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Pros & cons of federal regulation. History, court decisions, benefits of deregulation, economic effects, compensation schemes, market efficiency, fairness, ethics.... More...
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Pros & cons of federal regulation. History, court decisions, benefits of deregulation, economic effects, compensation schemes, market efficiency, fairness, ethics.
Insider Trading This paper will discuss the arguments for and against the federal regulation of insider trading. The first part of the paper will briefly examine the history of insider trading and its treatment by courts in the United States. The second part of the paper will examine the arguments in favor of the deregulation of insider trading, focusing upon the beneficial economic effects of insider trading. The third part of the paper will discuss the arguments in favor of retaining restrictive regulation on insider trading. The final part of the paper will rebut the pro-regulation arguments. This paper general supports the argument that insider trading should be deregulated. As will be seen, there are several benefits to be gained by the allowance of insider trading. First, insider
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198 ). If this argument were true, a competitive market forcapital would lead firms to ban such trading so that companies could sendsuch signals to investors. Rev. 1, 17 (1993). Newman, 664 F.2d 12 (2d Cir. Legal Stud. at 116. Thesearguments will be explored later in the paper. [xxxviii]Schotland, Unsafe at Any Price: A Reply to Manne, InsiderTrading and the Stock Market 53 Va. 32 Yale Law Journal 637 (1923).Wang. A firm whosemanagement has a reputation for insider trading will experience a declinein the price of its stock and its costs of raising capital will increase.Some large investors will even leave the market, raising the cost ofcapital for all firms.[lvi] Opponents of these arguments say that investors cannot easilydistinguish the firms where insider trading is frequent from the firmswhere it is infrequent. The shareholders of each firm shouldbe allowed to decide whether insider trading is in the best interest of thecorporation. [xxv]ITSA § 2. The firm would benefit from accurate pricingthrough reduced investor uncertainty and improved monitoring of themanagement's effectiveness. The Effect of Insider Trading Rules on the Internal Efficiency of the Large Corporation. Since the risk is systemic, itcannot be reduced by diversification; diversification, in fact, will ensurethat the investor's risk is that of the entire market.[lxiii] If this is true, then an investor is not harmed by insider tradingsince he can insure himself against this behavior by discounting all stocksby the risk of such trading for all firms. If the government still wants to "protect" outside investors,then it can set up some scheme which enables firms to prove to investorsthat insider trading is not allowed amongst its executives; investors canthen assume that all other firms allow the practice and invest accordingly. No. Repides, 213 U.S. Morgan Stanley, Inc., 719 F.2d 5 (2d Cir. Thus, the real concern is to what extent should principles ofmorality play a role in insider trading regulation. It mustusually pass through many levels before it reaches the senior managers.The net delay can be substantial enough to impair efficient corporatedecision making even without the intentional delays imposed by a managerseeking to personally profit from the information. 198 ). Code Cong. 19 (1987).United States v. News (98 Stat.)1264, codified at 15 U.S.C. 1968),cert. In the end, the risk of insider trading issystemic, inherent in every security. [liii]See Brudney, supra note 49, at 332-34, 346. Thiswould fit with the notion that insider trading harms outside investors byputting them at a disadvantage relative to investors possessing insideinformation. 1968), cert. Problems in the management would likely beknown only by insiders, yet these problems can have tremendous effect onthe true value of the company's stock. These types of information, such as the true value of assets andearnings and the true costs of new products or services, are crucial to theaccurate valuation of a company's stock. Thus, allowinginsider trading will encourage the disclosure of good news and permit somebad news to reach the market somewhat sooner than if insider tradings werebanned.[lxii] Proponents of regulation argue the portfolio theory. The third part of the paper willdiscuss the arguments in favor of retaining restrictive regulation oninsider trading. Such an agent is required todisclose all material facts to the principle.[xlvii] Profiting from suchconfidential information would be unfair because the agent is already beingcompensated for his efforts. Positive news benefits all stockholders, includinginsiders. Insider Trading an the Law Professors. §§ 77a-aa(?). Bases of Insider Trading Law. These provisionsare still based upon the federal common law prohibition against insidertrading and enforcement will also continue to be based upon the olderlaw.[xxiv] The ITSA increased the penalties for insider trading in three ways.First, it amended Section 21(b) of the 1934 Act in order to give the SECauthority to seek a monetary penalty of three times the profit gained orloss avoided by the inside trader.