some great stories. Texas Gulf Sulfur discovered massive copper, zinc, and silver deposits in 1963. Officers, directors, and their friends quietly bought stock for over a year before the company announced anything. Stock went from $17 to $71 after the announcement. The SEC sued and won.

Vincent Chiarella worked at a financial printer. He figured out which companies were about to be acquired just by reading the documents he was printing, even though the names were hidden with blanks and fake names. He made $30,000 in 14 months. Got caught, convicted, but then the Supreme Court reversed it because he had no fiduciary duty to those companies. The law later changed so that today he would be convicted under the “misappropriation doctrine.”

The Colt Industries case is my favorite. A lawyer named Grossman learned about a recapitalization from a colleague. He called 40 friends and relatives who bought deep out-of-the-money options for $38,000. After the announcement, those options were worth $1.5 million. How did they get caught? The exchange put pins on a map showing where all the buyers lived. They all lived within a few blocks of each other in Brooklyn. Classic.

Arguments for Banning It

Harris presents three main arguments for why insider trading should be illegal.

Fairness. People avoid markets they think are rigged. If insiders can freely profit from secret info, regular investors lose confidence and stop participating. Less participation means less capital, higher costs for companies.

Liquidity. Insider trading hurts market makers and anyone providing liquidity. When insiders trade, they always win, and the people on the other side always lose. This is the adverse selection problem Harris covered in earlier chapters. More informed traders means wider spreads means higher transaction costs for everyone.

Corporate control. This is the one Harris thinks is most important and least recognized. When managers can profit from secret info, they stop sharing information with their own board of directors. Why would you share info that gives you a trading edge? This makes it harder for boards to evaluate and control management. Even worse, managers might choose investment projects not based on what is best for shareholders, but on what creates the most volatile, tradeable information.

Arguments for Allowing It

Here is where it gets interesting. There are legitimate arguments on the other side.

More informative prices. When insiders trade, they push prices toward true values faster. Accurate prices help the whole economy allocate resources better. If you ban insider trading, you remove an important source of price discovery.

Harris has a good rebuttal though: enforcement only works for information that will be released soon anyway. If a company is sitting on a secret for years, regulators cannot catch the insider trading. So the only insider trading you can actually prevent is the kind that would have been public knowledge in a few days. The price efficiency gain is tiny.

Enforcement is too expensive and mostly fails. Insiders rarely trade themselves. They tip friends, who tip other friends. Proving the connection is extremely hard. Sophisticated traders just claim they did independent analysis and got lucky. Without clear evidence of how the info traveled, conviction is basically impossible. Some economists argue that having laws you cannot enforce undermines respect for all law.

Entrepreneurial incentives. This is the Henry Manne argument. If a manager has a great idea, they should be able to buy stock before implementing it and profit when the idea succeeds. This creates a natural reward system where only employees who truly believe in their ideas put money on the line. Regular compensation packages cannot replicate this because shareholders cannot easily evaluate who actually has good ideas.

Harris presents a smart rebuttal: this only works as an incentive if managers buy stock BEFORE they know the outcome. If they can trade after they already know they succeeded, there is no risk, so the incentive disappears. And you definitely cannot let managers short their own stock, because then they would be incentivized to destroy value. Destroying a company is always easier than building one.

Why This Debate Matters

Harris lands on a nuanced position. The debate is genuinely complex. There are real costs to enforcing insider trading laws, and some arguments for allowing it have economic merit. But the corporate control argument is strong enough to justify regulation. When managers can trade on inside info, it poisons how companies are governed from the inside.

The real question is not whether to have insider trading laws, but how much money to spend enforcing them. And that is a question nobody has a clean answer to.

This was the final chapter of Trading and Exchanges. Twenty-nine chapters covering everything from basic order types to market microstructure theory to regulation. If you made it through all of these posts, you now understand how financial markets actually work at a mechanical level, not the fairy tale version from intro textbooks.

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