Thayer Watkins


Explanatory notes on Henry Manne's article "Insider Trading and Property Rights in New Information" from Economic Liberties and the Judiciary, edited by James A. Dorn and Henry G. Manne.

Additional reference- Henry G. Manne, Insider Trading and the Stock Market.

Manne's article makes several important points. One of them is that the argument against insider trading rests on the emotional argument that shareholders who sell before favorable information is made public are hurt. Manne states,

"The most fundamental economic proposition in the whole topic of insider trading is that no shareholder is harmed by a rule of law that allows the exploitation of nonpublicized information about shares of publicly traded corporations. The naive argument in defense of the SEC's position on this subject is that if the shareholder had the information (good news) the insider had, he would not sell his shares." (page 317)

In order to understand why Manne takes this position we must understand that we are comparing the case (Scenario A) in which the insiders do not trade with the case in which the insider do trade (Scenario B). What we are not be comparing is the case of stockholders making their decisions without the information (Scenario A and Scenario B) with the case in which they make their decisions with the information (Scenario C). The ban on insider trading is not the same as a requirement that all information be made public.

Almost any stockholders who sold under Scenario B (insider trading) would also sell under Scenario A (no insider trading). To the extent that insider trading raised the price there might be some who sold who would not have sold if the price had not been raised.

To deal with such cases we must invoke a model of how investors decide to buy or sell. Generally we believe that people have their estimate of what the stock is worth and if the market price exceeds that then they sell. If it is below that they buy, but here we have to get more specific about the model. If the market price is below an investor's expectation of the price at that time and the investor is risk neutral (and there is no other investment with a higher expected return) then the investor would buy up to the limit of his or her financial resources. Risk averse investors would buy but not to the limit of their resources and the amount bought would depend upon the riskiness.

In order to keep the explanation manageable let us deal with the purchase or sale of only one share of a stock and assume that everyone's expectations are constant over the interval of time under consideration. Suppose the market price of a stock is $20. There may be people who believed the value of a share was, say $21, who would not sell at a market price of $20 but who would sell when the price rose to $22. The inside traders may have known that the market price would so go to $30 a share.

Set us consider in more detail the situation for those who believe the value of a share is 21. If the price changes continuously these people would sell out at $21.01. Under Scenario A (no insider trading) these people would sell at time T but under Scenario B (insider trading) they would sell at an earlier time S. The effect of a switch from Scenario A to Scenario B is that these people get their sale proceeds earlier and therefore they have a net gain from the switch. Thus the effect of the insider trading is to move backwards the time at which the stock achieves the reservation price of a particular investor.

There might also be those who would have bought a share at $20 but would not buy at $22 (and subsequently missed out on the raise to $30). But investors would have had an opportunity to buy at $20 and $20.01, etc. Such investors would not be affected by insider trading. So there would not be transfers of wealth from the current shareholders and prospective shareholders to the inside traders.

This is why Manne says the shareholders would not be harmed by insider trading. What people usually have in mind is a comparison of Scenario B with what would have occurred if the insider information had been known to the shareholders.

In the above it was presumed that market price follows a continuous path. If the price jumped discontinuously from $20 to $25 those with a reservation price of $21 would experience a capital gain that came from the price rising too quickly for them to sell out at $21. This gain comes from their having erroneous expectations but not having the opportunity to act upon them. It is somewhat of a problem as to how such gains should be counted. It is like someone wanting to buy a stock but finding that the broker refused to sell to him or her. Generally we would count such discrimination as a negative element in a person's life. But if the stock subsequently fell in price do we count the refusal as a benefit?

If people's expectations are not constant then the analysis is more complex but if each person's expectation relative to the market remains constant then the previous conclusions still hold. That is to say, if the individual who held a reservation price of $21 when the market price was $20 revises his or her expectation along with everyone else. Thus if the market price rises from $20 to $23 as a result of changing expectations (independent of the insider information) then the individual who thought the stock was worth $21 in the beginning may well think it is worth $24 when the typical investor thinks it is worth $23. If insider trading raises the price above the expected trend then that individual will sell out earlier than he or she otherwise would have.

In addition to the equity problem there is an efficiency problem. If the information is not made public then the prices of some goods are not adjusted and consequently people continue to consume resourses at one price when in fact these resources should command a different price. There is a net social loss for the period between the time the information became known to the insiders and when it became known to the general public. To the extent that the insider trading moves the prices closer to their proper level the net social loss is reduced. The more the insiders make use of the information the more rapidly the price rises and the lower the net social loss. It is the standard invisible hand effect.