[xxv] When added to the normal remedy ofdisgorgement, this provision effectively threatens the insider trader withpaying up to four times the profit gained. Restatement (Second) of Agency § 395 (1958).Bainbridge, Stephen. Carpenter, 484 U.S. Unsafe at Any Price: A Reply to Manne, Insider Trading and the Stock Market. Code Cong. 1974). 38 University of Florida Law Review 35 (1986).Brudney. 646 (1983); Chiarella v. [xiv]463 U.S. First, bonus plans may be rejected by courts. As a result, and believing that insider tradingis harmful, investors must assume that every investment carries the samerisk of insider trading as does the market as a whole. Books and ArticlesAmerican Law Institute. This says thatsince insider trading occurs randomly, investors do not know beforehandwhich firms will have material information or which firm's insiders willtrade on that information. A salary, therefore, wouldbe inappropriate.[xxxii] The contribution of an entrepreneurial agent to a firm is theproduction of new information which is valuable to the firm. Mar. Cox, Insider Trading and Contracting: A CriticalResponse to the "Chicago School," 1986 Duke L.J. A Short History of Insider Trading Regulation Before the enactment of the Securities Act[i] and the Securities andExchange Act[ii] were passed, insider trading was regulated by statecorporate law. Insider Trading as a Transactional Cost: A Market Microstructure Justification and Optimization of Insider Trading Regulation. 9 7 (1961).Moss v. Insider Trading: Rule 1 b-5, Disclosure and Corporate Privacy. In such a market, outside investors pursue strategic plans which will noteasily be affected by disclosures of information from insiders. S8912 (daily ed. First, insider trading tends to beeconomically efficient. In an efficiently diversified portfolio,losses from insider trading will be offset by increased returns fromcorporations where insider trading does not occur.[lxiv] Although it might then be argued that insider trading harms firmssince they have to increase their cost of capital by the amount thatinvestors discount the price of their securities, the companies can seekbonding and monitor their costs, signalling to investors that they have alower likelihood of insider trading. As will be seen, there are several benefits to be gainedby the allowance of insider trading. As a result of the distrust, relevant information islikely to be distorted or concealed. Winans, 612 F. [xxi]United States v. Carpenter, 484 U.S. §§ 78c, 78o, 78t, 78u, 78ff.Securities Act. [xxvii]ITSA § 5. His inability to distinguishthose firms in which insider trading occurs from those in which it does notis covered by this discounting. 53 Virginia Law Review 1425 (1967).Scott, Kenneth E. Instead, they are traded inanonymous markets where buyers and sellers are matched in a random fashion. 419 (19 9).United States v. Even where insiders are prevented from trading,investors will simply pay more money to uncover more information. CasesCarpenter v. [xxx]Henry Manne, Insider Trading and the Stock Market 166 (1966). D'Amato). It has been noted thatstocks and other securities of publicly held corporations are not typicallybought and sold in face-to-face transactions. & Ad. Rev. 1 51,1 53-62 (1982). [l]445 U.S. The first part of the paper will brieflyexamine the history of insider trading and its treatment by courts in theUnited States. Carpenter, 791 F.2d1 24 (2d Cir. 49 Ohio State Law Journal 354 (1988).Cox, James D. Morality usually seeks to regulate conduct which harms others. [xii]See, e.g., Dirks v. denied, 465 U.S. A transaction is usually seen as fair if it is what both parties wantat the time it is concluded. This paper general supports the argument that insider trading shouldbe deregulated. Thisprinciple was rejected by the Supreme Court in Chiarella v. D'Amato).13 Congressional Record S8912 (daily ed. 628, 635 (1986). 4-5, reprinted in 1984U.S. D'Amato); 129 Cong. Supp. Uniformed traders can avoid this "taking" by not trading. The manager who acquires such information may prevent other managersfrom receiving such information in a timely manner so that he can have thetime to trade on the basis of the information before the firm can act uponit.[xliii] Even without the delay imposed by such an insider, informationtypically winds its way slowly through a corporate structure. Theentrepreneur can purchase the firm's securities prior to the disclosure ofthe information/innovation and then sell the securities once a publicdisclosure has been made and the price of the securities has risencorrespondingly.[xxxv] Some commentators have suggested that advanced compensation schemesalso fail to adequately compensate managers. Fundamentals of Securities Regulation. On the other hand, the ITSA's legislative historycontains several references to the unfairness of informationaladvantages.