Asymmetrical Information

but ordinary passers-by who manage to somehow glean a shred of information

No. This is completely wrong. Beyond people who are fiduciaries, and tippees, to be liable under US insider trading law, the inside information must be misappropriated in breach of some duty to someone else, such as from an employer. For more information, see US v. OHagan.

If you are merely sitting at a bar and overhear inside information from the two people next to you, feel free to trade.

If you are merely sitting at a bar and overhear inside information from the two people next to you, feel free to trade.

But be aware that while A.S. has correctly summarized the current state of case law, the SEC's enforement division may disagree. Maybe things have changed in the past few years, but they have tried very hard (and, thankfully, unsuccessfully) to make the courts agree with them that any use of material non-public information is insider trading.

I think with the adoption of Rules 10b5-1 and 10b5-2 a few years ago, the SEC finally accepted that the misappropriation theory is the law. That's not to say that the enforcement division won't try to figure out some way that someone who traded on material non-public info owes a "duty of trust and confidence" (the relevant legal standard) to someone else and therefore has misappropriated the information. Indeed, if you look at Rule 10b5-2, it defines, among other things, when you have a duty of trust and cofidence to your own family such that if you overhear a family member talking about inside info you cannot trade on that basis. But the infamous situation of someone sitting in a bar overhearing inside info... I don't see any way that there is a duty of trust and confidence involved, thus no misappropriation and no insider trading liability.

My favorite insider trading joke (from "Money Culture"):

American trader: So, what do you think about trading on inside information.
French trader: Why would one ever trade *without* inside information? How risky. How naive. How American.

But the infamous situation of someone sitting in a bar overhearing inside info... I don't see any way that there is a duty of trust and confidence involved, thus no misappropriation and no insider trading liability.

I agree -- although there's a difference between innocently overhearing something and actively taking steps to eavesdrop. Information gained via the latter, I suspect, would be theoretically forbidden for purposes of insider trading. The key question is: has the information been stolen? If the answer is yes, then using it constitutes insider trading. Someone with fiduciary resbonsibilities to others is merely "borrowing" (i.e., temporarily possessing) necessary information in order to discharge his duties; "taking" the information and trading on it would constitute stealing it.

Oh, Professor Bainbridge is clueless, again? What a surprise; this is the same fellow who called the "Minutemen" group "vigilantes", thereby proving that either he didn't know what the committee of vigilance in San Francisco did, or couldn't be bothered to read what the "Minutemen" were doing.

I stopped reading him after that; anyone who makes such a huge blunder and can't admit it when he's wrong is too puffed up with false pride to take seriously.

Ellipsis, the cluelessness referred to the New York Times article, not Professor Bainbridge. This would be the place to make some snarky comment about reading comprehension, except I almost made the same mistake. As for the hubris or lack thereof, of the professor, I have no particular opinion.

A counter-example:

Suppose that I was an insider and I wanted to profit from it. I might arrange to have Acquaintance A happen to sit next to me at a bar while I talk to colleague B about the information. Acquaintance A happens to be with his Acquaintance C (who I do not know), and they both overhear me.

Acquaintance A then goes off and does the dirty deed for us safe in the knowledge that he has a witness to him having overheard it in a public place.

This is why the insider trading rules have to be fairly broad. It's also why you have to be suspicious and aggressive when you see a pattern of trading that appears too good to be true.

Yes, I know that it's hard to prove, and it puts people on the defensive. But to me that's a price to pay for that small minority of investors who buy or sell large blocks of a single stock.

I wouldn't go as far as Jane in suggesting that this reduces investors to a bunch of blind gamblers. To take one example, Apple's stock price is largely a function of how the market assesses its strategy, management and market prospects against a wide range of competitors. I can easily see how two investors could be in posession of the same company information while coming to divergent judgements about its prospects.

I might arrange to have Acquaintance A happen to sit next to me

That's called a "tip". Both you and Acquaintence A are guilty of insider trading.

A.S.
Yes, I understand it's a tip. But it's only a tip if you can prove it's a tip. Smart people can try to disguise things.

That was the point of my example.

