The Importance of “The Law of Conservation of Securities”: A Reply to John P. Anderson’s “What’s the Harm in Issuer-Licensed Insider Trading?”

Professor John P. Anderson’s article, What’s the Harm in Issuer-Licensed Insider Trading [1] argues that my “Law of Conservation of Securities” has no moral relevance to the question whether to allow such trading.

A stock market insider trade has two different classes of victims: those injured by the accompanying non-disclosure and those harmed by the transaction itself. The “Law of Conservation of Securities” identifies the individual(s) harmed by the insider trade itself, which is not necessarily the party on the other side.

To illustrate, suppose I sell 100 shares based on material nonpublic adverse information. If I had a pre-existing duty (or my sale triggered a retroactive duty) to disclose the bad news to my buyer (or to a larger class of purchasers), my nondisclosure harmed those buyer(s). Had I disclosed, these individual(s) would not have purchased.

As opposed to my nondisclosure, who is injured by my transaction? Had I not sold, the person on the other side might have bought from someone else. Nevertheless, assume that the number of shares is constant.[2] At the time of dissemination of the material adverse information, I have fewer shares. Someone else must have more. That someone is either an induced buyer or a preempted seller. My sale either induced someone to purchase and/or preempted someone from selling. [3]

Were the act of stock market insider trading victimless, society might regulate the conduct less strictly. The “Law of Conservation of Securities” shows that each act of stock market inside trading has particular victims.

As Professor Anderson acknowledges,[4] stock market insider trading may have adverse consequences. These include wider bid-ask spreads by market-makers and lower investor confidence. Both of these effects increase the cost of equity capital of public corporations. The “Law of Conservation of Securities” explains why the decrease in investor confidence is rational, especially because risk-averse individuals do not know whether they will be victims. The “Law of Conservation of Securities” also explains why market-maker bid-ask spreads will increase; because market-makers transact so frequently, they are especially likely to be induced or preempted traders.

With a utilitarian approach, Professor Anderson suggests that companies should weigh the negative results against the positive effects when deciding whether to permit employee insider trading.[5] The “Law of Conservation of Securities” underlies the costs that Professor Anderson wants issuers to consider.

Even if the firm fully discloses its policy of allowing insider trading and even if the stock’s market price somehow accurately adjusts (despite a general lack of knowledge of the size of the bid-ask spread increase and possibly the extent of insider trading), the price change will not fully compensate those who trade especially frequently.

Professor Anderson’s willingness to allow issuer-approved insider trading also raises corporate governance questions. Employee insider trading (or tipping) is a form of inefficient, possibly huge, and perhaps secret compensation. Were the board to grant such compensation, one might question whether the board really has the interests of the company and the shareholders at heart. Were the fully independent directors and shareholders to approve such compensation, one might question whether they understand the consequences.

A victim of insider trading victim may be either an induced purchaser or a preempted buyer neither of whom has previously held shares in the company. Even if the company decision-makers are both extremely independent and sophisticated in deciding to permit insider trading, they may not adequately consider the interests of these individuals who do not presently hold shares. While insider trading may raise the firm’s cost of equity capital, the company may be relying on other sources of financing.

The “Law of Conservation of Securities” shows that stock market insider traders benefit by “taking advantage” [6] of others: preempted and induced traders. Professor Anderson responds by claiming every stock market trader intends to inflict harm by profiting at the expense of others.[7]

Although this is an overstatement, many stock market traders do attempt to purchase undervalued shares or sell overvalued ones. If these traders are successful, the “Law of Conservation of Securities” does show that they gain at the cost of induced or preempted traders at the time the mispricing disappears.

The stock market insider trader knowingly profits by “taking advantage” of others before imminent public dissemination of material information. On the other hand, without knowledge of material nonpublic information, mispricing-seekers attempt to “take advantage” of others before the share price corrects. The question is whether a moral distinction exists between the two.

Often, mispricing-seekers mistakenly purchase overpriced securities or sell underpriced ones. Assume that, at some future date, the mispricing disappears. At that time, under the “Law of Conservation of Securities,” the mistaken trader has either more or less stock, to the benefit of preempted and/or induced traders.

In contrast, insider traders rarely if ever make errors about mispricing.

Therefore, both market-makers and the public will react far more adversely to corporate insiders transacting based on material nonpublic information than to traders engaged in the difficult and possibly futile[8] attempt to identify mispricing based on information available to all.

The “Law of Conservation of Securities” demonstrates that stock market insider trading is “advantage-taking.” Some “advantage-taking” stock transactions are moral; others are not. To determine when stock market insider trading is immoral, applying a principle such as utilitarianism or Anthony Kronman’s “paretianism”[9] requires considering the harm resulting from the conduct. The “Law of Conservation of Securities” identifies the victims of each insider trade and enables analysis of the indirect consequences of that injury.

ENDNOTES

[1] John P. Anderson, What’s the Harm in Issuer-Licensed Insider Trading?, 69 U. Miami L. Rev. 795 (2015).

[2] Even if the number of shares is not fixed, the insider trade still harms preempted and/or induced traders. See William K.S. Wang & Marc I. Steinberg, Insider Trading § 3.3.8 (3d ed. 2010). Nevertheless, assuming a constant number of shares simplifies the analysis. See id.; Anderson, supra note 1, at 802 n.43.

[3] See Wang & Steinberg, supra note 2, § §§ 3.3.5, 3.3.6, 3.3.7 (2010); William K.S. Wang, Stock Market Insider Trading: Victims, Violators and Remedies–Including an Analogy to Fraud in the Sale of a Used Car with a Generic Defect, 45 Villanova L. Rev. 27, 28-40 (2000). See also Jesse M. Fried, Insider Trading Via the Corporation, 162 U. Pa. L. Rev. 801, 806-07 (2014). Cf. id. at 827-28 (value diversion by insiders from indirect trading through company transactions amounts to several billion dollars a year). In an earlier article, Professor Fried estimated that in direct transactions, corporate insiders diverted almost $5 billion a year from the public. See Jesse M. Fried, Reducing the Profitability of Corporate Insider Trading Through Pretrading Disclosure, 71 S. Cal. L. Rev. 303, 323 (1998).

[4] See Anderson, supra note 1, at 799.

[5] See id.

[6] For a discussion of when to permit “advantage-taking” in contracts, see Anthony T. Kronman, Contract Law and Distributive Justice, 89 Yale L.J. 472, 478-97 (1980). Professor Kronman uses the word “advantage-taking” in a non-pejorative fashion. See id. at 480.

[7] See Anderson, supra note 1, at 803-04.

[8] Under the semi-strong version of the efficient capital market hypothesis, it is futile to attempt to find mispriced stock based on public (as opposed to nonpublic) information.   For numerous citations to commentary both endorsing and rejecting this hypothesis, see Wang & Steinberg, supra note 2, §§ 2.2.2 at 16 nn.33-35, 2.3.1 at 26 n.66. For arguments against the hypothesis, see William K.S. Wang, Some Arguments that the Stock Market Is Not Efficient, 19 U.C. Davis L. Rev. 341 (1986); William K.S. Wang, Index-Fund Outperformance Not Logical in Rational World, Pensions & Investments, Aug. 5, 2013, at 23 Even if not completely futile, identifying mispricing may be extremely difficult. See id.

[9] See Kronman, supra note 6, at 484-94.

The preceding post comes to us from William K.S. Wang, Professor, University of California Hastings College of Law.  It is part of a debate between Professor Wang and John P. Anderson, Associate Professor, Mississippi College School of Law, and is based on their articles that may be accessed here and here.