Anderson on Insider Trading

John P. Anderson has posted Insider Trading and the Myth of Market Confidence on SSRN with the following abstract:

Promoting public confidence in securities markets is a policy goal that is frequently cited by commentators, Congress, the courts, regulators, and prosecutors for the adoption and vigorous enforcement of insider trading laws. For example, in describing the motivating purpose and need for the Insider Trading and Securities Enforcement Act of 1988, Congress explained that insider trading “diminishes the public’s faith” in capital markets, adding that “the small investor will be—and has been—reluctant to invest in the market if he feels it is rigged against him.” In the seminal insider trading case United States v. O’Hagan, the U.S. Supreme Court explained that “investors likely would hesitate to venture their capital in a market where [insider trading] is unchecked by law.” More recently, Preet Bharara, who earned the title of “Wall Street Sheriff” by successfully prosecuting over seventy insider trading cases in the wake of the 2008 financial crisis, emphasized that part of his job as the U.S. Attorney for the Southern District of New York was to aggressively prosecute insider trading cases “to bring people back to a level of confidence in the market.” Such expressions of the link between insider trading and market confidence, however, assume far more than they explain.

At least three claims seem implicit in the market confidence argument. First, a large portion of the general public shares the perception that insider trading is economically harmful and morally wrong. Second, this perception will lead potential market participants to stand on the sidelines of any market in which insiders are free to trade on their material nonpublic information. Third, this chilling effect upon market participation will be significant enough to result in an appreciable decrease in market liquidity and therefore an increase in the cost of capital for those who would put it to socially beneficial uses.

This Article challenges the validity of the market confidence claim as a justification for the regulation of insider trading on two grounds. First, insofar as it relies on a sociopsychological claim—that most investors perceive insider trading as economically harmful or morally wrong—it is subject to the problem of false consciousness (i.e., the psychological claim could be true though the shared belief is demonstrably false).

Second, even if the problem of false consciousness is set aside, the market confidence argument’s empirical claims must be proven. Empirical evidence for the market confidence theory is, however, decidedly weak. Studies testing public attitudes concerning insider trading have reflected more ambivalence than fear or indignation. Moreover, there is no clear pattern of market reaction to major insider trading prosecutions, news of pervasive insider trading highlighted by the press, major court decisions affecting the government’s power to enforce against insider trading, or the adoption of insider trading regulations in countries that did not previously regulate it. Perhaps more concerning for the market confidence theory, however, is the ease with which its proponents explain away data that conflicts with its claim by shifting explanations. The impression emerges that the market confidence theory is not just unproven, but worse, unprovable.

The Article concludes by cautioning against relying upon such an unproven or unfalsifiable claim as a justification for existing or expanded civil and criminal insider trading enforcement powers.