University of Pennsylvania Law School
Penn Law: Legal Scholarship Repository
Faculty Scholarship
2001
On Insider Trading, Markets, and "Negative"
Property Rrights in Information
Zohar Goshen
Columbia University Law School, zgoshen@law.columbia.edu
Gideon Parchomovsky
University of Pennsylvania Law School, gparchom@law.upenn.edu
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Recommended Citation
Goshen, Zohar and Parchomovsky, Gideon, "On Insider Trading, Markets, and "Negative" Property Rrights in Information" (2001).
Faculty Scholarship. Paper 1367.
http://scholarship.law.upenn.edu/faculty_scholarship/1367
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VOLUME87
NOVEMBER 2001
NUMBER 7
A.RTJCLES
ON INSIDER TRADING, MARKETS, AND "NEGATIVE"
PROPERTY RIGHTS IN INFORMAT10l'�
"
Zohar Goshen* and Gideon Parchomovsk_v'
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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1.
l237
THE MARKET MECHANISM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A. The Market Players
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B. The Pricing Process ................................................................ 1238
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II. EFFICIENT AND LIQUID MARKETS . .
A. When Are Ji;Jarkets Efficient and Liquid? ............................ 1244
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B. The Relative Advantage of Anal_vsts over Insiders in
Providing
Efficiency and
Liquidity....................................... 1246
1. Efficiency ............................................................................. l246
2. Liquidity .............................................................................. 1251
C. Insiders' Exclusivity or Analysts' Competition .................... 1253
1. Inefficient Provision of Firm-Specific Information and
the Problem of intertwining Pricing and Management l256
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*Global Law Professor, NYU Schoo! of La'>v: '/isiting Professor, Columbia Law
School (Fa!l2001); Senior Lecturer of Law. !·kbre'>v University, Jerusalem.
*''Associate Professor, Fordham Law Schoo!. This paper has greatly benefited from
comments and criticisms by Bill Allen. Jan Ayres, Bernie Black, Lucian Bebehuk,
Abraham Bell, Yariv Brauner, Richard Buxbaum. R0b Daines, Kirsten Edwards, Mel
Eisenberg, jill Fisch, Jesse Fried, Ron Gilson, Victor Goldberg, Mitu Gulati, Jeff
Gordon, Joe Grunclfest, Assaf Harnclani. Henry Han:m><mn. Carolyn Jackson, Marcel
Kahan, Kimberley Krawiec, Yael Lw;trnann. Geoffrey Miller, Mitch Polinsky, Uriel
Procaccia, Dan Richman, Ed Rock, Roberta Romano. Alan Schwartz, Peter
Siegelman, Steve The!, ·william Wang. Charles Yablon, Omri Yadlin, and participants
at Law and Economics workshops at Boalt HalL Columbia, Stanford, NYU, and
UCLA.
1229
(Vol.
Virginia Law Review
1230
2. Inefficient Pricing and Reduced Liquidity
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III. POSITIVE EXTERNALITIES OF THE ANALYSTS' MARKET .
A. The Inform.ation iVJarket
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B. The Investment Banking Industry
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IV. THE CASE FOR NEGATIVE PROPERTY RIGHTS IN INSIDE
1:-�FORMATION
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V. EXTENSIONSOFTHEANALYSlS .
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A Selecrive Disclosure
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B. Warehousing .
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CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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INTRODUCTION
'R
..!..
EW issues have sparked as much debate and disagreement
among Law and Economics scholars as the prohibition on in­
sider trading.1 Ironically, the Supreme Court's attempts in Chiarella
v.
United States/ Dirks v. Securities and Exchang e Comtn.issiun/
and, most recently, in United States v. 0' Hagw/ to clarify the scope
and content of the ban on insider trading, and the subsequent reac­
tion of the Securities and Exchange Commission ("SEC"),; have
'See. e.g., Stephen Bainbridge, The Insider Trad i n g Prohib i t i o n : A Legal and
Economic Enigma,38
U. Fl a
.
L. Re v. 35,36 n.7 (1986) (noti n g that the a p p l i c ation of
the pri n ciples of Law and Economics to the problem of i ns i d e r trad i n g is h i ghly
controversial "both withi n the Law and Economics school and o ut s i d e it''). For useful
s u m maries of the debate, see generally Charles C. Cox & Kevi n S. Fogarty. Bases of
Insider Trading Law, 49 Ohio St. L.J. 353 (L988): Boyd Kimball Dyer. Economic
Analysis, Insider Trading, and Game Markets. 1992 Utah L. Rev. 1.
'445 U.S. 222,235 (1980) (holdin g that the ·'duty to di s cl os e under� iO(b) doe s not
arise from the mere possession of n o npublic market i n formation '').
'463 U.S. 646,654 (1983) (ho l d i n g that the duty
arises nut from the �lctual possession
to
d i sclose n o n p ublic information
of the in formation
relationship with the corporation or the sel l er of secur ities).
'521 U.S. 642, 647 (1997) (holding that "a p e r so n who
rc:rso n a l
profit. using confidential i n formation
but
t ra
des
misaprrupriated
from
in
in
:1
fiduciarv
·
se c ur it i e s
fo1·
br e a ch ot' a
fiduciary dutv to the source of the i n formation ,'· is guilty of viol a t i n g·� lO(h) a n d Rule
IOb-5).
'The S E C reacted to these holdings i n several ways. Following Cliiureila, in an
a ttemp t to narrow the scope of the holding, the SEC enacted Rule 14c-3(a), who se
validity in some contexts r e m a ins doubtful. Sec O'Hagan, 52L U.S. at 672 n.\7 (1997).
Then, in resp o ns e to Dirks the SEC had initially s u pporte d tbe co u rt ' s ru l ing ,
exempting sel ec t i v e disclosure to investment a n a l ysts. Later on, the SEC retreated
from i t s e a r li er position and attempted to expand Dirks' "person a l bc:n cfit" test. Sec
SEC v. Stevens, Litigation Release No. 12813, 1991 SEC LEXlS 451 (Mar. 19, Jl)9I)
( a tt em pti n g to hold Stevens l iable for i n forming market a n a lysts about earnings i n
20011
On Insider Trading
1231
onlv,..' added fuel to t he fire of t h e acade m ic debate already ragmg
.
6
on the 1ssue.
The most intrigui n g feature of the debate on insider trading is
that all contributors seek to promote the same goal: e n hancin g the
efficiency' and l iquidity" of securities markets.9 Substantial d is­
agrcernent exists. however, as to how the ban on i nsider trading
affects the twin goals of efficiency and liquidi ty. Critics of the ban
on insider trading main tain that permitting insiders to take advan­
tage of inside informati on is t h e best way to ensure efficie n t s hare
prices."' Given that insi ders have ready access to i n side informa­
tion, critics argue that permitting them to derive private benefit
from such information guarantees t hat new information \vill reach
t h e marke t rapidly, and consequently, that s hare prices will adjust
quickly to reflect the new information.11 By con trast, proponen ts of
t he ban con tend t hat repealing it will d im i nish market efficiency.'2
Since ins iders seek t o maximize their own gain, not market effi­
ciency, proponents con t end t hat absen t a prohibition on insider
trading, i ns iders would w i t hh old valuable information from t h e
market until i t is optimal for t h e m to trade, t hereby compromising
th e efficie ncy of the capi tal market.13
order to increase his reputation, although the action ultimately settled). Finding this
latter step ineffective, the SEC enacted the Fair Disclosure Regulations, 17 C.F.R.
§ 243 (2001 ), on August 24, 2000, partially reversing Dirks' holding. For a description
of the SEC's historical initiatives, see Donald C. Langevoort. Investment Analysts
and the Law of Insider Trading, 7(-, Va. L. Rev. 1023, J 034-36 (1990).
''Jonathan R. Macey. Insider Trading: Economics, Politics, and Policy 7 (1991) ("A
great deal of debate has concerned how much harm insider trading docs to
investors."). !vlaccy, perhaps the leading authority on the matter. writes: "Those ...
who takt: a ·tough minded' scientific or economic approach to the debate [about
insider trading] inevitably end by condoning the practice on efficiency grounds that
seem to others implausible. if not incredible.·· !d. at 2 (emphases added).
't\ securities market is efficient when share prices reflect all available information
about the traclecl companies and their businesses. Eugene F. Fama. Efficient Capital
Markets: c\ Review of Theory and E mpi ri cal Work, 25 J. Fin. 383, 383 ( l Y70).
'A sec uritie s market is liquid when investors can buy or sell shares on vcrv short
notice. Macey. supra note 6, at 7.
··See id. at ll ("All sides of the debate about insider trading have argued that the
rules they pr e fe r will enhance market efficiency and liquidity.").
;n
See id.
"See iJ.
12 See id.
''See. e.g .. David Ferber. The Case Against T nsider Trading: A Response to
Professur Manne, 23 Vand. L. Rev. 621, 6:23 (1970) ("But if insiders were permitted to
profit from inside information, there would be a natural tendency for insiders to
1232
Vir�inia Law Revie�v
(._,
L l
I ' l?/9
-87'
rvo1
L
Shifting the focus of t h e debate to a c o ntractual sphere, Carl t o n
a n d Fischel framed the m atter as an issue o f efficient allocation o f
property rights i n inside info rmation_'" Oddly, h owever, they as
well as other Law and Econo mics scholars h ave limited the li s t of
potenti al e nt i tlement h older s to t wo: tl�e managers a n d th e share­
scope of the inquiry has been
restricted t o the boundaries of the firm. ;\s Jonathan iVIaccy writes:
"[T)h e debate about insider trading is redlly a debate about how to
allocate a property right within a firm.,.,{, \Vhen insid e r trading is
permit ted, m an a ge r s '>vill reduce their salary deman d s by a n
amount equal t o the expected gain from insider trading, there fore
benefiting the shareho l d e rs wh o will pay !ower salaries to the man­
h olders_15 In
other words, the
agers. 17 The choice between paying higher sala ries a n d permitting
i n sider trading ultimately depends on the pa rticular c h a racteristics
of each i n dividual firm and on its m an agers' attitudes t oward risk.1�
Because d i fferent firms will choose to allocate property rights in in­
side i n formation diftercntly, a pmverfui argument in insi d er t r a d i n g
literature suggests t h a t s h areholders and manage rs should b e per­
mitted t o c ontract over the allocation of property rights in i nsid e
i nformation .19 Moreover, several schol ars h ave pointed o u t t ha t t h e
prohi bitio n o n i nside r tradin g does n o t benefit the shareholders be­
cause the ban does not transfer the value of the i nformatio n to t h e
prolong the period prior t o disclosun�··): Joel Seligman. The Reformulation of
Federal Securities Law Co;;cerning Nonpuhlic Information. 73 Geo. LJ. 1083, !119,
1121
(1985).
'"Dennis W. Carl t on & Daniel R. FischeL The Regulation
of Insider Trading,
35
�
�
Stan. L R e v. 857,866-72 (1983).
"See id. at 861, 863 (analyzing shareholders· and managers· e nti t l e me nts but stating
that "[w]hethcr insider trading is bendicial depend:; on whether the property right in
information is more valuable to the firm's managers or to the firm's inve�tors" and
structuring its analysis around this po int but acknowledging that "the arguments for
and again s t insider trading mav c;pply equally to t radi n g bv others''): see, e.g., David
D. Haddock & J on athan R. 1-l!accy, A Coasian Model of !nsidCi Trading, 80 Nw. U_
L. Rev. 1449,1449-50 (1986).
"Macey, supra note 6. at 4 (emph?.sis added).
17
Se e Macey, supra note 6. at 5-12: Haddock & Macey, supra note 15, at l463.
"See Macey. supra note 6,
at
4--12.
,. Carlton & Fischel, supra note 14, at 861--66 (applying the Coasc theorem to
insider trading ana ly sis ) : Haddock & Iv!accy, supra rwte l5, at 1451, 1468 ( calling for a
contractual resolution of the insider trading dilemma).
On Insider Trading
2001)
1233
shareholders, but rather to professional investors.2° Consequently,
the blanket prohibition on insider t ra di n g occasions a loss to the
shareholders as a group without o ffering them any redeeming
benefits. The shareholders lose twice: T hey pay higher salaries to
managers, and they do not get the value of the inside information.
The seeming superiority of a contractual solution to the problem of
insider trading has led several leac!in� C1.1mmentat ors to conclude
that the existing ban on insider trauing diminishes the welfare of
shareholders.:' Moreover, some of these commentators have even
sugges t ed that the ban on i nside r trading is the result of the dispro­
portionate political power of market a na l ysts who manipulated the
political process to e ffect a wealth transfer from the managers to
themselves.
