reflections on insider trading

CFA Institute

Reflections on Insider TradingAuthor(s): Michael S. RozeffSource: Financial Analysts Journal, Vol. 45, No. 6 (Nov. - Dec., 1989), pp. 12-15Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479271 .

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Current Issues: Insider Trading

Reflections on Insider Trading by Michael S. Rozeff, Louis M. Jacobs Professor of Finance, State University of New York at Buffalo

There is no consensus on the issue of insider trading among lawyers and economists. Even among Supreme Court justices, opinions on insider trading vary widely. Justice Blackmun sees it as inherently unfair. Other justices are concerned only if it involves traditional concepts of fraud or deceit. Still others believe that insider trading is wrong when it involves the misappropriation or theft of information. Among economists, positive and neg- ative views are on record. The SEC is the regulatory body most willing to restrict insider trading, to widen its definition from corporate insiders to anyone who possesses material non- public information, and to promote an egalitarian concept of information dis- persal.

How Significant Is Insider Trading? Studies suggests that insider trading is not significant. Finnerty's study of all NYSE insider trades found a total of 31,089 for the years 1969 to 1972- about one trade per company per month.' Seyhun analyzed insider transactions in 790 large NYSE firms for the seven years ending in 1981 and found a total of 59,000, or about 8400 per year.2 Seyhun's 59,000 trades average 11 per company per year or, again, about one per company per month.

But how big were these trades? They aggregated $11.1 billion, or about $20,000 per trade. Consider that a stock like Champion International trades 250,000 shares in a day at a price near $40 a share, or a value of $10 million. The amount of insider trading by corporation insiders is apparently

trivial relative to the total value of trading.

The significance of insider trading can also be measured by the number of enforcement actions against it. In 1980, Michael Dooley stated that the SEC had brought only 37 cases against insider trading in the years 1966 to 1980, most involving market profes- sionals, not corporate insiders.3 Most of these cases were settled with minor penalties. Kenneth Scott, surveying SEC actions since its inception found 106 trading episodes involving allega- tions of nondisclosure trading by defendants.4 But the trend in SEC actions is up. Commissioner Cox reported 54 civil actions and six admin- istrative proceedings in 1986. Still, those who have looked into this aspect of insider trading are telling us that there are very few actions against it. Might we say that "where there's no smoke, there's no fire"?

In short, the amount of insider trading is in fact trivial. The laws against it have not been very stiff, until recently. Enforcement actions against it are few. The penalties against it have not been severe. These facts tend to make one conclude that insider trading is a non- problem, not in the same league as other social issues and concerns such as drunk driving and drug-related crimes against people and property. There are many possible explanations for such a conclusion, ranging from the competition for valuable information to the creation of institutions and ethics that constrain potential problems.

What Are the Profits? We don't know the magnitude of the profits from insider trading because we don't know the full extent of insider trading. We do, however, know something about the profits earned by those who must report their trades to the SEC.

In his recent study, Seyhun said that

insiders' abnormal profits did not appear to be very large. Seyhun esti- mated that insiders' returns, over and above the normal market return, are 7.5 per cent per annum for purchases and 4.25 per cent for sales. However, these profit rates are overstated. Be- cause insiders tend to purchase shares in small companies and sell shares in large companies, and because small companies have on average earned a normal return that is higher than the normal return of large companies, the insiders' profit rates must be adjusted downward for size effect.5 When this is done, the buys and sells average about 3 to 3.5 per cent per annum in profitability. A recent study of insider trading in over-the-counter markets, where policing is less and profits might be higher, reveals that potential profits are only 3 per cent per year- far less than typical bid-ask spreads of 7 per cent.6

How much are profits in dollars? Recall that the total of all the insider trading in 790 large companies, over Seyhun's seven-year period was just over $11 billion. So 3.5 per cent of this is $385 million-for all corporate insiders in all 790 firms from 1975 to 1981. This figure is not large compared with other wealth gains by various groups, such as losses from bank frauds and losses to buyers of cars, appliances and construction materials from pro- tection of the U.S. steel industry.

