Insider trading has been a controversial issue in the U.S. and other countries. Generally, it is not a recent matter in the business, but insider trading legislation and enforcement are relatively recent phenomena since the 1980s. In fact, insider trading had been legal in almost all the countries until the 1970s.
As Marcelo wrote in his blog post, insider trading seems “simply unfair.” Insider trading may undermine public confidence in the stock market since the two parties in a transaction do not have equal information and an outsider is put in a less competitive position, but there are no clear and simple answers to whether insider trading should be prohibited or not. Economics professors and other researchers in law and economics have applied economic principles to the legal issues about insider trading regulations. Those for insider trading regulations claim that the regulations are based on fairness or equity and may increase social welfare by preventing insiders’ undesirable behavior, but those against insider trading argue that the ban rather reduces market efficiency.
Some studies have found that insider trading may have economic benefits for the capital market and a company under certain conditions. For opponents of insider trading prohibitions, there are two main arguments: an effect on the pricing of securities and an efficient compensation scheme.
1. The benefit for the capital market: insider trading promotes market efficiency by disseminating information
Insider trading has a positive effect on the market price of securities to move toward the accurate price by giving insiders incentives to make relevant information on the securities publicly available in the market. Through trade on the secondary market, insiders contribute to the efficient market. The regulations prevent the market from quickly adjusting to changes in the demand for and supply of corporate stocks, thus misleading market participants. Henry Manne, dean emeritus at George Mason University School of Law and an author of a seminal law and economics book “Insider Trading and the Stock Market,” explained in a WSJ article, “Corporate scandals such as Enron and Global Crossing would occur much less frequently and impose fewer costs if the government didn’t prohibit insider trading.”
2. The benefit for a company: assigning the property right to inside information to managers is an efficient compensation scheme
Insider trading is an efficient form of compensation to provide incentives for managers. It gives managers a right to alter their compensation given new knowledge on the company to avoid continual renegotiation. Insider trading reduces the uncertainty and costs of renegotiation, and increases the incentives of managers to produce valuable information. Moreover, compensation in the form of insider trading is cheap for long-term shareholders because it does not come from corporate profits.
I am not contesting the legitimacy of the current regulations here. These claims are not sufficiently backed by the empirical research, and insider trading might have some negative consequences on the capital market. Those who have found guilty of insider trading might have acted unlawfully under the current regulations, but there are still no simple and clear justifications that insider trading should be prohibited. I think that much research is required to fully justify—or to improve—insider trading regulations.