22
We challenge both these conclusions and the analysis on which
they rest. In particular, we posit that existing analysis is misguided
as it rests on the erroneous assumption that property rights to in­
side information must be allocated within the boundaries of the
firm-namely, either to shareholders
or to managers. Conse­
quently, existing analysis ignores the possibility of awarding the
property right of inside information to market analysts. This omis­
sion stems, in our view, from the analytical convention that
property right entitlements must be positively assigned to a particu­
lar well-defined actor or group-in this context, managers or
shareholders. We observe that property rights may also be "as­
signed" negatively to deny a certain group (managers) the use of a
particular resource (inside information) in order to afford free ac­
cess to the resource to anyone who wishes to utilize it (market
analysts). We utilize this observation to develop an innovative
market approach to the problem of insider trading.
The adoption of a market-wide approach to the problem of in­
sider trading enables us to present three novel insights.
,., See. e.g., David D. H:1cldock & Junathan R. :vlacey, Regulation on Demand: A
Private Interest ModeL with an Applic<�tion to I nsidcr Trading Regulation, 30 J.L. &
Econ. 311. 338 (1987).
"See Macey , supra note 6. at 3-5: Haddock & Macey. supra note 15, at 1468.
"Sec
Michael
P. Dooley.
Fundamentals
(explaining why the SEC targeted
of Corporation
markt:t analysts as
Law 816-57
(1995)
part of its enforcement
p rogra m ) : Macey. supra note 6, ai 17-2.0 (describing to whom the insider trading
re g u lati on
was sole!); Haddock & Macc:y. supra n ote 20. at 328-29 (same).
Virginio Law Review
1234
First, we show that when market analysts are taken into consid­
eration, it becomes apparent that the choice between insiders and
market analysts raises a broader policy inquiry: 'vVhich of the two
groups�insiders or analysts�wi!l better enhance efficiency in in­
formation and capital markets'):'
'vVe demonstrate that analysts outperform insiders in providing
efficiencv to. both markets.�' in ,;,�cmities rn<lrkt:ts. analvst5 orice
..1
-
-
'
,.1
1
stocks more efficientlY than insiders because analvsts consider both
t
fi rm - s p e cific informa ion and general rnarket inf�rmation.:' In con­
th,.: forrner type of information.
to price efficiently."'- In addition, analysts
provide superior liquidity to financi 21 rnarkets.27 Liquidity cruciaily
depends on the number of transactions in the market. Both insiders
and market analysts trade when the market v a l u e of a given share
trast
�
insiders oniv
und rmining their
consider
;bility
deviates from their private valuation. However, because the sub­
jective valuations of analysts widely diverge, the number of trades
in a competitive analysts' market far exceeds the number of trades
in a concentrated insider market. Moreover, because market ana­
lysts are better diversified and capitalized than insiders, the volume
of trades generated by a competitive analysts' market is far greater
than the volume of trades generated in a highly imperfect insider
market.2'�
Second, we show that allocating the property right to market
analysts is the only way to ensure the integrity of securities mar­
kets. Gathering and processing information about share prices are
services that may be pe r forme d either by insiders or by market
analysts. Because of their superior access to inside information, in­
siders
would consistently
beat
market
analysts
when
trading
against them in the market and would e v e n t u a l l y drive the analysts
'' See i n fra Section I. B.
''See i n fra Section ll.B
'' See i nfra Section Il.B.l.
"'Sec infra Sec t i on T.B.l.
27 See Laura Beny, i\ Cornparativ�� Elnpirical Investigation of .Ag�.:�ncy' and fv1arket
Theories of Insider Tra_ding 6. h t t p://papt' t·s.s�;rn .con1/sol3/papcrs.cfn1 ?abslract_ici
=1 93070 ( Sept. 1999) (unpublished mzww;cript) (comparing the i m p act of insider
trading regulation i n t hirty-three countric:�; and finding thztt "v;c:aker i n s ider tra ding
regimes have, on average. less liquid equity mz�rkcts").
"For our discussion on liquidi ty and the superiority ut· analvsts in providing
liquidity. sec infra Section II.B.2.
2001]
On Insider Trading
1235
out of the market.2" This dominance would come at a dear price.
The existence of market analysts generates valuable positive exter­
nalities that woul d be lost if insiders were to control securities
markets. A com pe ti ti v e analysts' mar ke t p roduces efficient infor­
mation markets.�" Competition among ana l ys t s is responsible for
the plethora of i nfor m a ti o n sources. such as financial newspapers,
financial klcvision channels, and financial web sites. These infor­
matiun suurces improve investors· understanding of financial
mJrkc:ts anJ enhance their confidence in them, which in turn in­
creases both the number of investors and their wi l lingness to
invest. Moreover, these information sources improve o ve ra l l pric­
ing by other professional investors. Additionally, a vibran t
analysts' market supports the investment banking market and
draws foreign corporations from a less d ev e lo ped analysts' market
to issue shares and list them in countries with a better developed
analysts' market.'1
Given the numerous po sit ive external ities generated by a vibrant
analysts' market-all of which t1ow directly from the prohibition
on insider trading and would not exist otherwise-the issue of in­
sider trading cannot be left to contractual arrangement on a firm
by firm basis. In deciding whether to permit insider trading, firms
only consider their gains and losses, and exclude from the calculus
the broad er societal interest in having developed financial markets.
In a contractual regime, firms who stand to gain from permitting
insider trading will pe rmi t the practice vvithout taki ng into account
the social cost of their decisions. Our analysis indicates that the so­
ci;;\l cost of permitting insider trading may far outweigh the private
gain to the individual firms that would otherwise permit it. The de­
cision as to whether to permit insider trading should not be th e
subject of private contracting; the imposition of a blanket prohibi­
tion is the most efficient way to address the issue.
Final ly, our anal ytical framework illuminJtes two specific prob­
lems w ith which the SEC and the Supreme Court
h ave long
involves discl osure of inside information by
to a small
grappled. The first is the problem of ·'selective disclosure," which
'''See infra Part I:� ll.C.
'"See infra Section lll.A.
·'1 Sec infrJ Section I!T.B.
m a n gers
[Vol. 8 7 : 1 229
Virgin ia L a w Re view
1236
gro u p of ana l ysts ahead o f t h e m ar ket. 32 The secon d is the proble m
of " wareho using . " which arises when a po tenti a l bidder t i p s a small
grou p of related investors abo ut her intention to bid for a s p ec i fi c
t a rge t corporation based on t h e u n derstandi ng th at the i n ve s t o rs
wil l tende r t h e i r h o ld i ng to h e r onc e the bid is made p u b l i c . ' '
E ffectivE a s o f O c tober 2 3 .
2000,
the S E C ' s n e w l y enac t e d Fair
D i s cl o s ur e Re2. u i a t i o n s p ro h i b i t any form of se l e c ti ve d i sclus u r c .
m a nda t i n g i n s te ad eq ual t i mi n g o f discl os u r e . '" S ince this r u l e i n ­
c r e a s e s c o m pe t i t i o n amo ng a n < t l ys t s , i t w i ll c l e a r ly h a ve a d e s i r a b l e
e ffect o n companies e nj oy i n g higl: l i q ui d i ty i n t r a d i n g a n J \v i J e
an alysts ' co verag e . However, we show !hat the
SEC
h a s fa i l e d to
consi der the bene ficial market effects of selec t i ve d i s c l o s u r e o n
s m a l l a nd r e l a t i v e l y i l l i q u i d c o mp an i es .
35
For com p a n i e s t h a t fa i l to
attract s ufficien t i n vest o r <1 t t e n t io n , sel e c t i ve disclosure is an i m ­
portant mechanism for i n i tiat i n g
analy s ts ' coverage.
Th us, w e
q uesti o n the over- i nclusiveness o f the new rule. ·wh i l e w e c o m ­
mend the a pplication of the n ew r u l e to com p a n i es t h a t a l re a d y
have w i d e a n a l yst s ' c overage , w e believe that s m a l l comp a n ie s
whose shares suffer from illiq uid tr ad ing should be ex em pt. '(
·
As for warehousing, although the p ractice is prohibited under
SEC
R u le 1 4e-3 ( a ) , '7 the val i d i ty of this rule in this context rem a i n s
u n c l e a r . '' We show that l egal reg u lation o f warehousing r eq u i r es
car eful b al ancing between the market for corporate control and the
capital m a r k e t . W h i l e ware h ous i n g fac i l i t a te s s uc ce s s fu l t a ke o v e r s ,
i t m a y reduce t h e return t o a nalysts o n investment i n i n form ation."'
The ar t i c l e c o n s i sts o f fo u r parts. In Part I, we w i l l p rese n t o u r
m a rket m o d e l i n w h ich fou r gr o u ps o f i nvestors- i n s i ders, i nf o r m a ­
t i on t r a d e r s , l i q u i d i t y t ra d e r s , and noise trade rs-i n te r a c t . U s i n g
'' S e e i nfr<l S e c t i u n J V . A .
' ' S e c i n fra S e c t i o n l V . B .
" Fa i r D i s c l u s u r e Regu l a t i o n ,; , 1 7 C F . R . � 243
( 2000 ) .
I n t h e s e reg u l a t i U Jb . t h e S E C
h a s c h a nged c o m p l e t e l y i t s e a r l i e r p os i t i o n o f s u p p�) r t i n g selective d i s c l o s u re t u
i n vt� s t m e n t a n a l v � t s . Sec Lan gc1·oo n . su pra n o t e 5 , a t l035-36.
" Se e i n fra Sect i o n i V . A .
'' See i d .
'' S e c u r i t i e s E. xc h a n gc A c t o f 1 934 � l 4e . 1 5 U .S . C . S . § 7Sn ( c ) .
'' U n i t e d S t i i t e s v . O ' H a g a n . 5 2 1 U . S . 642 . 6 7 2 n . l 7 ( 1 997) ( " We l e a v e f o r a n o t h e r
d a y . wh e n the i ss u e re q u i re s d e c i s i o n . t h e l e g i timacy o f R u l e 1 4 e - 3 ( a )
' w a r e h o u s i ng· . . . . " ) .
"' See i n fn1 S e c t i o n I V. B .
;JS
<l p p i i e d t o
O n Insider Trading
2 00 1 ]
1237
this model, we will assess the effect of each group on efficient stock
pricing. In Part I I , we will analyze the conditions for attaining e ffi­
cient and liquid financial markets.
We
w i l l demonstrate that
analysts provide s uperior efficiency and l i q u i d i ty to financial mar­
k ets relat i ve to insiders. Tn Part IIL we will u n v e i l and describe the
positive e x t e rn al i t i e s ana i ys ts c o m p e t i t i o n gc n e r < i t c s fo r the infor­
'
mation marke t and the i n ve s t m e n t ban k i n g : n J u s t ry . Finally, in
Part IV, we will point out a n d assess t h e i m p l i c: t i o n s of our m arket
approach for the ongoing de bate about the regu l a tion of selective
disclosure and ware housing.
I . THE M A R K ET M ECI-I A N I S ;-.. 1
In this Part we sketch out a new model for understanding the
market dynamics affecting information and i ts impact upon stock
pricing and liquidity. This conceptualization e nables us to show
that the choice facing policymak e rs in regulating insider trading is
whether to set up an insider-based information market or an ana­
lyst-based information market . Comparing the two options, we
observe that the insiders ' market is highly inefficient relative to the
analysts'
market.
As
a result,
efficiency-minded policymakers
should favor the development of an analyst-based information
market.
A . The J'vlarker Players
The capitai market cons i s ts of four g roups o f players: insiders,
information trade rs, liquidity traders, and n oise traders."" Insiders
have access to inside information ' 1 due to t he i r proximity to the
firm. They also have the knowledge and abili t y to e valuate this in­
formation and to price it.
Information traders, the second group, lack access to inside in­
formation, but are willing and able t o devote re sources to gathering
"' For a detai led analysis o f noise t raders in c:lpita! mark e t s. see J. B radford De
Long et a!.. Noise Trader Risk in financial Markets, 9S J. Po l . Eco n . 703 (1990).
'' We use the term " i nside i n formation '· to d e scribe a p iec e of firm-specific
information produced within the firm and unknown to t h e pub l ic. After p ublic
disc l osure, the piece of informati on transforms i n to "pub lic information.'· However.
for clarit v"s sake, i n our a nalvsis we n e vertheless c o n t i n ue to rdcr to this i nformation
as " i nsid e i n formation,'' traci n g it to i rs origi n s .