But the question is why should insider trading be illegal. Trading on nonpublic information causes the stock price to move when it should, in fact, be moving because something's about to happen to the company. In the case of good news, people buying are paying more nearly the "correct" price while the people who are selling are getting more money that they should get because their asset, unbeknownst to them, is worth more money. In a world in which there is no trading on nonpublic information, sellers sell for too little and buyers get an unearned windfall. What sense does that make?

Salamandyr gently corrected me:

Ellipsis, the cluelessness referred to the New York Times article, not Professor Bainbridge. This would be the place to make some snarky comment about reading comprehension, except I almost made the same mistake.

My reading comprehension is not always the best. Thanks for pointing that out.

As for the hubris or lack thereof, of the professor, I have no particular opinion.

I didn't used to, either, until witnessing him engaged in thunderingly stupid argumentation.

I wonder if anyone has ever attempted to perform even a simple cost/benefit analysis of the insider trading rules? Is all the overhead really worth it?

David Cohen,

Your example, as stated, makes sense (which is to say, in your hypo the restriction doesn't make sense.) But I suspect that a lot of the rules are made with a view toward the downside risk, where an insider (with special knowledge that his stock is about to be worth a lot less) unloads that stock on an unsuspecting buyer. There's a lot less popular sympathy for the seller in that scenario, don't you think?

"Beyond people who are fiduciaries, and tippees, to be liable under US insider trading law, the inside information must be misappropriated in breach of some duty to someone else, such as from an employer."

A.S., in that case please explain why Martha Stewart was accused of insider trading.

Martha wasn't charged with insider trading because they weren't sure they could win on that count.

She was charged and convicted of lying to investigators about the trades.

The SEC would have dearly loved to call it "insider trading" but the courts would probably have disagreed.

Kirk Parker:

Agreed. But even there, it is unclear what banning insider trading accomplishes. Because trading takes place on the exchanges, there is no direct connection between the buyer and the seller. In other words, the insider (aware of the coming catastrophe) doesn't sell directly to the innocent buyer and doesn't in any way induce his purchase. The buyer would have bought regardless of whether the insider sold, so the law doesn't actually prevent the harm.

On the other hand, there is at least the chance that, by entering the market, the insider or insiders will depress the stock price, particularly if it leaks that insiders are selling, and thus the harm to other buyers will be reduced. In the non-trading scenario, every other subsequent buyer is also harmed. It would be even better if publicly held companies were obliged to report insider trades immediately on their web sites. That way the stock price could move in the right direction even if the company needs to keep the exact nature of the information secret.

Martha's conviction was a sickening injustice, just like Leona Helmsley's before. Government prosecutors decide to "make someone an example" and they do it with no regard for the public, investors or anyone else. This is the same stinking burocracy that gave us Ruby Ridge and Waco. There's no excuse for it.

"Trading on nonpublic information causes the stock price to move when it should, in fact, be moving because something's about to happen to the company."

But the price will move anyway tomorrow, when they make the announcement.

There are two alternatives - the company can announce to everyone, at the same time, giving all current and prospective stockholders an equal chance; or we can first allow a partial, noisy leak through insider trading, where insiders make large profits in order for outsiders to get a vague hint only a day or two early.

Your argument, as I understand it, is that insider trading on material, specific changes should be allowed for the sake of an only slightly faster, noisy partial price adjustment. One problem with this is that it also gives insiders an incentive to manipulate the stock.

If managers could legally, freely trade ahead of their own announcements, how long would it take for them to start manipulating those announcements? They could make a takeover bid that they later planned to drop, but in the meantime the managers could get rich buying and shorting the stock at the right times, or they could even go through with the takeover simply because of the personal profit opportunities it would open up. Or they could announce a huge dividend increase or elimination only to profit from front-running the stock price reaction.

There is a lot more insider trading in many Asian markets, and it (rightfully) scares off many investors. Giving insiders a chance to regularly take money out of the market, using information they don't own, means higher costs of financing for companies, because outside investors quickly realize that the market is rigged against them.

Companies from all around the world come to US markets to raise capital because this is where the investors are. The investors are here because they feel protected by regulation that at least limits the blatant manipulation that goes on elsewhere. Why else would foreign companies voluntarily come to the market with the strictest regulation?

