Chapter 29

Insider Trading

Insider Trading: Definition

Inside information is material information that is not available to public traders.

Material information is information that would cause prices to change if it were widely known.

Managers must either keep material information secret or make it public.

Corporate Insider Trading

Corporate insiders should not trade stock in their companies on nonpublic material information.

Insiders must report their insider trades to the SEC. Initial purchases within 10 days and subsequent trades within the first 10 days of the month following trades.

Corporate Insider Trading-continued Have to return short-swing profits to

issuers (bought and sold in 6 months) Prohibit short positions in company stocks Needs corporate approval before trade Allowed to trade only during specific

intervals: trading windows

Practical Judicial Issues Enforcement is very difficult (confederates) Surveillance by the exchange Enforcement by the SEC or Department of

Justice (DOJ) Often grant immunity to the last person in a

chain of informed traders in return for his or her testimony.

Encourage people report insider trading (Offer up to10% of civil penalty collected )

Why Restrict Insider Trading?

Fairness Liquidity Corporate control issues

Fairness

Should reward traders for insightful research, not personal connections

Rebuttal: Firms will place restrictions in their employee labor contracts if such restrictions benefit them. Thus, no role for government regulation.

Rejoinder: Corporate directors are unlikely to limit their ability in insider trading.

Liquidity Effective restrictions against insider trading

make markets more liquid for uninformed traders (low spreads)

Rebuttal:• Competition among insiders will quickly reflect

their information in prices. It depends on the number of insiders!

• Insider trading profits are indirect benefits that will reduce direct compensation. Value irrelevance.

Corporate control issues

Insider-trading rules ensure efficient managerial labor markets.

Unrestricted insider trading makes insiders reluctant to share information. Thus, directors and shareholders find it difficult to evaluate managers.

Managers may make managerial decisions that maximize insider trading profits.

Insiders may front run.

Why Permit Insider Trading?

Informative prices Costs of enforcement Entrepreneurial incentives

Informative Prices

Insider trading makes prices more informative. Rebuttal:

• Restrictions on insider trading are effective only against insider trading on information that will soon be made public. Incremental value of more informative price (from short-lived private information) is not large.

• Unrestricted insider trading may decrease the information in prices because unrestricted insider trading diminishes managerial incentives to share information.

Costs of enforcement

Unproductive to have laws that are difficult to enforce.

Selective enforcement problems. Rebuttal:

• A law that is not effectively enforced is very different from no law.

• For most people, ethical costs of breaking the law are much greater than the expected costs of prosecution.

Entrepreneurial incentives Insider trading promotes entrepreneurial initiatives

of employees. Buy stocks before their ideas are common

knowledge and sell them after they are priced. Shareholders cannot create compensation

contracts that put their employees at risk of losing substantial wealth. Insider trading creates such contracts.

Employees self-select their compensation schemes.

Rebuttals: • Relevant only for the long-term incentives