[ V o l . 87 :1229
Viroinia
L a w RevielV
c"O
1 238
a n d a n a l y z i n g i n form a t i o n a s a b a s i s for t h e i r t r a d in g . A l t h o ug h in­
dividual
i nfor m a t i o n
t ra d e rs
do
not
necess a r i l y
p e rform
all
fun c t i on s o f i n formed t r a d i n g-for e x a m p l e . g a t h e r i n g i nfo r m a ­
tion,
processing
i nform a t i o n ,
and
trading
s e c u r i t ie s-t h e y
do
p er fo r m t h e fu n c t i o n s a s a gro u p .
I n fo r m a t i o n t ra ders a r e c o m p r i s e d o f t \\ ( ) s u b-gro u p s : mw!ysrs
a n d srock tJickcrs. i\ na lysts t1 r e e x p e r t s s p e c i a l i z i n g i n p r o v i d i n g
a n a l y t i c a l se rvices r e g ar d i n g t h e v a l u e of i nc !i v i cl u a 1 fi r m s as we l l a s
t h e m a r k e t as a w h o l e . I n t h i s A r t i c l e , we gro u p u n d e r t h e t e r m
' ' a n a lysts " a w i d e range o f pro fession a l i n ve s t or s w h o p r o d u c e fi­
n a nc i a l a n a l yt i c a l work upon wh i ch they n2se t h e i r i n v e s t m e n t
d e c i s i on s . L i k e t h e i ns i d e r s , a n a l ysts h a ve t h e a b i l i t y a n d k n o w l ­
edge to c o l l e c t , e v a l u a t e , a n d p r i c e i n form a t i o n . S t o c k p i c k e r s , t o o ,
c o l l ec t a n d e v a l u a t e i n fo rm a t i o n , b u t t h e y a r e l e s s effi c i e n t t h a n
a n a l ysts i n pe rfor m i n g t he s e fun c t i o n s . A s a r e s u l t , s to c k p i c k e rs
are " s l ow e r " at g a t h e r i n g . a n a l yzing, a n d respo n d i n g t o n e w i n fo r ­
m a t i o n . a n d t h e a c c u r a c y o f t h e i r e v a l u a t i o n s i s i nfe r i o r t o t h a t o f
a n a lysts . Therefore, s t o c k p i c k e r s oft e n b u y i n fo r ma t i on a n d a n a ­
l y t i ca l s e rv i ce s fro m a n a l y s t s .
The t h i r d group, liquidity traders, d o e s n o t c o l l e c t a n d e v a l u a t e
inform a t i o n ; r a t h e r , t h e i r i nv e s t m e n t r e flects t h e i r i nd i v i d u a l a l l o­
c a t i o n of r e s o urces b e t w e e n s a v i ngs a n d con s u m p t i o n . U n w i l l i n g t o
devote resources t o c o n s t a n t g a t h e r i n g a n d a n a l yz i n g o f n e w i n ­
for m a t i o n , l i q u i d i t y t r a d e r s , i f r a t i o n a l , w i l l fol l o w a s t r at e g y o f
b u y i n g a n d h o l d i n g a p o r t fo l i o o f s h a r e s .'12
F i n a l l y , n o ise traders , t h e fo u r t h group, act i r ra t i o n a l l y , fol l o w i n g
d i ffe r i n 2. m et h o d s of i nvest m e n t e i t h e r as i nd iv i d u a l s or a s a
V
gro u p . " ' Noise traders o ft e n b e l ieve t h a t t h e y are i n possess i o n o f
v a l u a b l e i nfo r m a t i o n a n d i n v e s t as i f t h e y a r e i n fo r m a t i on t r a d e rs . ' '
I n such c a s e s . o t h e r marke t p ar t i c i p a n ts c a n n o t s e p a r a t e n o i s e
t r a d e r s f r o m true i n fo r m a t i o n t ra d e r s .
B. Th e Pricing Process
I n si ders or i nfor m a t i o n t r a ders d e tect d i s cr e p a n c i e s b e t w e e n
v a l u e a n d p rice based o n t h e i n for m a t i o n t h e y p o s s e ss a n d t h e n
'' S e e I l a cl cl o c k & Macey, s u p ra n o t e 1 5 , a t 1 453-54.
"' S e e De Long c t a l . . supra n o t e 40. at 704.
" S e e i cl .
On Insider Trading
2001 1
1 239
trade t o c aptu r e the value o f the i r i nformational adv an tage ."5 W he n
the y obse rve u n de r v al uati on, the y buy, the re by rai si ng t he p ri c e ;
c onve rsel y . w he n the y sp ot ove r v al uati on, the y sell. the re by caus ­
i n g the p r i c e to d rop . S ince p ri ce change s are a l way s comp are d
with s o m e c <l i c u l a te cl v al ue . a trad e is tri gge r e d w h e n e v e r the p rice
c h a n Q.e i s n u l w a r ran t e d bv t he cu r re n tl v k n u w n i n form a t i o n .
(_l i v� n th i s i n \· l� s t rn e n t s t r a t eg y � t rad i n g a g a i n s t a p �l rty \\' i t h s u p!_-� �
-
.
r i or i nfo rm cl t i n n wi l l re s u l t i n a l oss .
L i q uid i ty t r a d e rs , w ho t rade i rr e sp e ctive of n e w informati on­
for ex ample . s e l l i n g for l iq uid i ty or bu yi ng fo r s a v ing-will trade
re g ard l e � s o f t h e 2 c t i o n s o f i nsid e rs and i n fo r m a t i o n t r ad e r s. 1 t is
i mp ortan t t o no te that insi d e r tr ad i ng d oc s not harm l i q u i d i ty t ra d ­
e rs. '" O bvious l y , whe n i nsi d e r trad i ng has n o e ffec t on stock pri ce s,
l i q uid i ty t r a d e rs w i ll not be harm e d . C ounte rin t ui tive l y , howeve r,
e ve n w he n i nsid e r trad i ng d oe s affe ct stock p rice s ( f or e xamp le ,
pri ces r ise w he n i n si d e rs buy) , i nsi d e r trad i ng d o e s not ad ve rsely
affe ct li q uid ity trad e rs." I nd e e d , if l i q ui d i ty trade rs tr ade i n the
same m anner as d o i nsid e rs-for e xample , buyi ng w he n i nsi d e rs
buy- the y lose since the y could have bought at a l owe r pri ce if t h e
i nsid e rs were not buying a s well. H ow e v e r, i f l i q ui d ity trad e rs tr ade
agai nst insi d e rs, the y gai n si nce the y w ould have bought for a
hi ghe r p ri ce abse nt sell i ng by i nsi d e rs. T he same i s true w he n li ­
q ui d i ty trad e rs sel l . Li q uidi ty trad e rs w ho foll ow the s trate gy of
buying and hold ing a p ortfol i o d o not lose on ave rage to e i the r in­
s ide rs or inform a tion trad e r s. W he n the y buy a p ort f oli o. t he y l ose
on some tr an sac tions ( w hen the y buy toge the r wi th insi d e rs or i n­
format ion
trade r s)
and g ai n on othe rs ( wh e n
the y buy w he n
insi d e r s o r i nf ormati on trad e r s are se lli ng) . Li kewise. w he n the y
sell t he p or tf ol io. t he y l ose at t ime s and gain at othe rs . O n ave rage
t hey earn t h e market re t u r n for the p e r i od of t h e i r hold ing. " O n ly
'' S e e .
e . !!
..
E u !! c n c:
A n �liysh J . .C S c pt .�bc t .
F.
F a m a . R a n d o m W a l ks i n S t ock
1 965. a t 55
iVL! rkd Prices. 2 1
Fi n .
(clc�cr i b i n g t h e p rocess by w h i c h rn a r k t: t prok,;si o n a l s
i n c o r por a t e i n fo r m a t i o n i n to pri ces ) .
" T ra d i n g bv i n fo r m a t i o n t ra d ers a l so d o c s n o t h a rm l i q u i d i ty t ra d ers.
" S ec l-! � J d d o c k & \'laccv. s u p ra note 1 5 , at 1 453-54.
.
'' I n o t h e r wor d s . the ' ' fa i r p l a y ' · or · ' m ar k e t i n tegr i tv . r a t i o n a l e s d o n o t h o l d w i t h
r c g a ;J t o t h ese i n\·c s t o rs : Th e v do n ot expect e q u a l a n d t i m c l v �1cccss t o i n formation
a nd i n d e e d they a n: not h a rn{ed by not ge t t i n g it. Cf. Robe rt' J. H a ft . The E ffect of
on the I n t e rn a l E ffi c i e n cy of
1 05 1 . 1 05 1 -53 ( 1 982 ) ( e x p l a i n i n g t h e " fa i r
l n > i d c r Trc1 d i n g F. uks
L. Rev.
t h e Large Co rpora t i o n s .
E:O
Mich.
p l a y " a n cl t h e ' · rn ar k t: t i n tegrity•·
[Vol. 87: 1 229
Virgin ia Lmv Re view
1 240
t ra d e rs wh ose trades a r e t riggered by c h a nges in p r i ce will l os e on
average w h e n t rad i n g aga i n s t i n s i ders or i n fo r m a t i o n t r a d e rs .�9
N o ise t r a d e rs a re a c t i v e b u t irratio n a l . T h e i r a c t i o n s a r e h a rd t o
predict . I f t h e y a c t corn p l etely r a n d o m l y t h e y w i l l c a n c e l o u t t h e e f­
fe c t o f e a c h o t h e r on p r i c e s . a n d . on average , t h e y w i l l n o t l ose t o
i n s i de rs o r �' n �1 l ysts . '" N o i s e t r zt d e rs . h owever. c;o m e t i m e s act as a
h e r d . T h e y Cii: he bear i s h or bu ! i i s h . as a g m L : p . ·w i t h r e s p e c t to a
spe c ifi c s t o c k :
�1
p a r t i c u l a r i n d ustry, o r e v e n
the rn a r k e t as a
w h o l e . 5 1 W h e t h e r t h e v w i l l l o s e t o insiders or i nform a t i o n t r a d e rs
deoe n d s o n t h e t i me i t takes t b e stock to r e a c h i t s e s t i mated
t
' ' v a l u e " as c a l c u l a t e d by i n si d e r s or i n fo r m ::1 ti o n t r a d e r s . S u ppose
i n siders anci i n fo r m a t i o n traders are of t he opi n i o n t h a t t he stock
I n t e r n e t . c o m i s over-va l ue d , and t hu s , sell t h e s t o c k . Noise t r a d e rs
w h o b u y t h e stock w i l l l os e i f t h e y b old t h e stock u n ti l i t e v e n t u a l l y
d r o p s . B u t i n t h e i nteri m p e ri o d t h e y c a n e arn a p o s i tive r e tu rn i f
t h e stock p ri c e c o n t i n u e s t o r i s e . I n t h e l o ng r u n , howe v e r , t h e y w i l l
l os e , a s a group. t o i n s i d e rs o r i n fo r m a t i o n t r a d e r s .
I n fo rm a t i o n t r a d e rs c a n n o t di s ce r n w h e t h e r p ri c e c h a n ge s are
caused by n oise traders o r b y i n s i d e r s . 5' W h e n n o i s e t r a d i n g is
m ixed with i ns i d e r t r a d i n g , i n fo r m a t i o n traders c a n n o t extract i n ­
forma t i o n fro m vo l um e o r price m ovem e n ts, n o r c a n t h e y d e d u c e
t h e i d e n t i ty o f t h e t r a d e r s _,_; T h u s , w h e n i ns i d e r s are p e rm it t e d t o
r a t i on a l e s ) : H a rrv I-k i i c r. C!ziun:lla. S E C R u l e 14c-3
Eco n o m i c T h e o ry . 3 7 Bus. Law.
5 l 7. 555-56 ( 1 982 )
an d
Dirks:
f a i rness versus
( m> t i ng t h a t i t is d o u b t fu l t h :lt
i n v e s t o rs q u e s t i o n the i n tegrity o f t h e nn rkct due tO k n own c! i fft.:r c n e e s i n i n fo r m a t i o n
avai l a b l e to i nvestors ) .
,., W i l l i a m K . S . W:.1 n g . Trad i n g u n M : 1 tc: r i a i N o n pu b l i c I n fo r m a t i o n o n Imperso n al
S t o c k M a rk e t s : W h o b f ! a rm e d a n d \V h o C; n S u e "vV h o m U n de r S E C R u l e l O b-s·: .
54 S.
C a l . L. Rev. J 2 l 7 . 1 3 1 1 - 1 2 ( 1 98 1 ) .