Even if corporate insiders do not earn very large profits, valuable information may fall into the hands of others who do. Boesky supposedly made $50 million. But this is atypical; the printer Chiarella made $30,000. Commissioner Cox of the SEC has reported that the SEC recovered $30 million of insider trading profits in 1986.

To sum up, we do not know the profits to insider trading. The available evidence suggests that they are not excessive by comparison with other 1. Footnotes appear at end of article.

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1989 O 12



wealth transfers and deadweight losses society creates.

Why Is Insider Trading a Matter of Such Concern? SEC rhetoric suggests a high degree of concern about insider trading. The agency wants investors to have equal access to information. Congress, by contrast, has never been very concerned about insider trading. Apart from the mild provisions in the initial 1934 legislation, little additional attention was paid to this area until recently. Most investors seem to be trou- bled very little by the knowledge that there are people trading in the markets who may know more than they. They seem to accept inside information as a fact of life.

Despite this background of Con- gressional and public apathy, we have an agency that has sought to expand the definition of insider trading and has taken a number of cases to the Supreme Court only to see them de- feated because the laws passed by Congress and even case law simply did not seem to support what the agency was trying to propose. Why is the SEC so zealous when it comes to promoting a concept of equal access to information for all investors?

The SEC regulates the securities industry. A logical hypothesis is that the regulators are being captured by the industry or certain influential seg- ments of the industry. One scenario is that if corporate insiders are forbidden to trade on inside information, then those next in line to learn about it (investment bankers?) would stand to gain the most by obtaining it.

Recent concern about insider trading is sometimes the expression of moral outrage. U.S. Attorney Anton Valukas has been quoted as saying that the rash of bank frauds and the insider trading scandals are both "sad symptoms of Boesky-era ethics." But no one knows if the ethics of 1987 vary significantly from the ethics of 1887 or 1387 or 7.

Some of the concern about insider trading is also, I hypothesize, an expression of self-interest by those who would like to use this issue to promote other items on their agenda. For example, the resistance to take-

overs shows up in attempts to thwart the democratic exercise of voting rights by shareholders and even the right to buy or sell stock freely. It shows up in statutes that make it man- datory to disclose stock ownership po- sitions, which seem to me to violate the most elementary right to privacy. It shows up in attempts to prevent people from buying shares in the open market or voting them. It shows up in court decisions that block tender offers and in injunctions that block people from acquiring common stock or in attempting to acquire control of companies without a court order. In short, certain vested interests are attacking shareholder rights vigorously. So how does insider trading relate to corporate takeovers?

There is a strong tendency to con- demn takeovers and say they are bad when in fact they may be very good. Michael C. Jensen and others have provided substantial evidence that the typical takeover creates wealth, at least for the acquired firm's stockholders.7 By contrast, the anti-takeover forces are long on claims and rhetoric and short on evidence.

One of the real problems faced by a potential buyer is accumulating shares without revealing information about what he is willing to pay or what he thinks the assets might be worth if they were managed by a new team. Obviously, this is not inside information because it comes from outside the company. It is better to view it as confidential information.

Any bidder wants to keep bids secret until the appropriate time, but this is very difficult to do within our sys- tem because, to cover various legal bases, others must be brought into the picture-lawyers, investment bankers, printers, proxy specialists. Fur- thermore, because there are restrictions on buying stocks in the open market to achieve control, there are large incentives to achieve the goal of takeover through cooperation among a number of parties that are willing to risk money and hold blocks of stocks separately and to aggregate them at the appropriate time. Arbitrageurs, who take the risks of outright ownership, have become prominent.

The development and control of in-

formation is a central issue in this entire process. The business of takeover can become intertwined with the issue of insider trading when the real issue is confidential information. Var- ious established institutions are de- signed to ensure confidentiality: Law- yers have stringent ethics codes on confidentiality; printers have codes of secrecy; investment bankers and bro- kers have audit and compliance de- partments. All these are evidence that individuals have learned how to control vital information. But leaks sug- gest that 100 per cent compliance is too costly.

