What’s the Harm in Issuer-Licensed Insider Trading?

I have argued that insider trading is morally harmless where the issuer approves the trade in advance and makes certain ex ante and ex post public disclosures.[1] I have also suggested that reforming the law to permit such issuer-licensed insider trading would result in a more rational, efficient, and just insider-trading enforcement regime.[2]

A common objection is that Professor William K.S. Wang’s “Law of Conservation of Securities”[3] proves that even issuer-licensed insider trading inflicts harm on some definite victim or victims. In my article, What’s the Harm in Issuer-licensed Insider Trading?,[4] I argue that the Law of Conservation of Securities is not helpful to a moral analysis of insider trading because it either proves that all profitable trades (or profitable abstentions) in advance of a material disclosure are morally impermissible (an absurdity), or it tells us nothing at all about the moral permissibility of such trades.

I summarize this argument below, but first I want to say something about why there is nothing wrong with issuer-licensed insider trading pursuant to either consequentialist or deontological morality—the two principal moral theories informing Western liberal jurisprudence.

Consequentialism identifies the rightness or wrongness of acts or rules with their results. The consequences of insider trading continue to be hotly debated. Those who suggest that insider trading results in a net benefit to society typically argue that it increases price accuracy, provides real-time information to the markets, has a market-smoothing effect, and offers an efficient means of compensation. Those who argue insider trading imposes a net cost to society typically claim that it increases the bid-ask spread set by market makers and that it undermines investor confidence in the markets, both of which purportedly increase the cost of capital to firms.

I don’t think we need to settle this debate to conclude that a rule permitting issuer-licensed insider trading is permissible on consequentialist grounds. For where insider trading is issuer-licensed, the firm’s own calculus should reflect that such trading will result in a net benefit for the firm. Moreover, such trading does not generate any of the disutility associated with the breaking of a promise to the firm. More still, to the extent issuer-licensed insider trading would benefit the firm (and therefore its shareholders) the practice should reinforce confidence in the markets rather than undermine it.

It is often suggested that even if the overall consequences of insider trading are beneficial to the markets and society as a whole, it should nevertheless be criminalized because “it’s just not right!” Such objections are driven by deontological intuitions.

Perhaps the most recognized articulation of a deontological moral theory is found in the “end-in-oneself” formulation of Immanuel Kant’s categorical imperative: “Act so that you treat humanity…always as an end and never as a means only.”[5] In other words, one should never use others for purposes they themselves would reject.

One need not look beyond the promise the insider makes not to trade on the firm’s material nonpublic information to conclude that issuer-proscribed[6] insider trading violates Kant’s categorical imperative. Such trading necessarily treats the promisee (the firm) solely as the means to an end (use of the company’s material nonpublic information for trading profits) that the promisee has expressly rejected. If an issuer publicly affirms that it does not allow its insiders to trade on material nonpublic information, then issuer-proscribed insider trading also treats other traders in that firm’s shares as mere means because they have presumably priced its shares based on the expectation that such trading is not permitted.

The moral landscape changes dramatically, however, when one engages in issuer-licensed insider trading. Such trading does not deceive or violate a promise to the firm because the firm has licensed the trade. And there is no deception of others who trade in the firm’s shares because the issuer has disclosed that it allows its employees to trade based on material nonpublic information and the profits earned by such trading. With these disclosures in place, all interested parties to the issuer-licensed insider’s trading are fully informed in advance of their decision to trade and are therefore respected as ends-in-themselves and not as mere means.

But have I missed something? If an insider purchases shares based on material nonpublic information, then she will have more of the relevant issuer’s shares at the time the information is disseminated. Consequently, assuming the number of shares outstanding remains constant, someone else must have fewer shares at the time of dissemination. Those who have fewer shares at the time of dissemination were either induced (to sell) or preempted (from buying) by the insider’s trading. These individuals were therefore made worse off as a result of the insider’s trade.

Professor Wang refers to this phenomenon as the Law of Conservation of Securities and he suggests that it shows each act of insider trading (even if it is issuer-licensed) harms specific victims. But this cannot be so, at least not on any morally interesting understanding of the terms “harm” or “victim.”