"' R a n d o m i z i n g
<:llld h o l d i n g
a
a
h rg c n u m b e r o f t r a d e s has t h e same protect ive: e f fe c t a s b u y ing
p o rt tc 1 l i u . H u w e v e r . t h is s t nt t e g y invo l ve s greate r trans a c t i o n costs.
" S e c De Long d a i . . supra nNe -10. a t 704--2 6 .
" C f.. e . g . . M o rris 1\ k n d c l so n . The Eco no mics of Insider Trad i ng Reco n s i d e re d , 1 1 7
U. Pa . L. R ev . 471J. 47-+ ( 1 969) (book review) ( ar g u i n g t h a t ' · [a J s l o ng as ot h e r
investors do n o t h �t v e t h e i n fo r m a t i o n [ t h a t i n s i de rs h a v e ] , t h ey h a v e n o reason to
c h a nge t h e i r u p i n i o n s o f t h e v a l u c of t h e s t o c k . ·' i rrespe c t i ve of n o i s e t r a d i n g ) .
" I t i s not ewort h y t h a t Professors G i lson and Kraakman h ave a rgued t h a t t he
t r a d i n g vo l u me or p r i ce move m e n ts may t h e m se lves s e n d a m e ssage to a n a l y sts
regard i n g t h e n a t u re tlt t h e i n s i d e i n fo r m a t i o n . especiallv if s o m e a n a ly s t s can d e d uce
t h e identity o f the i n s i d e t raders. Howe v e r , they have a c k n o w l edged that t his m e th od
is the least dficie n t \\"ay of ach i e v i n g e fficient pricing because t h i s p rocess o f
' " d e c o d i n g " i s i mpreci se: a n d s l o w . Sec R o n a l d J . G i l s o n & Re i n i e r H . K r a a kma n , T h e
M e c h a n i s m s o l· M a rk e t E fficiency. 70 Va. L. R e v . :549, :5 74--79 ( 1 9 84 ) . We sub m i t t h a t
200 1 ]
O n insider �Frnding
1 241
t r a d e , t h ey w i l l c o n s i s t e n t l y b e a t t he i n fo rm a t i on t r a d e rs . S i n c e i n �
form a t i o n t r a d e r s fo l l o w p r i c e s a n d r e a c t to i n form a t io n , t h e y w i l l
a l ways b e o n t h e l o s i n g s i d e . ' ' S u p p ose a n a n a l ys t . based o n t h e i n­
fo r m a t i o n a va i l a b l e t o h e r , b e l i e ves t h �1 t a price o f a ce r t a i n s to c k
a c c u r a t e l y repres e n t s i t s v a l u e . N o w s u p p o s e t h a t a n i n s i d e r is s e l l ­
i n g t h e s t o c k b a s ,� cl o n n e ga t i ve p r i v <H e i n fo r m a t i o n s h e p o s s e s s e s ,
c a u s i ng the stod: price t o ck c l i n � . The a n <t i ys L bc i ll g_ i gn c n a n t o f
t h e i n s i d e i n fo r m a t i o n . w i l l i n L c r p r c t L h i :s d c c l i n ·.:: a s a n tm d c r v a l ua­
tion a n d w i l l b uy t h e s to c k . The sLoc.k will c o n t i n u e.� L u d e c l i n e and
o n l y a ft e r the n e g a t i ve i n fo r ma t i o n becomes p ub l ic w i l l the a n alyst
r e a l i z e that she bought a n o v e r p r i c e d s t o c k . Th e same i s true of
p o s i t ive i n s i d e i nform a t i o n . I n !'orm 8 t i o n t r a d e r s c a n n o t d i vers ify
away t h e risk of t r a d i n g a g a i n s t i n s i d e rs . and t h e y w i l l a l w ay s l o s e
w h e n compe t i ng a g a i n s t i ns i d e r s . '' T h us , w h e n i n s i d e r t r a d i n g i s
p r e va l e n t , i n fo r m a t i o n t ra de rs vvi l l b e u n a b l e t o r e c o up t h e i r i n ­
vest m e n t i n i n fo rm a t i o n , a n d e v e n t u a l l y t h e y w i l l e x i t t h e m a rk e t .5'
our assu m p t i o n is more re a l i stic for several a d d i t i o n a l reasons. F i rs t . it is i m port a n t to
n o t e t h a t G i l s o n a n d K r a a k m a l l · s a r g u m e n t was m a ck rega r d i n g a market from w h i c h
n o i s e traders w e r e a bse n t . T h e a d d i tion o f n oise t r:td e rs m a k e s i t e v e n m o r e d i ffic u l t
for a n a l ys t s
to isolate i n fo rm e d t r a d i n g fro m
u n i n formed
t r a d i n g , t h us fur t h e r
reducing t h e efficiency o f d e c o d i n g . S e c o n d . e m p i r i c a l l y . t h e l'c a s i b i l i t v o f d e c o d i n g i s
c h a l l e nge d b y t h e fi n d i n g t h at m a r k e t s d o n o t d is p l a y ' · ,; t rong e ff i c i e n c y " ( i . e . . i n s i d e r s
d o o u t p e rform t h e m a rket ) . S e e . e.g . . Juse p h E . F i n n e rt v , I n s i d e rs a n d 1vl a rk e t
E f fi c i e n c y . 3 1 J . Fi n . 1 1 4 1 . ll4S ( 1 97 6 ) : H . Nej a t Sey h u n . I n s i d e r s ' profi ts . costs o f
t rad i n g , and m a rket e ffi c i e n cy. 1 6 J . Fin . E co n . l iN, 2 ll ( 1 986). T h a t i s . a n a l y st s arc
unabk t o d e t ect t h e n a t u r e o f the i n s i d e i n form a t i o n or tu deduce t h e i d e n t i ty o f t h e
i nside tra ders d u ri n g t h e t r a d e s o a s t u p r e v e n t :1 h n u r m a l re t u rn t o i n s i d e rs. S e e i d .
M o reove r. e ve n t h e i n fo r m a t i o n a b o u t <t l rc: a d v e x e c u t e d a m! rc p n r t e d i n s i d e rs · t rades
compo u n de d i n t h e S E C's Official Sum!IWIT i.s n n t a l way> e x h a �1stcd hy a n <J i v s t s . S e e .
e . g . . Jd'frey f. J a Uc . Speci a l i n form a t i o n a n d I n s i d e !· Trad i n g. -+7 J . B us. 4 LD. 428
( 1 974) ( s u gges t i ng t h a t i n ve�tors can p r u f i t i'rum p r o m p t usc or t h e Official
Summorv). C o m p a re H a l b e rt S . K e r r . The h a t t k of i n s i d e r t r a d i ng vs. m <�rk e t
d'fi c i e n c y . fi J . Portfo l i o M �m t . . S u m m e r 1 980. at -+7 ( u s i n � '! s t c� t i s t i c a i ana lvsis t o
s h o w t h ,1t exce s s r e t u r n s Gl� l n o l o n g e r be g a i n e d ) . w i t h R;1, m o n el G o l d i e & " K e i t h
A m b ach t s h e er. The b<m k o f i n s i d e r t ra d i n g v s . ma r J.: e t c fi'i c i c n c v : Com:nc n t . 7 J .
P o rt fo l i o i'v!gmt . . W i n t e r 1 9S l . a t 8 8 (concl u d i n g t h a t K e r r ' s re�u l ts ··sJww t h il t n o n ­
i n si d e rs con u s c the Official Sumn/ilrv t u e a rn excess p r o fi t s s i g n i f i c <1:l l l v m o re o ft e n
than not'').
" H a d d o ck & M J c e y . SLtpra n o t e 20. a l 3 1 S .
'' See W a l te r 13 a ge h o t . T h e O n l y G am e: i n Town. 2 7 fi n . A n a l vsts J . . 1\ Ln.-A pr.
1 9 7 1 . a t J2, 13 ( showi n g that in a mod e l wi t h i n formed t ra d e rs . m a r k e t m'1kcrs, and
l i q u i d i t y t raders. m a rke t m a k e rs a l wa y s l ose t o i n formed t raders).
"' Sec. e . g . , M i c h a e l J . F i s h m a n & K a t h l e e n M . H a g c r t v . I ns i d e r t r a d i n g and t h e
e ffi c i e n cy o f stock p r i c e s . 23 RA N D J . E c u n . . S p ri n g 1 9 92 . cH l 06. l JO (showing t h a t i n
a m o d e l w i t h out siders possessi n g kss p re c i s e '�'�d nl<) rt: cost!v i n fo r m a t i o n t h a n t h a t
' V \._·J i R
(J 7 · 1 ?/ 9
Virgin ia Lovv Review
1 242
L
� .
I
•
--
I n s h o r t . p e r m i t t i n g i n s i d e r t r a d i n g wou l d l e ad t o a m a r k e t w i th o u t
a n a l ys t s .
.:; ]
W h e n i n si ders a re r e s t r i c t e d from t r a d i ng, t h e o u t c o m e w i l l b e
d i ffe re n t . We c o n s i d e r a l e ga l res t ri c t i o n o n i n s i d e r t r a d ing t h a t i s
b a s e d o n t h e " d i sclose o r a bs t a i n " r u l e .'' U n d e r t h i :.; r u t·.: . i ns i d e rs
can e i t h e r d i s c ! <JS•.: L h e i n s i d e i n forrn a t i o n t h e y po�.; s ..:· '; ::, ;: ; ' ci t r a d e o n
t h i s i n fornt a t i o n l l! ��.t� !. he r \Vi t h I h C r e s t O f t h e lll � 1 r k ;�:- t O r J bs ta i n
from tracl i n so u n t i l s'o m c o t h e r le�al J u t v forces t h e m t u cl!:.;c i osc .'·'
O nce t h e i n fo r n 1 a t i o � 1 i s J i sclosed, i n s i d e rs a n d i n fo r i t� d t i o n t r a d � rs
compete to capt u re t h e v a l u e o f t h e i n form a t i o t1 . i n i i i �t i l y . t h e r e
w i ll b e o n l y a fe\v a n al ysts i n t h e m a r k e t w h o w i 1 l n: a k e a b n o r m a l
ret urns o n i n vest m e n t i n i n form ati o n . I n t h i s t ra n s i t i o n p e ri o d , t h e
m ar k e t w i l l be t e s s e fficie n t a n d less l i q u i d i n c o m p a rison w i t h t h e
�
�
�
p rece d i ng s tage i n w h i c h i ns iders were a l lowed t o trade ."') G ra d u ­
a l l y , h o w e v e r , t h e n um ber of a n a l ysts w i l l i ncrease a n d c o m p e t i t i o n
a m o n g t h e m w i l l b r i ng d o w n t h e r e t ur n
tion to
of
a
on
i n v e s t m e n t i n i n forma­
compe t i tive rate, thereby cre a t i n g a
more
effi c i e n t and
i n side r , the n u m b e r o f i n formed o u t s i ders d e c l i n es as � � f u n c t i o n o t t h e rc!;J t i ve
the i nside r:;' i n form a t i o n ) : H a y n e E . Leland, lnsickr T r a d i n g : S h o u l d It
Be Prohibited?. l O l l J . P o l . Eco n . 859. 883-85 ( 1 992) (conc l u d i ng t h a t i n a model w i t h
moiwp o l i s t i c i ns i de rs [l \)S s e s s i n g more pr e c i se i n fo rm a t i o n t h a n i n l n r m e d \l Utsick rs.
t h e w e l fare of i n formed u u t s i d e r s a l ways decl i n es w h e n the i ns i ders arc tr<Jciing ) .
" Evc:n i f o n e ;ls,umes t h a t a n a l v s t s c a n "decode" i n s i d e r t racl i n � o r clecl uce t h e
i d e n ti tv of t h e i n s i de t ra d e rs . it is clear t h a t t h is process or dccoJ i ng i> s l o w . cos t l y ,
and i mprecise. T h c r c !'ure. t h e e ffect of decoding on o u r a n ;1 l vsis w i ! l be: mcrdy
i n g w i l ! o n iy a ffect the degree w w h i c h i n � i d ·; rs \\' i i i d ri ve: a n a lysts
q u a n ti ta t i ve : D·.:cucl
.
out o f t h e m a r k e t - ra t h e r than z e r o a n alysts, t h e r e \Vi ! l be a .f(�t,· i d t . Yet. t h e process
\VC d escribed abuvc rcn-: a i n s v a l i d . In o u r ana iy·sis. \VC <1ssun1e ze n : d e c u d i n � i n o r d e r
t o h i g h l ight l llc. t e n s i o n h� t wct:n i ns i d e rs and a n a l y ;:; t s .