[lii] This definition would tend to support prosecution of anyonepossessing material nonpublic information; this would be much broader,however, than the current prohibition and would be inconsistent with thepolicies underlying securities statutes policies. [xxii]United States v. 1974).Strong v. Thosefirms uncomfortable with the prospect can prohibit the practice and enforcethis prohibition through employment contract provisions. Insider trading continued to occur at increased rates throughout the197 s and 198 s, in spite of the federal prohibitions. [xviii]United States v. denied, 394 U.S. Bus. 1868).Chiarella v. Danforth, 52 Barb. This means that a transaction is fair if itis consensual. L. Such value of these bonuses could be tied to the valueof the information provided. 1983), cert. The insider is bound to lookafter the interests of the stockholders. Members willplace time and effort into verifying information provided by other membersand will be suspicious of the other members' behavior. Carpenter, 791 F.2d 1 24 (2d Cir. L. §§ 78a-kk (1994). L. In response, mostinvestors will discount the value of any individual firm by the averageagency costs of all firms. Outside investors actually benefit from insider tradingbecause prices more accurately reflect values. One part of thisefficiency argument is that to the extent a firm's good fortune resultsfrom the actions of insiders, these insiders will have a greater incentiveto act on behalf of the firm if they know that they will have theopportunity to profit from the firm's good fortune. In fact, the agent'sabilities may very well be unknown in advance. This new theorylooked upon information as a form of property, similar to state lawtheories which had regarded inside information as a corporate asset whichcould be "converted," "stolen," or "misappropriated" for personalgain.[xvii] The Second Circuit adopted the misappropriation theory in1981, when it affirmed the conviction of an individual who had received andtraded upon information concerning targets of various takeoverplans.[xviii] Some decisions held that the information must be received inconfidence, rather than simply be nonpublic[xix] and that the onlyindividuals who had a private claim against the insider were those who werethe sources of the information.[xx] The Supreme Court upheld, by a 4-4split, the conviction on securities fraud of a Wall Street Journal reporterwho traded shares before publishing columns which had a perceptible impactupon companies' stock prices.[xxi] This practice contravened internalrules established by the Journal. [xx]Moss v. [xli]Id. Rev. 322, 344 (1979). Although renegotiation ofsuch schemes could account, in part, for the innovations wrought bymanagers, such renegotiation is expensive and may not occur frequentlyenough to provide managers with incentives sufficient to spur furtherentrepreneurial activities. [viii]See L. His or her failure to disclose facts which maychange the other party's mind at the time of the transaction does notconstitute deceit under commonly understood standards of commercialtransactions. Cox & Kevin S. [v]See, e.g., Dawson v. In addition, the cost of allowing non-disclosure exceeds the benefit of increased incentive to produceinformation.[xlviii] The argument with regard to insider trading is that the insidersacquired the relevant information in their capacities as fiduciaries of theshareholders. Allowing to entrepreneur to recover the value ofthis innovation would seem to be a fair and efficient method ofcompensating him for the information which led to the innovation. Dirks.[li] In Chiarella, the Court held that basisfor violation was the defendant's breach of his fiduciary duty, not hisinformational advantage. SEC, 463 U.S. L.J. 9 Journal of Legal Studies 8 1 (198 ).Solomon, Schwarz, et al. [iii]See, e.g., Carpenter v. at 56. Outsiders wouldbenefit from insider trading since the stock would not be so artificiallypriced. [lvi]Bainbridge, supra note 24, at 61. Second, insider tradingis inherently unfair to the other traders. 66 Virginia Law Review 1 (198 ).Georgakopoulos, Nicholas L. [xliii]Bainbridge, supra note 24, at 5 . Under the first approach, the insider had no duty of disclosureand was allowed to buy stock freely without regard to any informationaladvantage.[iii] Under the second approach, insiders were subject to noduty in the absence of "special circumstances" which justified theimposition of such a duty.[iv] Under the third approach, the insider wassubject to a fiduciary duty to disclose material information when buyingstock from shareholders.[v] By the late 193 s, the "special circumstances"rule had been adopted in the majority of states and the fiduciary duty rulehad been adopted in a significant minority of the states.[vi] These rules,however, were limited in their application. However, withoutthis information, outsiders cannot fairly evaluate the price of a stock.If insiders were allowed to trade with this information, the price of thecompany's stock would more accurately reflect its value. 23,1983)(remarks of Sen. Loss, Fundamentals of Securities Regulation 799-946, 1125-52 (1983). Rev. 857, 869 (1983). Scott, Insider Trading: Rule 1 b-5, Disclosure andCorporate Privacy, 9 J. The cases succeeding it constructed a federal common lawprohibition against insider trading under Rule 1 b-5.[xii] The SupremeCourt laid out the elements which established a violation of insidertrading prohibition.[xiii] First, there must be a relationship giving theinsider access to information intended only for corporate purposes.[xiv]Second, allowing the insider to take advantage of the information withoutdisclosure must be unfair.