Should All Trading While in Possession of Inside Information Be Illegal?

In a new article, I answer in the affirmative the question posed in the title of this post. In the United States, we should replace our current regime of muddled and confused insider trading law with a sweeping prohibition on trading when in possession of inside information, much like the prohibition already in place in the European Union.

Why should insider trading be outlawed? How we answer this question shapes our policy recommendations. One way to answer is to look at how the inside information was obtained. Was it taken in breach of a fiduciary duty? Is the information being used against the wishes of its original owner?  The judicially created insider trading prohibition in the United States is based on answering these kinds of questions. Simply put, courts have decided that trading on wrongfully obtained information often violates the statutory prohibition against fraud in securities markets. The result is a doctrine that imposes a straightforward trading ban when inside information is used in breach of a fiduciary duty but that is muddled and confused in other more complex situations.

Another way to answer the question is by turning to economic analysis. We can justify imposing a ban based on an analysis of when the costs of allowing insider trading significantly outweigh the benefits. Economic analysis of insider trading has a rich history. The watershed moment came with the publication of Henry Manne’s masterpiece, “Insider Trading and The Stock Market,” in 1966. Manne identified not just costs but also potential benefits of allowing insider trading and went so far as to claim that no one was worse off because of insider trading. While William Wang successfully rebutted that particular claim, the debate continues about whether and under what circumstances the marginal benefits of allowing insider trading exceed the marginal costs. There is no consensus based on the current economic analysis of the costs and benefits of insider trading that is sufficiently robust to provide a solid foundation for determining when insider trading should be banned.

There is, however, a fatal flaw in the economic analysis of the costs and benefits of allowing insider trading on which the current consensus is based. The most important and problematic cost of allowing insider trading is either ignored entirely or shunted to the side. In my article, I correct this deep flaw in existing scholarship on the economics of insider trading. I show that the defining economic feature of insider trading is the mismatch between private gains and social gains. This mismatch arises because of both how inside information is produced (largely as a byproduct of other activities) and how trading on this information generates profits (at the expense of others). This mismatch leads to an unusual problem: too much, or wasteful, competition. This is not just a theoretical concern. One can estimate the magnitude of the costs of this problem. Even a very conservative estimate puts the likely costs of wasteful competition to acquire and use inside information in U.S. equity markets alone in the range of tens of billions of dollars a year.

The policy implications are straightforward. First, insider trading legislation should be enacted that bans all trading when in possession of inside information and not just trading based on wrongfully acquired information. Second, the Supreme Court in Dirks vs SEC held that a tip provided by an insider will only trigger insider trading liability if “the insider personally will benefit, directly or indirectly, from his disclosure.”[1] The analysis here shows that there is no good reason to require proof that a tipper received a personal benefit to reach a finding of insider trading liability. The effect of this “personal benefit” test is to reduce the scope of the insider trading prohibition in a way that does nothing to ameliorate the wasteful competition problems created by inside trading. Third, the possession, and not the use, of inside information should be enough to trigger a trading prohibition. Prohibiting trading only when inside information is both possessed and used for trading purposes is more permissive and more expensive to implement than a strict ban. If the goal is to avoid wasteful competition, there is no offsetting benefit from incurring the expense of this limitation on when trading while in possession of inside information would be prohibited.

Insider trading is a socially wasteful activity that should be outlawed in a broad and sweeping manner in the United States.

ENDNOTE

[1]    Dirks v. SEC, 463 U.S. 646, 662 (1982).

This post comes to us from Professor Michael Guttentag at LMU Loyola Law School. It is based on his recent article, “Avoiding Wasteful Competition: Why Trading on Inside Information Should Be Illegal,” available here.

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