'' \Vc t �1 k c: w; g i v e n t h e c ur re n t r e g i m e prohibiting insiJc:r l r : t d i n g F o r a :; i � n i fi ca n t
propl"lS<t l to i n1 p r o v e t h e e x i s t i n g r e g i n 1 e . sec J e �se �d . Fri � d . R c d u c i n � t h e
P ru ti t ctb i l i t v o f Cor p o n l tC i n s i d e r T r a d i i� g Through Pr c t r a c! i n g D i :;c t l l:' U I C , 7 1 s� Cal .
L. R e v . :o r n . 306 ( i 9(,'8) ( a d vocatin g a rule t h a t req u i res i ;; �; i ck r:; t u d i s c J ,, s c: t h e i r
i n t e n d e d t r a nsact i u n :; prior t o t h t� i r execltt ion ) .
5'1 -Thc d i � c l o s c - o r - �l h :=; t �l i n r u l e d o c s n o t p re s cr i b e n p[t rt i cuLn 1 1 n1 i n g fu r d i sclo:-\ u rc .
R a t her. t h i s r u l e pe rmits c c c h i n d i vidual firm to a d o p t i t s o -.vn J i :-;c:cb u rc p o i i c y from
the pnm i ss i b k ra nge ck l i nc:.Hcd by m cmdawry d i sc l us u rc ruie,;.
· " Sec genera lly Reza u ! Kahir & Theo Vcrrnaekn, lnsider t r a d i n g res t r i c t i o n s and
t h e stock m a r k e t : Evidence rrom the A msterdam S t ock E:<cha nge . .:+() Eur. Ecu n . Rev.
l :i 9 L 1 5 9 1 ( l ':.l 96) ( e x a m i r� i n g the e ffect s ince l. 987 of i n t ro d ::c i n � i ns i d e r t r a d i n g
restri c t i o n s on t h e b c ! w ··.· i o r of t h e Amsterdam Stock E xc h a ngc , , n c! t'i nd i n g t h a t
" -;tocks b e c a m e l ess liquid" a n d t h at t h e re w a s s o m e e v i d c.: n cx o t· d ;�·� d u c t i o n '·in t h e
�;rock rnarket · � spc� c d o f adj ustn1ent t o positive e �t r n i ngs 1 1 C \VS . . ) .
an
precisi on of
")
() () .l1lJ
L.-U
On Insider Trading
l i q u i d m ar k e t .
'1
1 2 43
I n this m ar k e t , h oweve r , due t o t h e i r s u p e r i o r
skills, analysts will b e a t stock p ickers. Valuing i n fo r m a t i o n t r ad i n g
o v e r l i q uid i t y t r a d i n g b u t ack n o w l e dg i n g t h e superiority o f a na ­
lysts, stock p i c k e rs w i l l respon d by b u y i ng ana l y t i c a l s e r v i c e s fro m
a n alyst s . w h o w i l l s e l l r h e s e s e r v i c e s at a cornpe t i t i v e p r i c e .
,
I f o n l y a fc? \\' i n s i d e rs occ a s i o n a ll y v i o l a t e t h ��: r·�� s t �·i c t i c) n Ll n d
t rade o n i n s ici c i n !"o rnt a t iorL t h e a n a l y s t s � rn ar �: c t C ( ! n :_.; t i l l fu n c t i ·J � i .
S uch l i m i ted i n ·; i d e : t ra d i ng d i m i n i s h e s t o s o m e e ': l c n ; t h e c : ­
p e c t e d r e t u r n o t a n a lysts b u t l e a v e s t h e m a sufl:i c i e n t r e t mn t o
re m a i n ope r a t 1 v c .· T h e e :.: te n t o f i n s i d e r t r ad i n g � e h t h e o o u n d <; ­
r i e s o f t h e a n a l ys t < m 2 r k e t . Whe n t h e e x te n t o f i n si d e :· t r a d i n g i s
l i m i t e d , a c o m p e t i t i v e ana lysts' m ar k e t w i l l d e ve l o p : w h e n i n s i d e r
'
t rad i n g i s ext e nsive , n o a n a l ysts' m ar k e t w i ll form ." T h i s substi t u t i on
e ffect b e t we e n i D s i d c rs and a n a l ys t s i s the key to u n ck r s t a n d i n g t h e
b a n o n i n s i d e r t ra d i ng.
M a r k e t p r i c e s are the re sult o f the a c ti o n s of a l l fou r g r o u p s . In­
s i d e rs a n d i n form a t i o n traders follow market prices and c o u n t e r
.
d e v ia t i o n s from t h e i r c a l c u l a t e d s ubj e c t i ve ' ' v a l u e . , L i q u i d i ty t r a d ­
e rs who fo l l ow t h e b u y a n d h o l d s tra tegy d o n o t d i s t o r t p r i c e s
b e c a u s e o t h e r m ar k e t p a r t i c i p a n t s d o n o t assign i n forma t i onal c o n­
t e n t t o t h e i r t ra di n g activ i t i e s . N oi s e traders, o n acco u n t of t h e i r
i r r a t i o n a l i n vest m e n t s tr a t e g i e s , d i s t o r t p r i ce s . T h u s , t h e accuracy
o f s t oc k prices depends o n t h e a b i l ity o f ins i d e rs o r i n fo rm a t i o n
t r a d e rs t o coun t e r t h e a c t i ons o f n o i s e traders. Th e b e t t e r i n fo r m a ­
ti on t r a d e r s o r i nsi ders are a b l e t o c o u n te r p r i c e devi a t i ons c aus e d
by n o i se t r a d e r s or b y n e ,.v ! y disclosed i n fo rm a t i o n . the more e ffi ­
cient t h e m a r k e t .
l n l i ght o r I h i s rn a r k e t rn o d e L a n d g i v e n t h e go a ! df m a x i m iz i n g
t h e e ffi c i e n c y a n d l iq u i d i ty o f f i n a n c i a l marke t s , t h e q u c: s t i u n b e ­
carn e �·; \V h i c h group�i n s i d e rs o r an alys ts-is better �t b l c to a t t a i n
t h is goa l ?
"1 C f. Fish m a n & H a g e r t y . s u p r a n o t e 56. a t l 07 (arg u i ng t h a t · · i n ,; i Lk r t r �1di ng l e : t d s
k�:s e ffi c i e n t stock p rices ' ' ) . B u t s e c Beny. supra n o t e 27. a t 6 ( fi n d i ng t h a t " wea k e r
i n s i d e r t r a d i n � rcg i n 1 <� S h :·tve . t..) n a v e: rage. l ess l i q u i d e q u i t y lll<.l r k c t s ' ' ) .
" Se c J h i n y o u n g S h i n . The O p t i m a l Regulation o f l n sick ; Tr: 1 d i ng. 5 J . Fin.
l n t c r m c d i a t i u n -+9 . .+9 ( ! 9 9 6 ) (consi d e r i ng t h e op t i m a l e n fo r ce m ,� n t dfu n ' c1 n d c o s t s
to
in
a
model i n c l u d i ng i n ,; i d ers, i n fo r m e d m a r k e t p ro fe s s i o n a l s .
reve a l s that " to k ra t i n g
"·; ld.
i.l t
59.
sumc
i nsickr t ra d i ng
ca n
ami
l i q u i d i t v t ra d e rs
be t h e o p t i m a ! reg u ! a t t ; r v
!"J ! i cy'').
[Vol. 8 7 : 1 229
Virgin ia L a w R e view
1 244
T l . EFF I C I ENT A N D LIQU I D MARKETS
In t h i s P a rt , we a n a l yze t h e co n d i t i o ns u n d e r w h i c h c a pi t a l m a r ­
k e t s a re e ffici e n t a n d l i q u i d a n d expl a i n t h e i m p o r t a n c e t o t h e
e c o n o m y o f a t t a i n i n g t h es e g o a l s . I n t h e fol l o w i n g S e c t i o n s , w e
d e mo n s t ra t e . c o n t r a rv
t o c o n ve n t i o n a l wisdom . r h a t a n a l "vs t s a re
"
s u perior to ! n � i d c L' i n p r o vi d i n g e ffi c i e n c y a n d l i q u i d i t y to fin a n c i a l
m a rk e t s . I n t h e r-erT1 a i n d c r o f t h i s A r t i c l e , w e draw o n t h i s i m po r­
tar1t insi g h t t o p ro v i d e :1 n e w e c o n o m i c j u s t i fi c a t i o n for t h e b a n o n
i n s i d e r tra d i n g.
A Wh en A re Markets Efficien t and Liquid?
M a r k e ts are e ffic i e n t when prices accura t e l y r e fl e c t a l l a v ai l a b l e
i n fo r m a t i on rega r d i ng t h e assets t r a d e d in t h e m a r k e t ."4 A t t a i n i n g
effic i e n t pric i n g i s c r u c i a l fo r a c h i e v i n g effici e n t a l lo c a ti o n o f re­
sources in t h e e c o n o m y ."; A m o n g o t h e r t h i n gs, e ffi c i e n t p r i c i n g is
i m p o rt a n t for t h e market for corporate c o n t r o l , for m o ni t o r i n g a n d
c o n t r o l l i n g t h e m a n agem e n t age n cy problem , for t h e a l l oc a t i o n o f
resources t h rough i n i ti a l p u b l i c offe r i ngs ( " IPOs " ) a·nd s e c o n d ar y
offer i ngs, for k e e p i n g h i g h l i q u i d i t y i n t h e m a r k e t , a n d f o r o t h e r
t r a n s a c t i o n s i n t h e economy t h a t r e l y o n m a r k e t p r i c e s ."" M ar k e t s
are l iq u i d w h e n t raders c a n e x e c u t e t r a n s a c t i o n s s p e e di l y . T h e
m o re l i q u i d a m a r k e t , t h e fas t e r a t ra d i n g order i s e x e c u t e d .67 Liq­
u i d m a r k e t s b e n e fi t t h e e c o n o m y as t h e y reduce
the
c o s t of
t r a nsacting and the r i s k associ a t e d with i nvestme n t ."x
" S ee !vb rce l K a h a n . S c c u r i t i e ' Laws a n d t he S o c i a l Costs of " I n a c c u r a t e ' · S t o ck
P ri ce s . 41 D u k e L. J . 9 7 7 .
979 (1 992)
( d e scribing t h i s s t a t e as o n e w h e r e · · t h e m a r k e t
price o f a s t o c k cc> r r c � p o n d s to i t s fu n da m e n t a l v a l u e " ) .
6;
Sec genera l l y i cl . (descr i b i ng t h e v a l ue o f e ffic ie n t s t o c k p rices a n d various
reg u l a t i o n s t h a t a t t e m r t ro promutc e ffi c i e n cy ) .
'' S e e
id.
at
1005- 1 7 . 1 0 1 7-24.
1 028-34, 1 0l5-39
( d i s cuss i n g
c a p i t al
a l loca t i o n .
m a r k e t l i q ui d i t v . t h e p o t e m i a l o f management be co mi n g overly c o n c e rn e d a b o u t
maxim izi n g t h e
v a l ue
o f s t o c k ra t h :.: r t h a n t h e value o f t h e co r p o ra t i o n . t h e n ;; t u r c o f
t h e m a r k e t for c o r p o rate con t ro l a n d h o w i n effi c i e n t s t o c k prici n g m a y a ffect i t . and
o t h e r problems o r i n e ffi c i e n t stock p r i ces).
67
See
" See
id. a t 1 0 19-20.
id.
at
1 020
( d e scri b i n g
the
two
social
costs
of l o s i n g
l i q u i d i ty
' · t r a n s a c t i o n co� t s o f t rad i n g [ ] a n d t h e c o s t o f h o l d in g n o n -optimal p o r t fo l i os ' " ) .
as
the
On huider Trading
200 1 1
�
1 245
For marke ts to be e ffi c i e n t i nforn1 <1 t i o n a b o u t the v a l u e of firms
.
"�
.
1 pnces
mcorporaterd q u 1. c 1K I y ancl a c c u r at e I y m t o s t oc.(
.
,
must be
·
.
This process i n vo l ve s t \V O d i ffer e n t task s : o ro d u c t i o n of i n formal
•
tio n a n d p r i c i n g of i nform a t i o n . Production of infonnarion i n volves
searching for currc n i 1 y u n kno\vn i 11 forrnation that a ffe cts prices.
fJricing q�f in.f'n rn ? o rion req t i i re s a f H·Dces� of a n a l yz i n g l nforrn. a t i o n
i n o r d e r t o d e t e r rn i 1 1 e i t �) va l ue . :;cj t h c.t t o ne n1c1y t h e n trad e. based
on di screp a n c i e s bct\v�.-:: c n p rice and \' a lue.