Imagine a college student buys a new iPhone and loves it so much that she decides to buy ten shares in Apple Inc. The next day, Apple publicly introduces its much-anticipated iWatch. Shares in Apple skyrocket. Applying the Law of Conservation of Securities, we discover that the student’s purchase of Apple shares harmed and victimized whoever was induced to sell or preempted from buying as a result of the trade. Moreover, notice that the same law identifies every Apple shareholder at the time of dissemination as a but-for cause of harm to the persons who would have purchased those shareholders’ stock had they sold prior to dissemination. None of this tells us anything of moral significance.

The Law of Conservation of Securities reflects the trivial truth that someone is always made worse off as a result of any profitable trade or abstention. It does not tell us anything special about insider trades. It does no good to suggest, as Professor Wang seems to,[7] that the Law of Conservation of Securities identifies the harm but that only knowing or intentional inflictions are wrongful and therefore worthy of regulation. For all unknowing traders—i.e., those who fail to possess material nonpublic information—still trade with the clear intent to inflict precisely the harm identified by the Law of Conservation of Securities on others, which is only to say that they aim to profit by their trades. And to claim that aiming to profit by trading is morally blameworthy is to suggest that all (or virtually all) market participation is wrongful.

In sum, I have argued that issuer-licensed insider trading is morally permissible and should not be criminalized. Perhaps I am mistaken; but if I am, it is not because I fail to account for some harm or victim identified by the Law of Conservation of Securities.

ENDNOTES

[1] See John P. Anderson, Greed, Envy, and the Criminalization of Insider Trading, 2014 Utah L. Rev. 1, 27-43 (2014) (reprinted in 2015 Securities L. Rev. §3:4 (2015) [henceforth Anderson, Greed, Envy]. Note that in Greed, Envy, I refer to issuer-licensed insider trading as “nonpromissory insider trading;” I have since dropped that nomenclature.

[2] See John P. Anderson, Anticipating a Sea Change for Insider Trading Law: From Trading Plan Crisis to Rational Reform, 2015 Utah L. Rev.  339, 380 (2015); John P. Anderson, Solving the Paradox of Insider Trading Compliance, 88 Temple L. Rev. ___ (forthcoming 2016).

[3] See, e.g., William K. S. Wang & Marc I. Steinberg, Insider Trading § 3.3.5 (3d ed. 2010); William K.S. Wang, Trading on Material Nonpublic Information on Impersonal Stock Markets: Who is Harmed and Who Can Sue Whom Under SEC Rule 10b-5?, 54 S. Cal. L. Rev. 1217, 1234-35 (1981); 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 Vill. L. Rev. 27, 27-41, 63-65 (2000) [henceforth Stock Market Insider Trading].

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

[5] Immanuel Kant, Foundations of the Metaphysics of Morals 46 (Lewis White Beck trans., 2d ed. 1990).

[6] It is important to distinguish issuer-licensed insider trading (which is harmless and morally permissible) from two other forms of trading: (1) issuer-proscribed insider trading (where an insider trades based on material nonpublic information despite the fact that the insider has undertaken a commitment to the company not to trade on that information) and (2) misappropriation trading (where a corporate outsider trades based on misappropriated material nonpublic information unbeknownst to the source). Both issuer-proscribed insider trading and misappropriation trading are harmful, morally wrong, and should continue to be criminalized. See, e.g., Anderson, Greed, Envy at 27-43; Anderson, What’s the Harm? at 797-802.

[7] Wang, Stock Market Insider Trading, at 36.

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

2 Comments

  1. T Smith

    At least in the US, does the law actually prohibit issuer-licensed insider trading? It is not enough to trade on MNPI, but to commit insider trading one has to do so in breach of a fiduciary duty. If the board of a public company were to preclear and ratify insider transactions based on MNPI, those transactions would not be in violation of current law.

    The SEC would likely be livid, but I am not sure this would be illegal.

  2. JP Anderson

    I agree, T Smith. There are strong arguments (based on consistent Supreme Court interpretations of Section 10(b)) that issuer-licensed insider trading is already legal–so long as there is adequate ex ante disclosure of the firm’s policy, and ex post disclosure of profits earned from licensed trades. That said, I have no doubt the SEC would challenge any such interpretation–and at least some lower courts would back them. No firm would (or should) take that risk.

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