Actually, the SEC did accuse Martha Stewart of insider trading, in a civil complaint. The prosecutors in the criminal case did not accuse her of insider trading, however (likely because they knew they wouldn't win on that charge). Martha settled the civil complaint by the SEC, without admitting (or denying) guilt.

Professor Bainbridge explains here why the case against Martha for insider trading was so weak.

Government prosecutors decide to "make someone an example"

Actually, this a very good use of the government's resources. By making high-profile cases (and winning on them), the government likely deters a lot of illegal activity that might otherwise take place. That is, people who might otherwise commit insider trading might think twice when they see a high profile prosecution on the news every night.

Ann: You are assuming your conclusion. In effect, you are saying that "insider trading is bad because it's bad."

1. Insider trading wasn't illegal in most other major financial markets, including England and Japan, until the mid-80s. It is now illegal almost everywhere, including Asian markets. Certainly the Japanese experience doesn't show that there used to be a lack of confidence in the market and now there's been a resurgence of confidence.

2. I haven't been able to find any polling data, but my impression is that Americans believe that there is rampant insider trading going on. That is certainly what they learn from the New York Times.

3. What other property are people not allowed to sell because they know more than the buyer? What sales could take place if they were? If you sell your car "as-is," do you think that the buyer assumes that you have disclosed every negative thing you know about the car? When selling your house, do you make it a point to take the buyer around and show him every defect? In insider trading, there's not even any direct dealing between buyer and seller and the insider isn't making any representations, express or implied, on which the (more of less fictional) person on the other side of the transaction is relying. [For those of you who are about to object that corporate officers are fiduciaries and fiduciaries are forbidden to trade with those to whom they owe a duty unless they fully disclose, I would argue (1) that stockholders as a whole would want insider trading to occur, because it makes stockholders as a whole better off; and (2) that still doesn't explain why insider trading is a crime. If it weren't a crime, companies could still choose whether to allow it or not.]

4. As you seem to agree, allowing insider trading would allow at least some minimal diminution of the damages people suffer by selling or buying stock that is not worth what they think it is. Prohibiting insider trading maximizes the harm. Even if the diminution isn't much (and I don't know why you think it would only be one day; I can easily think of situations in which there would be months between an insider learning of tradable information and an announcement).

5. Companies making acquisitions are allowed to buy up to 5% of the stock of the target without making any announcement. How is that not every bit as bad as insider trading?

6. "Greenmail," the practice of announcing an acquisition just to solicit a payment to go away, used to be a problem until it was regulated out of existence. If your concern is with annoucements being manipulated, which would in any case be more difficult than you assume, regulate the announcements. It would be much easier than regulating insider trading.

I see that I left "it's better than nothing." off the end of point 4.

"If you sell your car "as-is," do you think that the buyer assumes that you have disclosed every negative thing you know about the car?"

A better comparison would be if you were buying a car and the seller was allowed to hide any damage or problems and refuse to allow you to inspect the car. Don't you think that this would discourage the used car market? Insiders sometimes have information that an outsider simply cannot get, no matter how much they 'do their homework'. And the insiders didn't produce this information through hard, independent work - they got it as part of their job, acting for the shareholders. To summarize: 1) the insiders didn't earn the information, 2) outsiders can't get it, and 3) the information gives insiders a strict advantage that lowers the expected returns to outsiders.

On Japan, there's a lot going on in any one country that makes comparisons hard, although I certainly don't think that Japan supports your point. The details and level of enforcement still vary widely around the world, so you can't really say that 'everyone has some form of insider trading laws now, so there's no difference between countries' (if that was your point).

I'm more familiar with Hong Kong, Singapore, Taiwan, Malaysia, Indonesia and the Philippines, and was teaching about financial markets in Hong Kong when their first substantive insider trading law was implemented. Both individual and institutional investors felt that they were at a disadvantage in most of those markets because of all the insider manipulation, and there were many examples of companies manipulating announcements to take advantage of changes in the stock price. Granted, the managers didn't always have to do this for their personal accounts, since the family that ran the company often owned more than 50% of the stock.