[xv] The Court then noted that the duty ofdisclosure arises from the insider's fiduciary relationship with thecorporation or seller of securities; it does not arise merely from thepossession of nonpublic information.[xvi] When the government found itself stymied in its efforts to prosecutecases which were based solely upon access to material, nonpublicinformation, it turned to a "misappropriation" theory. Much of this argument is based upon intuition, but itmust be given substantive content in order for it to be made an appropriatebasis for rule-making. 354, 364 (1988). 1985), aff'din part and rev'd in part sub nom., United States v. [iv]See, e.g., Strong v. 929 (1916).Dirks v. Regulation preventsthe economic workings of the market. In any event, it is uncertain whetherinvestors actually do demand a premium from those firms where insidertrading takes place. Themanager is more certain of his reward for such activity and will be spurredon to continuing developing valuable information.[xxxvi] The second part of the efficiency argument is that insider tradingpromotes market efficiency by causing the market price of the affectedsecurity to move towards the price which would reflect the information ifit were publicly available. This duty is not violated if theactions of the insider do not harm the stockholders. Pub. 1986), aff'd, 484 U.S. [xxxvi]Carlton & Fischel, The Regulation of Insider Trading, 35 Stan.L. The Regulation of Insider Trading. 26 Connecticut Law Review 1 (1993).Haft. 19 (1987). Co., 176 Iowa 362, 157 N.W.929 (1916). Mar. Second, insider trading is an economicallyefficient method of compensating insiders. In fact, it might be argued that insidertrading actually serves the stockholders' interests. Second, the ITSA amends Section32 of the 1934 Act to increase the maximum criminal fine from $1 , to$1 , .[xxvi] Third, the ITSA amends Section 2 of the 1934 Act toextend insider trading penalties to puts, calls, straddles, options, orprivileges.[xxvii] Because insider trading is prosecuted under the antifraud provisionsof the securities law, there is a general requirement that there beaffirmatively wrongful acts. 646 (1983).In re Cady, Roberts & Co., 4 S.E.C. The first argument focuses uponthe efficiency of the firm and the effects insider trading can have on thatefficiency. Thus, insiders will desire the disclosure of such information sothat they can profit from it. §§ 77a-aa (1994).Securities and Exchange Act. Although this prohibition is not completely effective,the rate of insider trading is small relative to the overall volume oftrading. Newman, 664 F.2d 12 (2d Cir. Morgan Stanley & Co., 623 F.2d 796 (2d Cir. Public disclosure of valuable information held by the insiderwill eventually provide an accurate measure of value of the resultinginnovation to the firm. Rec. [xiii]Dirks v. Such information is usuallyavailable only to insiders; access to such information has often been citedas one of the reasons for prohibiting insider trading. Although some commentators are concerned thatmanagers would spend all of their time trading in the company's stocks,this fear is unreasonable, since profits will still result primarily fromgood management. The value of future information,however, cannot be predetermined; its value becomes apparent only at thetime the information is presented. 976 (1969).Shapiro v. Even in normal circumstances,legitimate transactions, members of the group of decisionmakers engage instrategic behavior: such as one member holding out for a large share of the"corporate pie." It would seem highly unlikely that members of the groupwould trust each other when engaged in conduct which is punishable underthe securities laws. (1994).Walker. Theregulation of an economically efficient practice should not, however, bebased upon the reluctance of a few firms. [xlvii]See Dirks v. 222 (198 ); Restatement (Second) of Agency § 395 (1958). Few people feel bound to reveal all the information whichmay be material to any sort of transaction. Rev. 35, 4 (1986). [lxi]James D. The third definition of fairness states that an insider should notharm investors. [lv]Bainbridge, supra note 24, at 6 ; Dooley, supra note 48, at 35-36. UnitedStates, 445 U.S. The second definition of fairness is that of equality of information:no trader should possess information not possessed by other traders. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228 (2d Cir. No. [xv]463 U.S. L. L. Rather, the decision of whetheror not to prohibit insider trading should be left up to each firm. at 654. 419 (19 9). [xxix]Solomon, Schwarz, et al., Corporations Law & Policy 9 9 (1994). While the first argument canbe discussed purely in practical terms, the second argument evokescounterarguments of what place moral issues should take in suchdiscussions. Society as a whole wouldbenefit through the improvement in the economy's allocation of capitalinvestment and through the decrease in the volatility of securitiesprices.[xxxvii] Some have argued that allowing insider trading will defeat thepurpose of getting inside information to the outside investors more quicklyby encouraging insiders in possession of such information to keep theinformation secret for a longer period of time so that they can purchasemore shares at the lower price.