The takeover business is likely to be smeared with the same brush as insider trading. At the same time, the SEC's investigation of insider trading is being used as a wedge to conduct a broad inquiry into corporate takeover practices, including junk-bond fi- nancing.

The Major Arguments Against Insider Trading Many people regard insider trading as unfair and harmful. The crudest argument goes-(1) inequality is unfair; (2) insider trading involves the information advantage of one person over another; (3) ergo, insider trading is unfair. In other words, it is unfair for some people to have something (often of value) that others do not have. The underlying assumption is simply that equality of resources, wealth, information and other things of value is a desirable ethical ideal. The implication is that public action is necessary to remedy inequality.

Inequality is not necessarily unfair or bad, however. It has both costs and benefits. Specialization, which has many benefits, creates inequality. In- equality also occurs spontaneously, as a result of individual choice. Society itself is based upon inequality, with some people having more power and status-and, frequently, more re- wards-than others.

Insider trading is not necessarily bad just because it involves inequality. Nor is it necessarily good. The burden of proof, however, falls upon those who want equality of disclosure, because it is they who want to interfere with the voluntary contractual ar-

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1989 0 13



rangements between entrepreneurs, managers and stockholders, which have evolved over a long period of time to meet perceived needs.

A second argument against insider trading says that unearned profits are unfair. The idea is that insider trading is wrong because it involves theft or misappropriation of information that belongs to someone else. Chiarella was a printer who broke his employer's code and figured out which stocks were going to get tender offers. He then bought stock and benefited from this information. One Supreme Court judge observed that he was practically betting on a sure thing. This seems neither fair nor honest, and most of us would consider it to be wrong. Simi- larly, one could say that Dennis Levine stole information that belonged to those who had consulted the company he worked for. Some people have argued that a manager's use of information is wrong because the information belongs to the company or its stockholders.

Information is clearly valuable. The central issue is, who owns it and should benefit from it? Consider this general principle: If you create something, you own it and can do what you want with it. If you paint a picture, write a book, invent a cereal or design a curriculum, it is possible for you to establish property rights in these things. This approach is consistent with a free society and is also consistent with creating an environment in which there are strong incentives to create. Allowing property rights in information is thus appropriate.

The practical problem is the rich variety of possible specific instances that arise. If you are inside IBM and you learn that a customer has just placed a big order, should you benefit from this information? This is not an easy question to answer from an armchair. There is intense competition for valuable information. If a job holder were well situated to find out valuable information and benefit from it, appli- cants would compete for the job and, in the process, drive down the salary necessary to attract people to the job. In effect, stockholders would allow employees to use information as a form of pay and pay them a lower wage.

It is also conceivable that stockholders might elect to police information and have rules and procedures (codes of ethics) forbidding its use by employees.

I believe that questions of property rights in information must be solved by those who experience the costs and benefits of alternative ways of estab- lishing property rights in information. The solutions that people choose will depend on what sorts of information are really valuable, who has access to them, how much competition there is for them, policing costs, etc. Armchair theorizing about general legal, ethical and economic principles simply can- not solve questions of how to establish property rights in information.

Who Is Hurt by Insider Trading? New and valuable information is created in a variety of ways. How is it created? Who owns it? What measures do they take to retain rights to it? When is it stolen? How should rights to information be allocated? How should these rights be protected? How do those who either create or find information first elect to profit from it? How do they elect to control its dispo- sition? A score of questions arises, making it very difficult to judge when someone is stealing or when someone is being hurt by the use of inside information.

When someone executes a trade based on an informational advantage, are the traders on the other side of the trade harmed? Cases have sometimes awarded damages on this basis, but these is a strong argument that these traders have not been harmed. When they enter the market, they do so without coercion and with the knowledge that others may know more than they. Their actions are not caused by the other traders' actions, they are independently arrived at.