Production of i n fo r m a t i o n i n v o l ves two d i ffer e n t t yp e s o f i n for­
m a t i o n : fi rm -specific i n form a t i on a n d general market info rm a t i o n .
Finn -sp ecific info m za rion i ncludes information a b o u t various at­
tributes o f the firm , such us the q us l i ty o f its m an agement, its
business plans a n d past record, its fi n a n c i a l posi t i o n , a n d the suc­
cess of the fi rm's rese a rc h and dev e lo p ment e fforts. General
market info rm a tion i n cludes inform ation about the gen erai cond i ­
t i o n s i n w h i c h t h e fi rm functions, s uch as the prospects o f
corn p etitors, t h e i n d us t ry as a w h o l e , a n d the l o c a l and g l o b a l
economy.
Pricing i nformation comprises t;,v o dist inct functions: a nalyzing
i nfo rmation and t r a d i n g A nalyzing info rm a tion req uires analyzing
.
both firm-specifi c and g e n e r a l market informa t i o n . Firm-specifi c
information cannot be accu rateiy p r i ce d i n isolation. One cannot
evaluate t h e future prospects of a corporation wi thout knowledge
about t h e estim a ted c o u rs e o f the local and global e co n o m i e s .
Trading is t h e a c t
by
whi c h inform ation is c ommunicated
to
the
market. Trading c a n l <l k e o n e of t1vo forms : d i rect t r a d i ng or indi­
rect trading through recom m e n d a t i o n s and advice 10 o t hers.
For m arkets to be liqui d , there m ust e x i s t s uffi cient trad i n £ to
e n a b l e m os t buyers and se l l e rs to con s u m m ate transactions expedi­
tiously . Liq u i d i t y i s a c h i e v e d as a res u l t o f three pri ncipal r-easons:
p o rtfolio adj ustm e n t s , con sumpti onlinvestmem adj ustrnents, and
'
divergence of opi n i ons. " Portfolio adjustnz enrs provide liquidity by
c a using c o n s t a n t changes i n the c o m p o s i t i o n of p or t fo1 i os t o bring
them in conformity w ith i1we s t ors ' predeterrn i n e d l e v e l s of risk and
''' See G i : s o n & K raak m a n . supra note 53 ( g i v i n g a comprehensive d e scri p t i o n o f the
processes by which m a rk e t s <lt t a i n e ffici ency).
7 0 H· ans
R . Stol i , A l t ';� r n a t i v c '-/ ie,vs o f �v,fa r k c t �·.tf a k i ng� in r•,.:I a r k � t i\.�ic.king a r: d the
Ch anging S t ruct ure of the S e c u r i t i e s l n d u s t r y o7. 67-68 (Yakov A rn i h u d C! al. eds . .
1 985 ) .
[Vol. 8 7 : 1 229
Virginia Lmv Re vie w
1 246
r e t u r n . This k i n d o f t r a d i n g i s r a n d o m among i nvestors. Consump­
tion/in vestment adjustments cre a t e l i q u i d i ty b y e f fe c t i n g s h i ft s o f
fun d s f r o m i n vestment t o c o n s um p t i o n a n d v i c e v e r s a . T h i s k i n d o f
t r a d i n g i s r a n dom w h e n i n d i v i d u a l s ' d e c isions t o red uce o r i n cr e ase
s a v i n gs are u n e o rr e l a t e d , but i t i s n o n r a ndom \\ h e n s p u rr e d by
t re nds in the c c o n o rn y (for e x a m pl e
reduced s a v i n
fo l l owing a
recc?ss i o n ) . U i v crgence of op in ions a m o ng m a r k ," l p l a y e rs c re a t e s
l i q u i d i ty b y p r o m p t i n g m a r k e t p L:tyers wi t h l o \Y C r v :l l u �l t i o n s t o
t r a n s a c t w i t h i n vestors w i t h h i g h e r v a l u a t i o n s . Th i s k i n d o f t r a d i n g
.
i s p a r t l y r a n d o m a n d p a rt l y n o n r a n d o m . D i scre pan c i e s b e t w- e e n
p r i c e a n d v::: l ue v i s - a - v i s n o i s e t r a d e rs c a n b e e i t h e r r�: n c! o m o r n o n ­
random
depe n d i n g
on
how
irra t i o n a l l y
n o ise
t ra d e rs
b e h av e .
D i v e rg e n ce o f o p i n i o n a m o n g a na l y s t s i s s p r e a d a l o n g a s p e c t r u m
w i t h some d e g r e e o f corre l a t i o n s i n c e v a l u a t i o n m e thods s h a re
m a n y c o m m o n c h a r a c te r i s t i cs .
B . Th e Relative A dvan tage of A nalysts o ver insiders i n Pro v iding
Efficiency and Liquidity
1 . Ejficien cy
Producti o n o f g e n e r a l m ar k e t i n form a t i o n i s costly. I t r e q u i r e s
s e a rc h in g , s o r t i n g , a n d orga n i z i n g i n fo r ma t i o n fro m a w i d e r a n g e o f
s o u r c e s . I ns i d e rs h ave n o a d v a n t age over a n a l y s t s i n prod uci n g
general
m a rk et
i n fo r ma t i o n .
On
t h e contrary.
a n a lysts
e nj oy
e c o n o m i e s o f scale a n d scope i n p e r form i n g t h i s t a s k . K n o w l e dge
ga i n e d wi t h r e s p e c t to o n e corpora t i o n in a part i c u l a r i n d u stry c a n
o fte n be used w i t h respect t o a n o t h e r . a n d k n ow l e d g e p e rt a i n in g t o
t h e e c o n o m y as a w h o l e i s u s e fu l i n a n a l yz i n g a l l corpor a t i o n s . I n­
s i d e rs
do
not
c h aracteri s t ic a l l y
produce
ge n e r a l
market
i n fo r ma t i o n , a n d i t is r e as o n a b l e t o assume t h a t t h e y wi l l b u y s u c h
i n fo r m a t i o n from a n al ys t s . 7 1
N o r d o i ns i d e rs h ave a n a d v a nt age w i t h r e s p e ct t o p ricing g e n ­
e r a l m a r k e t i nform a t i o n .72 H e r e , t o o , i t i s r e a s o n a b l e t o a s s u m e t h a t
7 1 As d iscussed l a t n i n this Article, analysts will prubdbly br: fu rced o u t o f t h e
m a r k e t . I t is u n l i ke l y t h a t the sale o f generz,) m a r k e t i n fo rm a tion to i n s i ck rs w o u l d
g e n e rate sufficient returns to sustain a compet i t i ve a n a l yst mark e t .
-, O n e oft-ci tt:d e:-; J m pl c is the f a i l u r e of i nsiders to foresee t h e October 1 987
m a r k e t crash. S e c: H. Nej a t Seyh u n . Overreaction or Funcl a m t n tals: S o m e Lessons
;o· o 1- lJ
1 247
On Insider Trading
-
i n s i d e rs will bu y pri c i n g services from a n alysts. S t i ! l . ge n e ra l ma r­
ket i n fo r m a t i o n t h a t is produced and p r i ced b y a s i n g l e a n a l y s t who
se l l s h e r s e rv i c e s to i ns i d e r s wi l l be i n fe r i or t o g e n e r a l market i n ­
p r o d u c e d a n d p r i ce d by n u m e ro u :s a n a l y s t s
71
o p e r a t i n g i n a c o m p e t i t i v e m a r k e t . A n a l ysts enj o y �� g 1 •.: a t e r c o l ­
l e c t i ve i n forn·l a t iu n b�tsc \vh i c h gives t h e n1 a gre a t �-:: r ! i � -..: ! i h t--, ncl o f
p r i c i n g accura t e l y gi \·r.: n t h e i r uncorrc l a t c d d i lfe r i ng \'c·t l u � t t i <J ! i S .
Prod u c t i o n o f fi r m - �; pe c i fic i n form a t i o n i s a byp rod u c t o f m a n <l g ­
i n g t h e c o r p o r at i o n . T h e m o r e bus in e ss c h a n ge s o c c u r . t h e m o r e
fi r m -specific i n fo rm <H i o n e x i s t s . T h e cost o f p r o d uc i n g fi r m - s r e c i ti c
i n fo rm ati o n h a s t w o c o m p o n e n ts : c r e at i n g b u s i n e s s c h �l n g c s a n d
l e a rn i n g a b o u t them . N a t ur a l l y, a n a l ysts ca n n o t 2 1fc c t b us i n e ss de­
c i s i o n s , s o t h e y m u s t l e a rn o f c h a nges after t h e y h ave o c c u r re d
Conseq u e n t l y , a n a l y s t s ' p ro d u c t i o n costs e q u a l t h e r e s o u rces s pent
form a t i o n
that is
.
on d i s c o ve r i n g firm s p e c i fi c in fo rm a t i o n
I n s i d e rs . i n con t r as t , c a n b o t h affect b u si n e ss deci s i o n s a n d s i ­
-
m u l t a n e o us l y
" l e arn "
.
a b o ut
them.
vVe
call
the
first
L! c t i vi ty
' · i n fo r m a t i o n - p r o d u c i n g m anageme n t . " W h a t i s t h e cost of i n for­
m a t i o n p rod u c i ng m a n a ge m e n t ? W h e n i n sider t r a d i n g is p r o h i b i t ed
-
,
i n s i de rs ' i nvestm e n t i n m a n a g ing t h e firm is a fun c ti on o f t h e i r
c o m p e ns a t i o n p ack ages a n d t h e e ffe c t i ve n e s s o f t h e app l i c a b l e
m o n i t o ri n g mechanisms. I t i s against t h i s benchmark t h a t t h e c o s t
o f i nform a t i o n-prod ucing m a n age m e nt s hould be m e asured . A s ­
s u m e t ha t u n d e r a restri c t i o n o n i ns i d e r t r a d i ng, i n si d e rs w i l l i n v es t
$ 1 00
in m an aging t h e fi r m and the v a l u e of the firm w i l l be
When i ns i d e r t ra d i n g i s p e rm i t t e d
,
$ 1000.
i n s i d e rs \Vi i i i n v e s t a d d i t i o n a l
res o ur c e s , o r d i ve rt exis t i ng ones, to cause busi ness c h a n g e s t h a t
i n c r e ase t h e i r t rad i n g o pport u n i t i e s . C e rt ai n l y i n i h i s c a s e . m ore
fi r m -specific i n fo r mation wiJ! be prod u c e d . Bm w h a t i s t h e cost o f
t h i s a d d i t i o n a l i n fo rm a t i o n ? This question c a n n o t be <1 nswerecl i n
t h e abstract. S i n c e i n s i d e rs m a y create a d d i ti o n a l t ra d i n g o p p o r tu ­
n i t i e s e i th e r by m a k i n g poor b u si n ess d e c i s i o ns or s o u n d •J n e s . o n e
m ust consi d e r the t o t a l e ffect of t h e s e d e ci s i o n s t o d e t e r m i n e t h e i r
d esi r a b i l i ty. A s s u m e that i n s i d e rs invest $20 i n order t o gain $30 i n
,
from I n s i d e rs' Response t o t h e 1Yl arket Crash of 1 987, 45 J Fi n . 1 36 3 , 1 36.1-6-1 ( 1 990)
(concl u d i ng from an examination of aggregate insider tran�;a c t i u ns t h a L t h e l 987 c r a s h
was largely unant ici pated ) .
' ' Set: G i lson & Kraak m a n . supra note 53. at 5 8 1 . Th i s i s the •.:s.c,c n er: P l t h e efficient
capi t a l m a rk ets h ypothe�;is: that n cl a nalyst wi l l be able t o beat the m a rk e t p rocess.
.
.
Virgin i({ Law F:evieH·
1 248
fVol
� 7 ·. ,l �
L;
·' · ..._
_n
;;
l
traclin ::::>o mofits. The $20 investment may be in addition to the $ 1 00
previ ously I n vested in managing the firm or i t may be par t of it i f
r e s o urces c:. r e n o w d iverted t o increase trading opportunities. I n e i ­
t h e r c a s e , r h . i s i s n o t t h e oniy effec t of t h e policy c h a n ge : Th e va l u e
o f t h e firrn \V O L:ld be affected a s \ve l l . 1'he val u e o f t h e fir1n rn ay go
dov.::n � S �lY t o SSOU� or go Li. p . sc;.y ! t) $ 1200. rfh�t t i s . t h e a t t e rn p t to
cc1 p t u r�; .:..l!...��E t i on a ! t rad i ng prDfi -r:; cc; u l d e i t h e r i n c rc. c 1 ��c o r- dccre::t:..� e:
.'l
the ·. ;(� l ue o f t h �.:: t"irrn . \v i t h n o r e l a t ionship t o thr: t r a d i n g p r o fi ts .