But you seem to be shrugging off the mere possibility that dividend announcements (or even earnings announcements, since there's always some discretion) or takeover bid announcement might be manipulated by managers that want to profit from trading. From what I saw in countries with little or no enforcement of insider trading laws, there were plenty of opportunities.

"As you seem to agree, allowing insider trading would allow at least some minimal diminution of the damages people suffer by selling or buying stock that is not worth what they think it is. Prohibiting insider trading maximizes the harm."

A weak, noisy signal does not necessarily make stock prices more efficient, since the added volatility may more than offset the general weak trend in the 'right' direction.

More importantly, if no one is allowed to trade on inside information before the announcement, then everyone faces the same risk and is on the same footing. The only way to 'beat the market' then is by understanding the company better or somehow producing your own information that may actually improve the efficiency of the stock price.

If you instead allow large returns to go to people who have provided nothing, produced nothing (independent of their job duties) and are simply using information that isn't theirs, you take away the incentive for people to work hard and actually contribute, because the deck is stacked in favor of those that are taking advantage of the company's information.

There's always uncertainty that won't get revealed until later - that's part of all investing. General uncertainty is different from a strict bias that allows some insiders to profit at the expense of others. If your objection is that announcements aren't made early enough in some cases, then why not change the timing of the announcements in those cases?

My objection is that people are not allowed to do what they wish with their property, on penalty of jail time, for no social benefit whatsoever.

I'm confused by your claim that there is corporate value that is not due to the efforts of corporate employees. Do the corporate value gnomes come out at night? But, in any event, the employees benefit from insider trading only to the extent that they are shareholders. (I agree that it is more problematic where the insiders use their position to avoid losses that they cause, but I still don't see why it should be a crime. It's distasteful, but it's not theft.)

If preventing insider trading could prevent actual harm to outside shareholders, I'd be all for it. But shareholders decide to buy and sell based on the market and don't know that insiders are trading. There is no causation between here. So now, with insider trading banned, shareholders still trade in ignorance of coming announcements, and some random person gets the benefit of the resulting windfall. Banning someone from selling their own property when doing so doesn't cause any one else to suffer a loss is silly.

If the corporate website announces that the top 10 insiders just sold or bought, I don't think that signal would be at all "noisy." But you do seem to come dangerously close to suggesting that increased buying pressure or increased selling pressure won't necessarily have an effect on the price. If that's the case, why would we worry about insider trading at all? No one would be worse off because of the trading. Some insider/shareholders would be better off. An act that raises the sum total of utility in the world, or even just among shareholders, seems like an odd candidate to be made into a criminal offense.

And what about companies trading in the target's stock before making tender offers? Why should that be legal but not other trades made on inside information? Why the company and not the officers, if the company chooses to allow it?

You suggest that allowing insider trading would eliminate confidence in the market, buy why? Don't most people assume that insiders do trade? Weren't Japan and London home to very stable, very secure, very trusted exchanges even when insider trading was legal?

Let's not forget the argument that the insider information is actually corporate property. Those who come into possession of it almost never do as 'shareho;ders' but rather as officers and emplyees.

Why do we permit the taking of corporate property?

Why cannot the corporation trade in its own shares using the insider information that it owns? It feels wrong to let a corporation sell stock to the public when the corporation knows its results are coming up poor. Is that enough? Somehow (to me and obviously subjectiely) it does not feel so bad to let a corporation buy a bunch of its stock back knowing its results are coming up great.

"when doing so doesn't cause any one else to suffer a loss"

Then where does the money come from? You're assuming that insiders can make profits from insider trading with literally zero effect on anything else. Maybe those corporate value gnomes that you mentioned also print money.

"My objection is that people are not allowed to do what they wish with their property"

The trading profits are due to the inside information, which is the property of the company, not the employees. So we're not preventing people from selling something that belongs to them, we're preventing them from misusing a corporate asset for their own personal gain. And they know this before they take their job - certain jobs include restrictions, and you're always free to choose another career.

Should lawyers and accountants also be allowed to trade ahead of corporate announcements? Should securities analysts be allowed to trade for their personal account before releasing recommendations or reports? Should regulators (say, at the SEC or FDA) be allowed to trade stocks ahead of the announcements of their decisions? Should the people that count the votes for the Oscars be allowed to sell information on who won?

