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Defending insider trading

Insider trading is almost universally judged to be bad. Company insiders, using information not available to the public, making stock trades and usually very high profits: Is that fair? How could allowing abuse like this be beneficial?

But if you value the importance of prices as conduits of information, allowing insider trading makes a lot more information available.

The Wall Street Journal article Learning to Love Insider Trading, written by Donald J. Boudreaux, makes this argument: “Far from being so injurious to the economy that its practice must be criminalized, insiders buying and selling stocks based on their knowledge play a critical role in keeping asset prices honest — in keeping prices from lying to the public about corporate realities.”

Here’s an extended explanation from the article:

Suppose that unscrupulous management drives Acme Inc. to the verge of bankruptcy. Being unscrupulous, Acme’s managers succeed for a time in hiding its perilous financial condition from the public. During this lying time, Acme’s share price will be too high. Investors will buy Acme shares at prices that conceal the company’s imminent doom. Creditors will extend financing to Acme on terms that do not compensate those creditors for the true risks that they are unknowingly undertaking. Perhaps some of Acme’s employees will turn down good job offers at other firms in order to remain at what they are misled to believe is a financially solid Acme Inc.

Eventually, of course, those misled investors, creditors and workers will suffer financial losses. But the economy as a whole loses, too. Capital that would otherwise have been invested in firms more productive than Acme Inc. never gets to those firms. So compared with what would have happened had people not been misled by Acme’s deceitfully high share price, those better-run firms don’t enhance their efficiencies as much. They don’t expand their operations as much. They don’t create as many good jobs. Consumers don’t enjoy the increased outputs, improved product qualities and lower prices that would otherwise have resulted.

It’s possible that scandals like Enron and Global Crossing might have been avoided if insiders were allowed to trade. Those who knew the true condition of these companies could have made a lot of money by trading on that information, thereby sending out price signals that these companies had serious troubles — information not known by the investing public.

Yes, these insiders might have become rich — unjustly so, say critics — and that’s the reason why insider trading is illegal. But contrast that with the tremendous losses suffered by investors in these companies who didn’t know what the insiders knew.

Boudreaux says that there are times when information should remain secret: “There are, of course, situations in which it is in the interest of both a company and the public for that company to delay the release of information. Such information should be protected as company property.”

So what is the regulatory solution? Let each company decide how it defines inside information, and how employees are allowed — or not — to use it. Investors will factor these policies into their investment decisions: a company that prohibits insiders from trading will be judged as riskier than companies that allow insider trading. That’s because investors will have less information about the secretive companies.

Because of the tremendous variety of companies and business strategies, corporations should be free to select their policies regarding insider trading. Realizing, of course, that all companies compete for investor capital, and a company’s information transparency is one factor in the competition.

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