Man Without Qualities

Friday, December 20, 2002

No Discounts?

One of the characteristics of insider trading that makes it so common is that it is not often detected and, when it is, it is very hard to prove. For that reason, many people believe that it is especially important that insider traders be fined a multiple of their illegal winnings if the behavior is to be deterred. The reasoning is fairly straightforward: If there is only a 10% (say) chance of getting caught and fined, then the actual fine should be fixed at ten times the amount obtained through insider trading - so that when discounted by the 10% there is no ex ante benefit to breaking the law.

It is therefore curious that George Soros was fined only what he obtained in his insider trade. This fine provides little incentive to refrain from additional insider trading - although it does provide some.

Of course, there are some serious people such as Henry Manne who believe that insider trading actually helps the economy. If that is true, it is always economically irrational to deter insider trading - and every fine is too much, at least from an efficiency standpoint.

Last August 2, for example, Professor Manne argued in the Wall Street Journal article linked above ("Options? Nah, Try Insider Trading"):

Now, ... as we are seeing the problems of stock-option plans, insider trading is beginning to look like an interesting alternative.


The problem was -- and is -- that no one could suggest an alternative to stock options for encouraging management to behave in the interests of shareholders. A few academics have joined me in suggesting that insider trading was nearly ideal for that purpose. But politicians won't come near it, and the SEC gags at the suggestion.


After the option is exercised, the executive becomes a larger shareholder. Stock ownership pushes management to maximize share price, especially if the shares represent a substantial part of an employee's undiversified portfolio. But as the employee's shares represent only a tiny fraction of all shares outstanding, the induced incentive for risky choices may still fall short of what would be dictated by the interest of shareholders. In other words, stock options offer no greater incentive than would a similar number of shares held by the manager, however acquired.

Insider trading , on the other hand, allows the insiders to meticulously craft their own reward for innovations almost as soon as they occur and to trade without harm to any investors. The incentive is immediate and precise and is never confounded with stock-price changes that are not of the managers' making. The effect of this trading will always be to move the stock price in the correct direction quickly and accurately, irrespective of what accounting entries are made for the underlying event. Stock prices will, for example, reflect the present value of anticipated future gains from new developments, something accounting cannot and should not provide for.


Currently, the SEC sees its job as regulating the entire market for information. This is madness. It starts at the supply side with accounting rules that began life as managerial tools and tries to make them into a valuation scheme. It finishes on the demand side by restricting insider trading , which merely shifts the identity of the people who may trade first on undisclosed information.

If insider trading were legal and used to replace or supplement stock options, there would be no "tragedies" of employees being left high and dry with options way out of the money. There would be no loss of reward when an innovation merely resulted in a reduction of an expected loss. There would be no unearned gain because a company's stock appreciated in line with a market or industry rise. And there would be no peculiar problems of accounting since such trading would be entirely extraneous to the company's accounts.

There are plenty of ways companies could regulate their own insider trading to best fit their needs. Some might limit trading to buying on good news and prohibit selling on bad news. Some could limit the amount of stock an employee could purchase, or outlaw insider trading altogether. We would certainly see some innovation in enforcement techniques and perhaps in the publicity given to insider transactions.


All we have to do is make the present laws optional. Just one thing: I would require companies to disclose details when they had adopted an insider trading system. That way I could go load up on the company's shares.

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