If insider trading was going to be allowed, it would obviously be better to post information on the website, but people still wouldn't know why insiders were selling, so it wouldn't be a noiseless signal. It could easily lead to over-reaction, with insiders selling to pay for some personal expense and outsiders trading on the possibility that there was 'something going on'. You seem to be saying that a posting of which insiders traded before an announcement is every bit as clear a signal as the announcement itself, but even then, why is it better than the announcement?

What about the possibility of managers manipulating announcements in order to profit personally? You can't answer that concern by simply repeating that, in your opinion, Britain looked pretty good even without insider trading laws (after all, the fact that they were advanced for their time doesn't mean that they would be strengthened today by changing back). As for Japan's 'very stable, very secure' exchanges, wasn't that during their bubble?

Many countries have had examples of blatant manipulation of stocks by insiders which has affected their corporate cost of capital, even after introducing half-hearted token rules against insider trading. The US hasn't eliminated all insider trading - that's probably not possible - but it doesn't have the extremes that other countries have. Why aren't companies around the world rushing to sell shares in countries with very low investor protection? Many exchanges would be happy to join a race to the bottom, if it paid. But it's easier and actually cheaper to raise funds in the U.S. (or the U.K.), under stronger regulation, because the investors value the protection they receive and thus demand a lower return.

Your bottom line seems to be that the profits from insider trading appear out of nowhere, so why not let insiders help themselves to extra compensation that's not in their contracts? In fact it's a win-win, since the market is so much more efficient and less risky after insiders take money out of it. So I ask again, where do the profits to insider trading come from, if not from other investors?

The corporation is not a "they" that operates in some isolated plane from the shareholders. The shareholders are the corporation: without them, the publically-owned business ceases to exist for want of capital.

The idea that part-owners who have acquired special information ahead of the other owners, have a right to act on it ahead of the other owners, is a rather impressively-stretched interpretation of co-ownership rights. The fact that stock markets make it very easy for owners to divest or potential owners to buy, does not change the fact that it is a co-ownership, and each shareholder is therefore subject to a different set of regulatory requirements than would be the case with a wholly-owned property.

Suppose A, a multibillionaire who invests for himself and who has a very good public record for picking winners, decides to buy $500 million in Company B.

The mere fact that he has bought shares of Company B is enough to send its stock skyrocketing. If he buys the stock without first making a public anouncement, is he an inside trader?

Suppose he is on the board of company B, is he an inside trader?

Other than cosmetics, what is the difference in these 2 situations?

"who invests for himself"

- you gave the main difference right at the front. There's nothing wrong with profiting from your own ideas - our markets depend on it. But when you're acting as an agent for others, and get that information as part of your role acting for others, the information doesn't belong to you. So, if the person got the information through being on the board of company B, he may be restricted in how he can use the information.

It's also possible that he's on the board of Company B but got all ideas and information independently. This law may limit legitimate contributions at times, since it's hard to tell where an idea came from (although he's only prohibited from trading on material, specific information, not on general knowledge). But no one is forced to serve on a board - if this person doesn't like any limitations that come with the position, he doesn't have to accept the place.

The insider trading rules are a result of an conflict of interest that the stock markets have with themselves.

Markets need to promote and facilitate liquidity. People with different amounts of information are good for the markets, as those with more information will always be trading with those who have less information, and there will always be plenty of opportunties to buy and sell.

On the other hand, in order to convince new blood to enter the market, the market must say to these inexperienced folk who are simply looking for a relatively smart place to put their money: "Look here; we are a safe, logical place to put your money. You have as much chance of making a nice, predictable profit as most anyone else here. Just follow the rules."

The insider trading rules, the Sarbanes-Oxley act, etc. are all a product of this conflict of interest. On one hand, every market player wants to be able to sell stock for more than it is worth, to some poor fool who has no idea what he's buying. That's the whole reason you get into a market in the first place. On the other hand, these market players need to convince said poor fools to get into the market in the first place.

These regulations are always created in response to widely reported instances of people with lots of information selling stock to people with less information, for much more than the stock is worth.