[xxxviii] Professor Manne responds byarguing that insiders will be loathe to risk their profit by delayingdisclosure of such information. Fogarty, Bases of Insider TradingLaw, 49 Ohio State L.J. [xlii]Nicholas L. SEC, 463 U.S. [x]4 S.E.C. 1966 at 114.--------. United States, 445 U.S. The fact that an insider decides not to tradestock or disclose inside information will not deter the outside investorfrom pursuing his or her investment plan.[lxi] In response to the argument that allowing insider trading willencourage insiders to delay disclosure of material information, proponentsof deregulation say that insiders will actually have an incentive todisclose information. Rep. Georgakopoulos, Insider Trading as a TransactionalCost: A Market Microstructure Justification and Optimization of InsiderTrading Regulation, 26 Conn. First, insider trading tends to create harm to the firmwhose stock is involved the holders of that stock. Trading on Material Nonpublic Information of Impersonal Stock Markets. Morgan Stanley & Co., 623 F.2d 796 (2d Cir. Third, the agent and the firm may not be able toagree upon the value of the contribution. However, in the desire to create conditionsof equal access to information, courts have accepted the proposition thatwhen an informational advantage has been dishonestly acquired from oneperson, it may not be employed in trading.[xxviii] The Case for Deregulation Few arguments were forwarded against the regulation of insidertrading until the 196 s. The final part of the paper will rebut the pro-regulationarguments. The Use of Personal Profit of Knowledge Gained While a Director. 1983), cert.denied, 465 U.S. Regulation was accepted as necessary forcombatting this situation.[xxix] In 1966, however, Professor Henry Manne published a seminal work inthis area: Insider Trading and the Stock Market. Texas Gulf Sulpher Co., 4 1 F.2d 833, 848 (2d Cir. [ix]In re Cady, Roberts & Co., 4 S.E.C. Stock prices will generally reflect their realvalue if insider trading is allowed. For instance, the seller of anautomobile will seldom disclose all of the car's problems and a jobapplicant will almost never initiate discussions concerning his or her weakpoints. [lx]Cox & Fogarty, supra note 17, at 359. In the end, outside investors benefit from the more accuratestock prices. Even where this distinction can be made, theinvestor may be willing to pay a discounted price. [lxiv]Id. Such outside use will reduce the value of the information tothe firm.[xliv] Insider trading may also injure a firm by creating distrust and ill-will amongst the firm's top decisionmakers. A legal duty not toact is found when an underlying analysis suggests that the activity shouldbe banned. Whether ornot an insider buys or sells stock on the open market will not affect thefortunes of an investor. The onus of insidertrading thus remains with the firm. 863 (1983).United States v. [xvi]463 U.S. Aninsider trader rarely expresses or implies anything which is untrue aboutthe securities involved. at 653-54. Insider trading, despite its horridreputation, is economically efficient. In Defense of Insider Trading. Repides, 213 U.S. Different types of informedtraders take different amounts when transforming their information intotrading profits. denied, 464 U.S. According to Professor Manne, managers operatethe firm according to predetermined guidelines. Compensationfor this agent must bear some relation to the value of the contribution.The agent needs reasonable compensation in order to give him an incentiveto provide more valuable information. It was not the efforts ofCongress which resulted in this supersession, but the rulemaking process ofthe Securities and Exchange Commission under Section 1 b of the Act and thefederal judicial interpretation of these rules and provisions.[viii]Section 1 b and Rule 1 b-5 were not cited as regulating insider tradinguntil 1961. Cal. This ultimatelyprotects the uninformed investors. [xlix]Brudney, Insiders, Outsiders, and Informational Advantages UnderFederal Securities laws, 93 Harv. 1985), aff'd in part and rev'd in part sub nom., United States v. However, as seen in the second part of this paper, it isquestionable whether insider trading harms outside investors. 9 7 (1961). Many have suggestedthat the mild sanctions and relatively low level of SEC enforcementactivity made insider trading a low-risk activity. [xxiv]Stephen Bainbridge, The Insider Trading Prohibition: A Legal andEconomic Enigma, 38 U. No. Deregulation could substantially increase the incidence ofinsider trading, which could lead to a marked increase in investor flightfrom the market.[lviii] As pointed out above, those who argue in favor of deregulation pointout that arguments which cite the duty of the insiders to the firm as abasis for regulation are basically circular in nature. Consequently, theInsider Trading Sanctions Act (ITSA)[xxiii] was enacted in 1984 in order toprovide a more effective deterrent to insider trading. Rev., Nov-Dec.1966 at 114. 863 (1983); Shapiro v. Code Congressional & Administrative News 2274.Lake. 646 (1983); Chiarella v. 1868). Corporations Law & Policy. National Life Ins. on Energy and Commerce, Insider Trading Sanctions Act of 1984 H.R. Since such an analysis is conclusory, it should have no placein policy-making.