Some argue that insider trading by corporate insiders harms the stockholders of the company the insiders work for. In legal terms, this argument sees the corporate official as a fiduciary who has a duty or responsibility to the shareholders. The fiduciary concept, however, begs important questions. If information is developed, does it be- long to the shareholders or to its de- velopers, or to both? Shareholders

could easily forbid insider trading or develop mechanisms to handle insider information, but we observe little if any voluntary attempts to control insider trading by stockholders and managers. From this, Carlton and Fis- chel infer that there is no insider trading problem, and no harm being done to shareholders that is worth the effort to remedy.8

Frank Easterbrook uses the business property approach to information: If there is a rightful owner of information, and if secrecy is needed to preserve the information's value, then another person may not lawfully exploit the information, as this amounts to theft.9 Ap- plying this principle is far from easy.

Consider Mr. Winans, who wrote a column for the Wall Street Journal. Mr. Winans collected information about companies (not inside information) and wrote columns. He tipped the contents of his columns to several others, who made profits from the tips. A small fraction of the profits was shared by Winans. Who owned the information that Winans put into his columns? The prosecution argued that Mr. Win- ans breached a duty to his employer by divulging confidential information. Did Mr. Winans divulge confidential information? If he did, was it a crime? What kind of contract did Mr. Winans have with the Wall Street Journal? Did they not sanction him by firing him and publicizing what he did?

Conclusion The subject of insider trading is filled with an unusual number of paradoxes. The Boesky case, the Levine case, the Winans case make us think that the practice is widespread and very prof- itable. Yet the available evidence on corporate officials suggests that it is neither. The SEC is known for its zeal in promoting a fair market, one in which investors have equal access to information, and yet their enforcement actions have historically been few in number. (Parenthetically, the SEC certainly does not make disclosure documents easy to come by.) In- sider trading is thought to be an evil that causes harm, and yet ethics and the law have difficulty coming up with clear definitions of what the evil is, or even what insider trading is. Many




countries with thriving capital markets pay little or no attention to insider trading. Several recent cases termed "insider information cases" do not involve inside information, but valuable confidential information.

All of this suggests that we know far less about insider trading than we think we do. We have not given enough thought to many central questions concerning the creation of valuable information and the mechanisms that individuals have created to pro- tect the rights of those who create it.

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Footnotes 1. J. E. Finnerty, "Insiders and Market

Efficiency," Journal of Finance 31 (1976), pp. 1141-1148.

2. H. N. Seyhun, "Insider's Profits, Costs of Trading, and Market Effi- ciency," Journal of Financial Econom- ics 16 (1986), pp. 189-212. Although these are the reported trades, not all involve insider information, because corporate officials and large owners make many portfolio ad- justments for personal reasons. At the same time, there are ways to take advantage of insider information without trading directly in the affected security.

3. M. P. Dooley, "Enforcement of In- sider Trading Restrictions," Virginia Law Review 66 (1980), pp. 1-83.

4. K. E. Scott, "Insider Trading: Rule lOb-5, Disclosure and Corporate Privacy," Journal of Legal Studies 9 (1980), pp. 801-822.

5. M. S. Rozeff and M. A. Zaman, "Market Efficiency and Insider Trading: New Evidence," Journal of Business 61 (1988), pp. 25-44.

6. J. C. Lin and J. S. Howe, "Insider Trading in the OTC Market" (Working paper, Louisiana State University, 1989).

7. M. C. Jensen and R. S. Ruback, "The Market for Corporate Con- trol," Journal of Financial Economics 11 (1983), pp. 5-50.

8. D. W. Carlton and D. R. Fischel, "The Regulation of Insider Trad- ing," Stanford Law Review 35 (1983), pp. 857-895.

9. F. H. Easterbrook, "Insider Trad- ing, Secret Agents, Evidentiary Privileges, and the Production of Information," The Supreme Court Re- view, 1981, pp. 309-365.




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