On one hand, Enron-type stock volatility is the whole reason markets exist -- if buyers didn't think they had more information than sellers, then nobody would ever buy or sell stock unless they were permanently getting rid of their equity holdings. There would be no reason to jump in and out of any particular stock, as each purchase or sale would seek exactly as risky as any other purchase or sale. Might as well just hold on to the stock you own; selling it would just create transaction costs, and leave you in the same position as before you sold.

On the other hand, nobody wants to get into a market where Enron can happen to them. So in order to find fresh meat to enter the market, those who already have insider information in their little niche areas have to play dumb, and pretend they're just "investing" in "equity" rather than trying as hard as they can to find a sucker to buy or sell from.

Well, we've reached the going around in circles portion of our entertainment.

The whole point is that there is no inducement from the insider to the outsider, so by definition that outsider has decided to trade independent of the information known to the insider -- she's going to trade no matter what, suffering the "loss "no matter what. The insider does not in any way cause the loss. Indeed, because the insider necessarily represents additional trading, the outsider might possibly suffer less of a loss.

Profit is diverted from other random traders, who would otherwise get a windfall. But why should we care? Of course, if our principle consideration is "insiders are bad, let's punish them," then by all means let's cut off our nose to spite our face (i.e., decrease total societal wealth and suffer a less efficient market in order to punish insiders). That does seem odd, though.

I don't think that a quick announcement that insiders are trading is as good as full disclosure, but it is better than nothing and there can be a long period of time between when insiders first know something is going on and an announcement could be made. (I misspent my youth at a large NYC law firm and, on several occassions, knew market moving information months before it became public.)

To answer Ann's question, I think that lawyers and accountants should not be allowed to trade on inside information.

The information is corporate property. So is the money that insiders are paid every week or two. So are the stock options they receive. So is the money that pays them when they're on vacation (OH MY GOD, insiders get paid for not working. It otta be a crime.) If the corporation doesn't mind, why should we? As Ann suggests, insiders could go to a company knowing whether they would be allowed to trade, and presumably their pay and benefits would reflect that fact. Equally, shareholders could trade in the company knowing that insiders were allowed to trade. My guess is that shareholders will prefer it.

"she's going to trade no matter what"

You can't possibly know that. Suppose someone has a limit sell order at $21, and the stock is currently trading at $20. Then an insider buys a bunch of stock ahead of a good announcement, pushing the price up to $21 and triggering the sell order. If the insider hadn't bought, the order wouldn't have been triggered and the current shareholder wouldn't have sold quite yet. Then she would have gotten the benefit of the good announcement that would have quickly pushed the stock up perhaps well beyond $21.

Similarly, someone who hasn't placed a limit order but is watching for a good time to sell might notice the price increase caused by the insider and decide to sell, when he wouldn't have otherwise. Plus, as I said before, others might notice the movement and start betting on what the insiders know, leading to more volatility.

Think about it this way: the price in the end is the price such that the market clears, i.e. supply equals demand. If there's net selling of 50 million shares, there must be net buying of 50 million shares, since I can't trade unless someone (perhaps a specialist or market market or even short seller, but someone) takes the other side. You're saying that an insider can buy, say, 5 million shares, and yet no other trades change at all - the other 50 million shares purchased and 50 million shares sold are fixed. No one changes any trades, yet 55 million shares are bought and only 50 million shares are sold. How does that happen?

You're biasing the debate in two ways: 1) by assuming that all other trades are inevitable; and 2) by looking only at the period just before an announcement. What about the broader incentive effects? What about the stockholders that never enter the market in the first place, because they know that they'll have to trade against insiders with a special advantage?

Again, you haven't answered my question: where do insider trading profits come from? You claim that insiders can take large amounts of money out of the market and yet, if anything, improve the profits of outsiders. Everyone gets more!

What you're really doing is focusing on the possibility that one or two people that planned to trade anyway might actually be helped by the insider's trades. I grant that, but that's only in certain special cases - perhaps a few people are helped, but others are almost sure to be hurt. If we look at the broad, overall effect, if the insiders are getting big profits, then someone else must be losing. And long term, the company is the ultimate loser because its cost of capital is higher.

Ann: Now you're just being disingenuous.

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