[lix] In reality, the basis for such a duty is normativein nature. Insiders will then have more incentive to act in the company'swelfare, since their compensation will be directly tied to the value of thecompany's stock. However, it also generates a cost:informed traders "take" part of the stock market returns from uninformedtraders. However, the argument that investorsprefer to invest in companies which forbid insider trading has not held upto close scrutiny. 1981), cert.denied, 464 U.S. 827 (S.D.N.Y. S3865 (daily ed. [lix]Id. 19 (1987).Walton v. This requires that managers be allowed to "make a market" fortheir company's shares. Morgan Stanley, Inc., 719 F.2d 5 (2d Cir. [ii]15 U.S.C. Insider Trading This paper will discuss the arguments for and against the federalregulation of insider trading. Nov-Dec. 8 Michigan Law Review 1 51 (1982).House Comm. [xlvi]Bainbridge, supra note 24, at 55. 35 Stanford Law Review 857 (1983).129 Congressional Record S3865 (daily ed. [li]463 U.S. [vii]Walker, The Duty of Disclosure by a Director Purchasing StockFrom His Stockholders, 32 Yale L.J. Rep. [lxii]Kenneth E. The second argument focuses upon more normative, and ethereal,notions of what is fair in the marketplace. Therefore, a salary is an appropriate method of compensating themanager.[xxxi] An entrepreneurial agent, on the other hand, does notoperate according to predetermined guidelines. [xvii]See Charles C. Insider trading can harm the firm by creating incentives for managersto delay the transmission of material information to the hierarchy in thefirm. Thus, the focus should be onequality of access to information, rather than on equality of possession.Since the inside information is the property of the firm and is not legallyaccessible by the outside investor, the insider's use of such informationfor personal gain is unfair to the outside investor.[liii] Opponents ofthis argument respond that the price of the firm's stock adjusts quickly tothe information, just as if it were public information. 98-376, 1984 U.S. Ch. Thus, some scheme of compensation mustbe implemented which will correspond to the eventual value of theinformation.[xxxiii] One compensation scheme which immediately springs to mind is thepayment of bonuses. Rev. 1217, 1226 (1981). Co., 176 Iowa 362, 157 N.W. [xi]SEC v. The amount of profits realized depends upon howcompetitively the traders trade. 1986), aff'd, 484 U.S. Harvard Business Review. Inside information will usuallyresult in short-term price effects, rather than long-term effects.[xxxix] Allowing insider information would also promote market efficiencythrough price accuracy. Code Cong. SEC, 463 U.S. 863 (1983). 8 1, 81 -11 (198 ). Merrill Lynch, Pierce,Fenner & Smith, Inc., 495 F.2d 228 (2d Cir. Enforcement of Insider Trading Restrictions. The better the firmdoes, the greater the opportunities there are for the insiders to profitfrom trades with outsiders.[xxx] It must be noted that this argument does not support suchcompensation for managers. L. Rev. 547, 578-79 (197 ). June 29,1984)(remarks of Sen. UnitedStates, 445 U.S. Monopolistic informed traders take largeprofits without much in the way of beneficial adjustment of prices.[xlii] More generally, there have been two major arguments made againstinsider trading. Prohibiting insider trading willeliminate these costs.[xlix] As will be noted later in this paper, thisargument has been countered by arguments that duty analysis is circular inits reasoning, that insider trading is a form of compensation, and thatinsider trading is efficient. Some commentators havesaid that informational disadvantage is only unfair when the outsideinvestor cannot obtain the same information. Even if one does not accept the argument that insider trading maybenefit outside investors through enhanced price accuracy, it is still ahuge step to accepting the opposite argument that insider trading is unfairto the point that it hurts outside investors. This argument also holds that price movements whichordinarily signal the presence of undisclosed information and whichultimately dampen the price shocks which result from the disclosure of suchinformation are not present in the case of bad news. at 5 -51; see also, Haft, The Effect of Insider Trading Ruleson the Internal Efficiency of the Large Corporation, 8 Mich. Insider Trading and Contracting: A Critical Response to the "Chicago School." 1986 Duke Law Journal 628 (1986).Dooley. 19 (1987). Others point out that the issue is oneof cost: an outsider is required to pay a higher price for information heldby a manager simply as a result of the natural division of labor. Thus, managers would still have the incentive to spendmost of their time managing.[xli] The Case for Regulation Insider trading is a form of "informed trading." Informed tradingpromotes accurate securities prices. at 913. Fairness can be defined in three ways: requiringthat no trader breach a fiduciary duty by trading; requiring that no traderpossess an advantage with regard to information; and requiring that atrader not harm those with whom he or she is trading.