Monday, 26 October 2009

Justifying insider trading

Greg Mankiw apparently thinks insider trading is a good idea...at least, he links approvingly to this defence of it by Donald Boudreaux in the Wall Street Journal [An analysis of Greg Mankiw's clever "link deniability" strategy is coming in another posting].

An intriguing notion. It is broadly based on the idea that information is going to be hidden by companies anyway, so we may as well hope that insiders accidentally give it away by buying and selling stock.

Doesn't that seem rather defeatist? If public companies aren't providing the right information to investors, so the investors can't make accurate decisions, shouldn't we find a mechanism to make them do so?

Insider trading, because it enriches executives at the expense (at least in the short term) of other investors, destroys the trust which is a key variable in how well capital markets work. There is always an agency problem inherent in one person managing an asset on behalf of another. Trust is an important way in which this is overcome.

A narrow libertarian view of markets might imply that investors are purchasing management services from executives at arms length, and that it doesn't really matter whether they trust each other, because both parties are applying rational criteria of service quality and price. But a moment's reflection about the nature of organisations, work relationships, leadership and motivation makes it clear that intangible trust factors are really important.

And I believe that - in our present cultural context at least - if insiders are allowed to use privileged information at the expense of investors, trust will be destroyed.

An alternative proposal, then: insiders are only allowed to buy and sell shares by announcing a month in advance (or a week, perhaps) that they are planning to do so. This provides the same signalling benefits as Boudreaux's proposal but gives investors a chance to evaluate why the insider wants to transact, and decide whether to follow them in.

Some kind of protection would be needed against price movements and faking: the executive should enter into a conditional future contract, with the company or a broker, to buy or sell their shares provided the market price is within a certain range. The fixed range protects the executive against price movements; the future contract protects against people announcing their intention and then backing out after investors have acted.

This would give investors a chance to ask why the transaction is happening. If anything appears to be suspect, large investors will have the leverage (and resources) to conduct a proper investigation with a good chance of finding out whatever information they don't have.

As a nice bonus, this rule solves the other problem Boudreaux highlights: that executives can currently benefit from inside information by choosing not to buy or sell shares. At any given time when the insider has not announced a sale one month ahead, they have implicitly announced that they will not sell in the next month. Thus making clear to the market whatever it is that that signal implies.

1 comment:

Terry Arthur said...

Isn't Richard Epstien's idea simpler?

‘… for a company to legitimise insider
trading all it needs is a provision in its charter saying “if you
want to deal in the shares of this company, please understand
that every employee and every director is entitled to
trade on inside information to their heart’s content. If you
do not want to trade with us you are free to buy shares in
our competitor which does not allow that option”.’

The relevant article is in "Regulation without the State" (Readings 52, p39) published by the IEA