Assurning t h e pote n ti a l for trading profits fron1 pour a iH..l b e n e ficial
bus i n e ss ch 2ci:>1 U n s i s equal, the ex p ected addi i i o n a l ·val ue front in­
fotTn c. tit; n - p,·u d u c i n g management will be zero. The e x a c t e ffect o f
permitting ir�sider trading would u l timately depe:1d o n the c o m ­
pensation schemes and m o n i toring mechanisms i n each specifi c
fi rm. Thcref•.) re, for t h e purpose o f our analysis , w e assume n o i n ­
format i o n · p roducing m anagement-that i s , t h a t management
decisions are n o t distorted by the desire to p roduce firm-specific
inform atio n .
W e are l e ft wit h the " l earning" cost o f i n s iders. Because i nsiders
are an integral part of management, the marginal costs of o b ta i n i ng
firm ·spec i fic i n formation for i n s i ders is zero. M oreove r , the costs of
gath er i n g and organizing such i nformation ( for example, account­
ing) are borne by the corporation i n the regular co urse of business.
Theu:fore , n o incentive is required to motivate insiders t o learn of
and process fi rm-s p ecific inform ation .'• Con s e q uently, i nsi d ers
have an a dvantage over an alysts i n producing fir m-specific i n fo r ­
matio n . FlO\ve v e r . Lhe rnore firm -speci fic i n form<1 tion i ns i de rs
disclose to t h e:- rn arke t � the l e ss reS(1Urces ana lysts '.Vi E h ave to e x ­
pend tc this end. First , the discl osure duties placed em i nsiders,
apart frorn res trict i ng insid e r t r a d i n g � red u ce the a n alysts' costs u f
proclt�cing fi. rn1-,specific in forrr1ation . ':-; S e c o n d , even \vithin the d i s -
7 -l T h r: s c fl:c: ! s �L�ggcs1 t h a t t h e lcga! system s h o uld n o t gra n t i nsiders a prop�rty right
or a n y nthc"C p r •. • p ri::� r a. ry e n ti t1 c rn e n t in the i n forn1 a t i o n . Sci� /\. n t h o n y 1�. Kronrn ::·! iL
�v'1 i s t <� k e . I:: i ��cl',:':� u r c . I n ftJrn1atio n � iJnci the: L�=t\v o f C o n t racts. 7 J. Legal S t u d . l , 1 3-- ! .:�
( 1 972;) ( c rguing
U1at
�)ne
b e n e f i t frcrrn i L , b �i t t h a t
\Vht) deli berately acquires i n forn1ation rnust be a n c)\vcd Lo
there is no n r.:: e d !O p r o t e c t i n [o nr1 a t i o n 2c q ui red ;:Jsu. a l l y
w i t h o ur c; dei it·c ratc and cos t l y s e n rch ) .
'' S e c . e . g . , DougiciS \V. Diamon d , Optimal Release o f Information by Firms, 48 J .
F i n . I U7 L 10 7 1 ( 1 9S5) (demonstrating th:H w h e n the cost of relc::!sing ir.lo rrna.tion t o
t h e firrn i s l D \\·::.:: r rh,�n t h e aggregate expen d i tur� inc urred by investors t o ::�c q u i re the
info nn;,tion i n d e p e n d e n t l y , wcifarc is e n hanced i f the firm discl oses the i n fo r m a t i on ) .
200 1 ]
O n Insider Trading
i 249
cre t i o n a ry b o u n d a r i e s set by the m a nd a tory d i sc l os u re regu l a t i ons,
t h e prese n ce o f a n a l ys t s c a u se s corpora t i o n s t o a d o p t m o re reveal­
i n g disc l o s ur e pract i c e s . S in c e a n al y s t s are repe a t p l ay e rs i n t h e
c a p i t a l m a r k e t a n d c a n reward good a n d reve a l i n g d is c l o s ur e prac­
t i c e s and p u n i s h r e s t r i c t i v e o n e s . corp o r a t i o n s h ave an i n c e n t i ve t o
a d o p t r ·.� \ e a l i n g d is c l o s u re p ra c L i cc s .7'· T h u s . at t h e e n d o f t h e d a y .
i n s i d e rs · �l c! V< � n t a ge o v e r a n a l y s t s , i n t h i s r(�:; p c c t . w i l l h e m i n i m �1 l .
A s fm : i s p ri c i ng fi r m - s p e c i fi c i n for m a t i on i s c o n c e rn r:: d , i n s i d e rs
e nj o y �! rc a t e r p ro x i m i t y to t h e fi r m · s b usi nes s , h u t t h e y l a c k obj ec­
t i v i t Y . N�..: ve rt h e l c s s . t h e co n v e n t i o n a l v i e w m a i n t a i n s t h a t i n s i d e rs
h av e a b e t t e r u n de rs t a n d i ng o f t h e fi r m ' s b us i ne s s . T h i s ass u m p t i o n
e q u a t es s u p e r i o r access w i t h s u p e r i o r p r i c i n g a b i l i t y w h i l e i g n o r i n g
t h e p ro b l e m o f l ack o f o bj e c t i v i t y . T h i s v i e w i s b a s e d o n e m p i r i c a l
f i n d i n gs t h a t i n s i d e rs c o n s t a n t l y o u t pe r fo r m t h e m ar k e t .77 However,
t h e abnormal re t u rns of i n s i d e rs d o not necessarily i n d ic a t e t h a t
t h e y a r c b e t t e r t h a n a n a l y s t s a t p r i c i n g f ir m -s pe c i fi c i n fo rm a t i o n .7'
Firs t , i ns i d e rs use fi rm-specifi c i n fo rm a t i o n a ft e r a n a l ys t s h ave
priced all a v a i l a b l e g e n e r a l m ar k e t i n fo rm a t i o n . If i ns i de rs h a d t o
p r i c e b o t h types o f i n fo r m a t i o n s im ul ta n e o u s l y , t h e i r r e t u rn s would
l i ke l y be much lower .7y Second, i n s iders e nj o y two a d v a n tages over
'" A nalysts c1n punish companies tha t engage i n rest rictive disclosure practices by
rec o m m e nd i n g to t h e i r c l i e n t s t h a t they s e l l t h e stock of such co m p a n i es-<1
.
recom m e n d a t i LJn t h a t may c a us e t h e stock t o c r as h . This i s very s i m i l <lr to t h e ""\Val l
S t r e e t r u le . · ·
" Sec F in n c: rt y . ,; upra n o t e 5 3 . �> t 1 1 48: S e v h u n . s u p r J n o t e 5 3 . J t 2 1 0- l l .
Cf.. e . g . . S u g a t o C h a k r a v a n y & J oh n J . M c C o n n e l l . Docs I n si d e r Tra d i n g R e a l l y
M ove S t ock Pri ces":'. 3 -l J . fin. & Q u <J n titativc A n alysis 1 9 1 , l lJ l (1999) (<1 n a l yzing t h ·�
' " t ra d i n g �K t i v i tv or a cnn fcsscd i n s i d e t r a de r, [ v �: m Bocsky, i n c�nn a t i o n 's stock j u s t
p r i o r to N e s t i e " s ! 904 a c q u i s i t i o n o f C a rn a t i o n . " a n d f i n d i n g t h a t " o ur t e s t s �He u n a b l e
t o d i st i n g ui s h t h e p r i ce effect of B o e s k y" s ( i . e . . i n fu r mt: d ) p ur c h a s c>s o f Cm1 : H 1 u n ., ,
s t o c k !rum t h e e ffect of n o n - i n s i d e r ( i . e . , u n i n form e d ) purch ase s " ' ) . T h i ,; r e s u l t
w e a k ;.; n s the c LJ i m t h a t i ns i d e r t r a d i n g h as a b e t t e r price d i scovery p rocess.
" As e vide n ce t1l this likelihood . one may compare t h e lo w e r re t u rn s o f i n s i u e rs in
l arge firms- i n which the ab i l i t y t o have a s ub s ta n t i a l <Jdva n t a ge ove r firm-specific
i n fo r m a t i o n i s l i m i te d a n d m a cr oe co n o m i c fac t o r s h ave ;rre a t e r i n fl u e n c e o n f i r m s ·
p e rfo r m a n ce -w i t h t h e h i g h e r r e t u r n s o f i n s i d e rs i n s m� l l fir m s . T h i s co m pa r i son
s u p p o rt s om c l a i m . S e c . e .g. , T h o m a s Gosne l l ct a ! . , B a n k ru p t cy a n d I n s i d e r Tra d i n g :
D i ffe r c: n c c s B e t ween E x c h a n g e - L i s t e d a n d OTC F i r m s , 47 J . Fi n . 349, 3 6 1 -62 ( 1 99 2 )
(finding that insiders i n sma ller non-listed firms were t h e h e a v iest n e t sell e rs p r i o r t o
ban kruptcy. while weaker results w e r e obtained w i t h regard to insiders i n l m g e r listed
fi rms ) : S e y h u n . supra n o t e 5 3 . at 203 ( de m o ns t ra t i n g t h a t i n s i d e rs in s m a l l e r fi r ms
tend to t r a d e o n f i nn -s pe c i fi c i n fo r m a t i o n , wh i l e i n s i d e r s in l arg e r f i r m s , who are l t: s s
successful p r e d i c to r s o f t h e i r own fi r ms ' p e r form<J n ce , t e n d t o t r a d e m o r e on t h e b a s i s
'·'
Virgin ia L a w R e v ie 1 v
1 25 0
a n alysts:
timi ng
[ V o l . 8 7 : 1 229
a n d im m u n i t y from outside c o m p e t i ti on."' I n s i d e r s
c a n use firm-specifi c i n formation be fore ;:m a l y s t s g a i n access t o i n ­
form a t i o n w i t h o u t fac ing a n y compc L i t i ,) n from o u t s i ders .", T h u s ,
insiders' abnormal r e t u r n s arc n o t n e cessa rily t h e p r o d u c t o f s u p e ­
rior t �1 l e nt o r s kin and d o n o t indicatt"� r h �: r t h e y a r e b e t t e r a t p r i c i n g
fi r n1 -specific i n forr-r: a. t i c.: n . ·<� F� a t h c r . t h ;· ·; :�: (' rc: t u r n s a r e q u a s i -
o f m acrueconomic factors): i d . a t 20 1 ( o hsc: rv i n c: t h a t ·· i nsi d e rs i n s m a l l fi rms e a r n
s u b s t 8 n t i a i l y g re a t e r abno rrn � ! l cosrs o n t h e u n i i."n !!lh : d t r ::-t d c r:-; t h a n t h e i n s i d e rs i n
la rge
firms ' ' ) .
I n (l d cl i t i o n . a s t u d y o f i ns i d e r t r a d e s i n t h e U s l o S t oc k Exch a n ge -wh i c h i s a l e ss
e ffi c i e n t e x ch a n g e co m p a r c.d w ; t h t h c: m a r k e t ' in t h �� U n i te d S t a t e s-·' d ur i n g a pe r i o d
.
of l a x e n forceme n t of i ns i d e r trad i n g regula t i o n s . fo u n d t h a t i n s i d e r s e arned "zero o r
ncga t i w: a bn orma l " re t u rns a;-:d we re o u t pc r t'ormcd bv n w t u 3 1 funds. B . Espen Eckbo
& D a v i d C. S m i t h , The Cond i t i o n a l Pe r forma nce ut ! n :, i d e r Trades, 53 J. F i n . 467. 467
( 1 998) . S i mi l a rl y, a s t udy o f the p ro fi ta b i l i t y ( ) f i n s i J e r t r�1d i n g on the Vanco uver
Stnck Exc h a nge-a l s o a i c s s effici e n t m a r k e t t h c; n the m a r k e t s in the U n i t e d Stat es­
" wh e r e it m i gh t he a rg u e d t h <1. t t h e r e are l a rge i n fo r m a t i o n a l asy m m e t ri e s , " fou n d
t h a t , " d e s p i t e b e i n g a b l e t o i d e n t i fy p a r t i c u l a r prufitablc i n s i de r t r a d e s , t h e i n si d e r s d o
not, over a l l thei r t ra d es. o u t pe r fo r m t h e o ut s i d e rs . .. Robert H e i n ke l & A l a n Kra us.