[xlvi] An agent in a fiduciary relationship has a duty not to useconfidential information for personal profit. In addition, the longerit takes for information to be transmitted to the senior managers, thegreater the risk becomes that outsiders will discover the information andact upon it. Because insidertrading has not been shown to harm the stockholders' interests, there is noreason to prohibit such actions. [xix]See Walton v. The second part of the paper will examine the arguments infavor of the deregulation of insider trading, focusing upon the beneficialeconomic effects of insider trading. In 1968, theSecond Circuit Court of Appeals held thatanyone in possession of material inside information must either disclose itto the investing public, or, if he is disabled from disclosing it in orderto protect a corporate confidence, or he chooses not to do so, must abstainfrom trading in or recommending the securities concerned while such insideinformation remains undisclosed.[xi]The decision in this case established a precedent for other federal courtsto follow. Consequently, they may not use this information in dealingswith the shareholders. §§ 78c, 78o, 78t, 78u, 78ff. 9 Massachusetts Law Journal 427 (1937).Loss, L. [xxxix]Manne, Insider Trading and the Law Professors, supra note 35,at 567-68. [xxvi]ITSA § 3. 1981), cert. D'Amato).Cox, Charles C., & Fogarty, Kevin S. Three approaches were developed by state courts during thistime period (the first three decades of the 19 s) for dealing with insidertrading. 93 Harvard Law Review 322 (1979).Carlton & Fischel. Trading hasoccurred for the past sixty years under a legal scheme which prohibitsinsider trading. The trial court ruled that thepublication schedule was proprietary information of the Journal and thatthis information was misappropriated by the reporter and his friends.[xxii] The Supreme Court apparently split over the question of whether theacknowledged fraud was "in connection with" securities transactions, asrequired by the Securities and Exchange Act. [xlv]Id. Insiders may delay the impact of bad new bynot trading. Danforth, 52 Barb. L. 427, 447-51 (1937). Thebeneficiaries are brokers.[lvii] However, proponents of regulation pointout that there is insufficient data to make such assertions. June 29, 1984)(remarks of Sen. 23 Vanderbilt Law Review 547 (197 ).--------. The Insider Trading Prohibition: A Legal and Economic Enigma. 5 U.S.C. §§ 78a-kk (?). [xxxiii]Id. [xxxii]Id. Notes Bibliography StatutesInsider Trading Sanctions Act. News (98 Stat.) 1264, codified at 15 U.S.C. The result will beinefficiency and lower quality decisions.[xlv] The other major argument against insider trading is that it isinherently unfair. [xxxvii]Id. Those firmswilling to allow their executives trade on inside information should not befettered by government regulations. Winans, 612 F. & Ad. 222 (198 ).Dawson v. The dumping of stock by an insiderwould provide a sign to outside investors that all is not well with thecompany and that the price of the company's stock is artificially high.[xl] In addition to the examples provided above of how insider tradingmakes the market more efficient, there is one more way in which it promotesefficiency. [xliv]Id. 222, 232-33 (198 ). With the passage of time, interveningevents can erase the advantage held by the insider and the effect of theinside information can be nullified. Rec. A consensual transaction involves no duress or deceit. Florida L. 222 (198 ); United States v. [lxiii]Solomon, Schwarz, et al., supra note 29, at 912. Decisions reached are thus likely tobe inaccurate, untimely, or insufficiently comprehensive. In exchange transactions, no duty of disclosureexisted in most jurisdictions.[vii] The passage of the Securities Exchange Act in 1934 superseded thesestate laws, although it did not preempt them. [lvii]Carlton & Fischel, supra note 36, at 879-8 . at 5 . There are five problems, however, with theuse of bonuses. [xl]Id. (1983).Manne, Henry. Investors as a class would benefit byreceiving the full value of their investment. at 572-73. Insiders, Outsiders, and Informational Advantages Under Federal Securities Laws. Supp. Insider trading is said to harm investors in three ways:the investor's trades are made at the "wrong" price; the investor isinduced to make a bad purchase or sale; and the investor is preempted frommaking beneficial trades.[liv] These arguments have been countered bycommentators who believe that investors will not all respond to the effectsof insider trading, noting that those who are most sensitive to pricefluctuations realize that such fluctuations will result from many factors,including insider trading.[lv] If insider trading is perceived as unfair by investors, they willlose confidence in the market and will refrain from trading; or they maydemand a premium from a firm in which insiders trade. 1 25 (1984).SEC v. Insider Trading and the Stock Market (1966).Schotland. Fifth, a firm which is suffering losses will be unlikely to paybonuses even if the information/innovation holds down losses.[xxxiv] A more effective method of compensation is the allowance of insidertrading. Allowing them to trade on theinformation they possess will encourage them to work for the benefit of thecorporation, since they stand to profit from the company's fortunes. [lviii]Bainbridge, supra note 24, at 61. Rev. 1, 64 (198 ). [xxxi]Manne, In Defense of Insider Trading, Harv. In reality, relatively few companies havesought to prohibit insider trading through employment contracts orcorporate charters, in spite of the fact that insider trading does occur.This would tend to mean that investors are either indifferent to insidertrading or even regard it as beneficial.