Monday, August 18, 2014
I’ve been reading up on insider trading recently (as part of a project on what happens when government applies price instruments to limited-liability firms), and it’s tough to find academics who think trades by insiders should be universally prohibited. This is odd not least because every modern economy that I know of in fact bans insider trading. What gives?
(UPDATE 8/20: Bainbridge points you to some much more thoroughly thought-out answers here: http://www.professorbainbridge.com/professorbainbridgecom/2014/08/why-is-insider-trading-illegal.html)
The academic defense is fairly straightforward, as I understand it. For one (per Carlton & Fischel), it allows managers to hedge, which should help to make them more risk-seeking, reducing the need for other forms of costly incentive pay. Defenders also still sometimes say that inside sales can send signals to the market, which is potentially useful information that would otherwise be unavailable or slower to arrive (Henry Manne is the go-to cite for this one).
Well, sure, maybe. How costly would insider trading be as an incentive-aligning device, though? The costs would be off the books, which would look nice to rationally ignorant shareholders. But the costs could be quite large.
As a Columbia guy, I tend to agree with John Coffee that the big cost here is the lemons problem. If I know the manager *could* be trading on bad news known only to her, I discount the value of the stock; the fact that she is willing to sell even at my discount price tells me the stock really is a lemon. (Sung Hui Kim also offers a recent spin on this point.)
Carlton & Fischel acknowledge the lemons argument, and they say in response that traders always know that there is someone better informed than them, and yet this does not seem to paralyze markets. Jon Macey also makes a version of this point. I’m not sold.
There are lots & lots of differences between buying from an insider and from, say, a brokerage house. Just to take the most obvious, the broker is a repeat player and would rather do business with you (or another buyer) again than rip you off, while the manager might retire on the earnings from her insider stock dump.
Also, there’s just a difference in degree, and I think that’s critical to lemons markets. A seller who’s done more research than me can only swindle me so far, because by definition her information is public: if this deal seems too good to be true, I can do my own research (and, if her offer is way better than my alternative investments, it may be rational to invest in that research). And she knows that.
In contrast, and also by definition, the insider’s information cannot be countered, giving her more room for manuever. So the game-theoretically minded buyer should form an expectation of value that covers a wider range. When this range is wider (i.e., includes more really low numbers), expected value is lower, meaning rational buyers will pay less. And, as rational buyers pay less and less, fewer and fewer rational quality sellers should be in the market.
And that’s only the biggest cost. What about the costs of credit? Would you lend money to a firm whose managers get rich when the firm goes bankrupt? I wouldn’t, or not unless I could securitize the loan and pass the risk on to some unsuspecting retirement funds. (I kid, friends! I only sell my securitized debt to sovereign wealth funds from really mean countries.)
I also think that the information argument is essentially dead, although one can still see its zombie shambling around in law reviews. Macey very gently and politely killed it in a review article of Manne’s work back in 1989. He pointed that as soon as managers’ sales are meaningful enough to move the market, the managers’ lose their insider edge, and all their subsequent sales are no longer profitable. So the manager has an incentive to sell in a way that discloses as little as possible (e.g., in little dribs & drabs over months that can be disguised as portfolio balancing or liquidity sales).
I’ll admit that so far I have a story about why rational shareholders should want to prohibit their officers from insider trading, but not particularly a story about why (other than as a preference-estimating default rule) we’d want that to be the law. Let’s save that for the next post.