Famous Insider Trading Cases

The next fundamental economic argument, one no economist has ever denied, is that insider trading will always push stock prices in the “correct” direction.6 That is, the effect of insider trading will always be to move a share’s price towards the level correctly reflecting all the real facts about the company. There is a debate on how quickly insider trading will do this and what the impact of insider trading is on the timing of public disclosure. But there is no debate on the basic proposition, and the economic logic underlying it is straightforward. The price of any commodity reflects individuals’ subjective measurements of a good’s utility. But individuals’ subjective measurement of the value of any good is obviously a function of information they have about that commodity. A nugget thought tobe iron oxide is discovered to be gold. That discovery tells us that the “market” will put a higher value on the nugget than was previously thought tobe true. And that is precisely the process by which insider trading (or for that matter any informed trading, whether by insiders or not) will shift stock prices in the correct direction. The direction is “correct” simply because it reflects more valid information. Obviously the process whereby markets process information into prices is conceptually and institutionally quite complicated,1 but happily this matter, as it relates to insider trading, is not in dispute. What is new since I first made this argument is a tremendously increased sensitivity to the importance of “correct” stock prices, or of an efficient market. Dependent functions include, for instance, investment decisions, the allocation of capital, the market for corporate control, and the market for managers. Each of these requires correct stock prices to function effectively. I might add that the welfare ofthe many economists basing their work on the accuracy of stock market pricing is also at risk.

Information as Compensation In my 1966 book I made another economic argument that I believe has had too little attention from mainstream neoclassical economists

The SEC has recently given convincing evidence ofits own inability to police its rules against insider trading, particularly where foreign funding of such trades may be involved. Mr. John M. Fedders, Director ofthe SEC’s Divisionof Enforcement, has proposed a rather extraordinary exportation of American law to foreign jurisdictions, particularly Switzerland. Under his proposal any purchase or sale of securities in the United States would automatically carry with it a waiver of the applicability of foreign secrecy laws.’5 The real effect of this is likely to be to force Swiss banks, which are unlikely to give up the advantages of bank secrecy, to refuse in the future to finance trading in American stocks.Amore classic use of regulatory apparatus to restrain foreign competition would be hard to imagine. And for the U.S. Securities and Exchange Commission even seriously to consider such an idea can only mean that it is severely frustrated in its efforts to bar insider trading. This argument is revealing in another regard since it suggests that there may be greater political pressure from some important SEC constituency than has been generally realized. After all, everyone understands today that insider trading is in the nature ofa “victimless crime.” Somehow it seems unlikely that such extraordinary pressures would be mounted by the SEC merely to police Swiss bankers’ morality. We shall return subsequently to this point. The enforcement problems I havejust been referring to are inherent in the SEC’s insider-trading rule. The ability to detect the practice will always be difficult, and when the gains that can be realized from the practice, discounted by the risk of being apprehended, are compared to the potential costs, many people will have the incentive to tradeon inside information. But there is an even more fundamental reason why there can never be significant enforcement of a rule against the profitable use of new information in the stock market. Most of us think that insider trading only takes place when the officers or other insiders, as in the classic Texas-Gulf Sulfur’6 case,
place an order with their brokers to buy stock before important new information about the company is disclosed publicly. That kind of trading may have some price impact, but we cannot be sure a priori how much impact it will actually have, if it will have any at all.’7 Given modern portfolio theory,” the assumption is that the demand curve for any given company’s stock is extremely elastic. Thus even large purchases of a stock will not necessarily have an immediate and noticeable effect on its price since many other stocks are seen as perfect substitutes for this one in other investors’ portfolios. This elasticity, however, is never perfect and, in general, heavy purchases or sales of a stock eventually will have an effect on its price. In fact, many people who exploit new information do not buy additional stock; rather, they simply do not sell.’9 If the stock is already in their portfolio, it may be sold or not as conditions dictate. However, with inside information, they know when not to sell any of their present holdings. Refraining from selling stock that would otherwise have been sold has exactly the same economic effect on market price as a decision to buy that same number of shares. But there is one crucial legal distinction: A failure to sell cannot be a violation of the SEC’s Rule lOb-5, because there has been no securities transaction. The SEC might like to punish people for what is in their head, but under the present state of law they cannot. The upshot of all this is that.people can make abnormal profits in the stock market simply by knowing when not to buy and when not to sell. They will not make as much perhaps as if they could trade on the information more efficiently, but nonetheless they will still make supra-competitive returns. And this is a form of insider trading that no one can do anything about. It may also be the dominant method of using inside information

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