[lxv] Conclusion As can be seen from the above discussion, the regulation of insidertrading tends to create more problems than it solves. Several types of information are not readilyavailable to the public under the current regulations concerning themarket. 581 (N.Y. In addition, changes in stock priceswill occur more quickly and frequently if insiders are allowed to trade onthe information they possess. Similarly, the price of the company stock would be more accurateif insiders were allowed to trade on the information concerning the stateof affairs of the management. The Duty of Disclosure by a Director Purchasing Stock From His Stockholders. As aresult, the taking by the informed traders resembles a transaction costsince it can be avoided by not trading. Second,bonus plans must be publicly disclosed and some entrepreneurial agents maynot desire the publicity. L. [vi]Lake, The Use of Personal Profit of Knowledge Gained While aDirector, 9 Mass. 646 (1983). As noted,insider trading helps to establish accurate stock prices by forcing themarket to respond to information/innovation more quickly than it wouldotherwise. denied, 464 U.S. [xxxiv]Manne, Insider Trading and the Stock Market, at 135. Texas Gulf Sulpher Co., 4 1 F.2d 833 (2d Cir. at 653. at 574. Fourth, while a bonus is paidannually, the value of the information and the resulting innovation willoften produce beneficial returns for the firm over a period of severalyears. The view of insider trading as "playing cardswith a marked deck" was generally accepted by lawyers, academics, and thepublic at large from the early years of the 2 th Century until the 196 s.The practice was tinged with the color of unfairness: corporate insidersbenefitted unfairly from their advantaged position, edging out theuninformed outside investor. 23, 1983)(remarks of Sen. 54 Southern California Law Review 1217 (1981).----------------------- [i]15 U.S.C. In this book, ProfessorManne defended insider trading as economically efficient. [xxviii]See Cox & Fogarty, supra note 17, at 361. Insider trading smoothes out the ups and downs of a stock'sprice by making the market react to even small inappropriate pricemovements. denied, 394 U.S. They were applied only insituations where the insider engaged in face-to-face transactions withexisting shareholders. In that year, SEC Chairman Cary decided that the ruleprohibited insider trading.[ix] In that decision, the Commission held thatinsider trading constituted fraud or deceit in connection with the purchaseor sale of securities, in violation of Rule 1 b-5C.[x] This ruling amounted to a prediction of how the federal courts weregoing to interpret Rule 1 b-5 with regard to insider trading. Both the firm and themanager know what the manager will do and what the manager's abilities are. Allowing insider trading would require that theshareholders demand a premium to compensate for the risk imposed or willexpend resources to police management. Rev. 1425, 1448-49 (1967). Ch. It forces stock prices to moreaccurately reflect actual stock values and to adjust more quickly to insideinformation. 646, 654 (1983). 1 25 (1984). 98-376, 1984 U.S. However, the Courtunanimously rejected objections that the misappropriation theory madeemployer work rules into criminal statutes. UnitedStates[l] and SEC v. SEC, 463 U.S. Similarly, it is hypocritical to demand that a stock trader revealall the material information he or she possesses, especially that whichmight hurt their bargaining position.[lx] Even acknowledging that the corporate insider occupies a fiduciaryposition in relation to the stockholders of the corporation does notjustify the restriction of insider trading. The manager can tailor his compensation to fitthe information he or she produces by trading on the new information. [xlviii]Bainbridge, supra note 24, at 56; Dooley, Enforcement ofInsider Trading Restrictions, 66 Va. [xxxv]Manne, In Defense of Insider Trading at 116-19; Insider Tradingand the Stock Market at 138-41; Manne, Insider Trading an the LawProfessors, 23 Vand. [xxiii]Pub. News 2274; 13 Cong. [lii]See House Comm. Some company's may be uncomfortable with such a scheme and may preferto prohibit their executives from trading on inside information. Newman, 664 F.2d 12 (2d Cir.1981), cert. [lxv]Carlton & Fischel, supra note 36, at 858. National Life Ins. [liv]Wang, supra note 37, at 1235-4 . 976 (1969). 827 (S.D.N.Y. 4-5, reprinted in 1984 U.S. L. Such price accuracy would benefit both thefirm and society as a whole. 15 U.S.C. & Ad. By allowing managers to engage in insidertrading, compensation can accurately reflect information/innovationproduced by the managers without having to engage in frequent, andexpensive, renegotiations. 581 (N.Y. at 866-67; Wang, Trading on Material Nonpublic Informationof Impersonal Stock Markets, 54 S. on Energy and Commerce, Insider Trading SanctionsAct of 1984 H.R. 637 (1923). No. 355, 98th Cong., 2d Sess. 355, 98th Cong., 2d Sess. In addition, thecompensation of insiders, especially entrepreneurial agents, will be moreeconomically efficient if it includes the ability to trade the company'sshares.
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