The e ffect o f i n sider t rad i ng o n a verage rates o f re t ur n , 20 Ca n . J . Econ. 588, 588
( 1 987) (e m p h a sis o m i t t e d ): see R o n a l d J. D a n i e l s & J effrey G. M a c i n t os h . Toward a
D i s t i n ct ive C a n a d i a n C o rpo r a te L a w Regi m e . 29 Osgoodc H a l l L.J. 863, 873-74, 877
( 1 99 1 ) ( n o t i n g that C.1 n ad i a n m a r k e t s a rc i l l i q u i d a n d less •effi c i e n t ) ; J e ffrey G.
M a c i n t o s h . T h e Role o f I n s t i t u t i o n a l and R e t a i l f n v e s t or s i n Ca n ad i a n C a p i t a l
Markets, 31 Osgoodc Hall L J . 37 1 . 384 n.-+8 ( 1 993 ) ( noting t h a t Canad ian markets are
i i liquiJ).
"' See, e . g . . S t e p h e n H . P e n n: �m . A Cump<�riSl)n u l t h e I n fo r m a t i o n C o n t e n t o f
I n s id e r Trading a n d M a nagt· m c: n t
E a r n i n g s F u rcca�; t s . 2 0 J . F i n . & Q u a n t i t a t i v e
A n a l ysi s l . l ( 1 985) ( p r o p n s i n �. i h a t the ti m i n g o f i n si ck r t ra n s<Jcti ons r e l at ive to
v ol u n t ary e a rn i ngs i'o rc c as h i s . i n <tllll o f i tse l f. a ''<t i u a b l e piece o f i n formatio n ) :
S t e p h e n !-! . P ·c n m a n . I n sic!ct· Tr�; d i ng and D i s se m i n a t ion o f F i r m s · Forecast
I n fo r ma t i o n . 55 J. Bus. 479. 49 ! ( 1 98 2 ) ( fi n d i n g t h a t regi:,tc recl i n s i d e rs t e n d e d t o buy
( s e l l ) t h e i r firm's s h a r e s i n the pniod i m m e d i < t t e l y p r e ce d i n g favo r a b l e ( u n fa v o r a bl e )
e a rn ings �; n n o u n c c m e n t s a n d t u s e l l ( b u y ) s h �t rc:< s h u rt l v a ft e r Lt v o r a bl e ( un fa v o ra b l e )
a n n o u n ce m e n ts . co n cl u c! i n ;e t hc!l i n s i ck rs usc t he i r fcn·ccc; s t i n fu r rn �l l i o n i n tra d i n f( a n d
time t h e i r t r a d e s r e l at i v e t':� t h e fo r e c a s t d a t e ) .
" We ass u m e t h a t i n side r s in t o p posi t i o ns ctrc a b i c to a v o i d c o mpetit i o n n o t j ust
from outside a na l y s t s b u t from o t her i n siders as w d L I nd e e d , e m pi r ic al s t u d ies reveal
t h e existence o f an i n f o r m a t i o n c t ! h i e r a rch\' e frc c t a m o n g Ji f k r e n t i n s i d e r groups. Sec,
e . g . , K e n n e t h P. N u n n J r . e t � d . , A rc s o m e i n s i d e· ;·:; n w r c · ' i n si d e ' · t h an o t h e rs'), 9 J .
Po rt fo l i o M g m t . . S p r i n g
·'' I n d e e d , i ns i d e rs
arc
1 983. a t
l S.
o n l y �thk to bc t t c r " p r e d i c t .. /urge
llr
w z cxpccred ch an ges . Sec,
e.g . . J o h n E l l i o t t e t a l . . T h e .L\ ssoci a t i o n b e t ween l n sider Tra d i n g a n cl I n f o rm a t ion
-A7l � o u n ceme n t s , 15 R � n cl J. Eco n . 5 2 1 , 528--30 ( 1 984) (obse rving t h a t the strongest
e v i d e n c e of i n fo r m a t i o n -r e l a t ed t ra d i n g occurs a r o u n d e a rnings c h a n ges , p a r t i cularly
for small fir ms ) : J a m e s H . L o r i c & V ic to r N i c: Li c dwfre r. Predict ive a n d S t a t is t i c a l
P r o p e r t i e s o f I n s i d e r T r ad i n g . l l j. L. & E co n .
35. 4o-4 7 ( ! 9o8)
( p osi t i n g t h a t i n s i d e rs
2001]
O n Insider Troding
125 1
m o n o p o l i s t i c re n t s , ste m m i n g fro m the i n s i d e r s · e xclusivity over
'-'
n o n p u b l ic i n fo r m a t i o n .
I n s u m , i n s i d e rs a re not s u p e r i o r to a n alys t:;; i n produc i n g ge n e ra l
m a r k e t i n for m a t i o n o r i n p rici ng i nfo rrn a t i o n--b,� i t firm-spe c i fi c
o r g e n e ra l m a rk e t i n fo r m a t i o n .
' !.. i q u idirv
t t i s \�.r i d c l y agreed t h a t j n s i d e r t radi n g d i r n i
' :�� l i q u � d i L y . · r h i s
v i e \v i s b a s e d o n a t h e o re t i ca l n1 o d c i t h tl t suggc:)t�� t h J t rn a r ke t
m a k e rs 'N i l l ofls c t t he risk o f t r a d i n g ag::t i nst i ns i d e rs by i n cre a s i n g
''
t h e b i d - a s k s p r e a d . A l t h o ugh t h e i n c r e c1 s e d b i ci -:. t s k S Ji r e <:t d a rgu­
ment is s u p port i ve of o u r v i e w , we d o n o t w ;m t t o h clse our a n a l y s i s
s o l e l y on t h i s a r g u m ent for t w o r e a s on s . F i r s t . t h i s i s n o t t h e o n l y
e x i s t i n g m o d e l i n t h e l i t e ra t ure. A com pet i n g m o d e l s ugg e s t s t h a t
m a r ke t m a kers c a n b e t t e r compensate t h e m s e l ves b y r e d u ci ng t h e
b id - ask spread a n d i ncre a s i n g t h e vol u m e o f t r<H..l i n g."' S e co n d , e m ­
o i r i c a l s t u d i e s t h a t t e s t t h e impact of i n s i d e r t rad i n Q. o n t h e bid-ask
� p r c a d provi d e i n d e t e rm i n a t e re s u l ts . "
�
are s u p e r i or
forecasters of
l a rge-gre a t e r t h a n e i g h t perce n t-ch a n ge s i n t h e p r i c es o f
t h e i r own fi rms).
" Fo r a n example u r i n s i ders u s i n g i n fo rm 8t i o n to t h <:: i r ach a n i<tgc at t h e e x pense o f
t h e p u b l i c . see J i - C h a i L i n & J o h n S . H o w e . I n s i d e r Tr;J d i n � i n t h e O T C M a r k e t . 45 J .
Fi n .
1 273. 1 283
( 1 990) ( ri n d in g t h a t i n s i d e rs c o n s i s t e n t l v m a d e t h e righ t p e r s o n a l
we J i t h maxi m i z i ng deci s i o n : thev rdrai n e J fro m r u r c h a s i ng stuck u n t i l a ft e r t h e
release D f u n fa\·orabk i n fo r m a t i o n a n d from S•: l l i :1 g s t ock u nt i l <t ftt:r favor a b l e
i n fo r m a t i on w a �
re lease d ) .
,, S e c , <:: . � . . B a l'.c h o t , s u p ra n o t e 5 5 . a t 1 3 : Lawr.: nce R . C l u s l c n ,�\: p,; u i R . M i l grom.
�
Bid . ..-\ s k �<! n c! "rr,msaction Pr i c e s i n ;� S p c c i <l l i s t \:Li r k •: i w i t h f k t e ro ge n e o u s l v
7 1 . 72 ( i 98 5 ) . O n e �> ; i g h t ;nguc· t h ;; t m a rk e t m a ke rs
u u t o f the m a r k e t as a rc:suit u l· i nside'! tr:1d i n g because t hey c o u l d
p r u t c c t t h c n1�e ! v:::-; b y adj us t i n g t h e b i d -ask :=;prclt J . \V h i lc ; h i s n : :- � :.- b.:. t r u e . o n l y a
s m a l l p o r t i o n uf e� nalysts are m a r k e t make rs. and <: \ e n t h is s m a l l p tT , tect i n n wo u l d
c o m e a t t h e c o s t u f i i q u i J i tv.
'' S e c Thomas .1 . G e o rge c: t a l . . Tr a d i n g Vol ume and Tr<�<h<tctiun Cosh in S p e c i a l ist
!vl arkets. ·l9 J . F i n . l -tS9. 1 498 ( 1 994).
'" C o m p<lre Kce H . C h u n g & C h a rl i e Charoc n wung. l m ; d e r Tr; t d i ng and t h e B i d ­
A s k S p r e a d , 33 ;:- i n . R e v . . A ug. 1 998. a t J. 1 7 (esw b i i s i l i ng t h ;t t .. a l t h o ugh speci a l ists
may not be able to d e t e c t i n s i de r t r a d i ng i n a t i m e l y fa:; h i c :l . thcv p : o t c c t t he m s e l v e s
i n a g e n e r a i wc;v w i t h w i d e r s p r e a d s for stocks w i t h crD�s-se c t i u n ; i ! l v h i g h e r ins i d e r
t r ad i n g " ) , wi t h B r adford C or n e l l & E r i k R . S i r r i . The R e ;;ct i u n u f i n v e s t o rs a n d S to c k
Prices to I n s i d e r Tra d i ng. 47 J. F i n . 103i. l 0 3 2 ( 1 992 ) ( f i n d i ng t h a t i nsider tra d i n g
s ur ro u n d ing t h e acq u i s i t i o n o f C a m p b e l l Taggart hy /, n h e u :;,; r - B u�;ch did n o t re s u l t i n
wi d e n i n g or b i d - ask spreads ) , a n d O m c s h K i n i & S h ·: h z,,d ;vr i a n . Bid-Ask S p r e a d a n d
O w n e rs h i p S t ru c t u re . L S J. F i n . P.c s . 40 1 . 4 0 4 ( 1 9lJ:'i i ( li n d i n g " rw e v i d e n c e o f a
I n fo r m e d Tra d e r s . l 4 J . fin. E cu n .
wo u l d n o t
be d r i v e n
Virginio L o w Review
1 25 2
[Vo l . 8 7 : 1 229
\Ve argue
that the focus o n the i m p a c t of insider trad i n g on t h e
as determ i n e d by an u n i n fo r m e d m a r k e t m a k e r w h o
tr a des against i n formed insi ders, myst i fi es the an alysis. T h e u n i n­
for m e d
m a rk e t maker faces t h e p ro b l e m o f asym met ric
i n fo r m �t t i o n w h e n trad i n g e i t he r a g a i n s t a n a l y s t s o r a g a i n s t i n s i d ­
e rs L•, , t ! ! g i"Cl lt p s h : tve o.n i nfo r m a t i o n <.:· d �c: . Il u we ve r. t D d i ng by
i n s i d c: r�; i m p :J s e s < t m u c h g r e a t e r r i :.; k u 1 1 t h e u n i n l'o r m c d m d r !-.: c t
m a k r..: r. l n s i c! c rs . cl u e t o t h e i r e xr:: l u s i v i t v O \ C i' i n s i d e i n fo r m �H i o n .
ca n m a n i p u l a te t h e timing a n d volume o f the i r t r a ck s . <1 f2ct which
incre��scs t h e risk o f the u n i n formed m a r k e t m a k e r t r a d i ng a gai n s t
the m . B y c o n t r a s t , analysts, even w h e n e n j oy i n g a n i n fo rm a t i o n zl l
a u v a n tc t g e , w i l l a l way s h o l d diverging o p i n i o n s as t u t h e e x a c t i m ­
p a c t o f the i n form ation on stock prices, a n d t h e i r t r a d e ord ers w i l l
t h e re fo re d i v e rge from one anoth e r. This, i n t u rn, reduces i h e risk
faced by the u ni n form ed market m a k e r . I n a dd i t i o n , because ana­
l ys t s face compe t i ti o n fro m other an alysts, they cannot !l1<tn i p u l at e
o r t i me t h e i r orders. Thus, trad ing by ana lysts prese nts the u n i n ·
forme d market maker with a much lower risk r e l a t i ve t o trading by
i n siders.
Furthermore, the relative liquidity e ffects of insiders a n d ana­
l ysts ca n be a n al yzed i ndependently o f the reaction o f the
u n i n formed mnrke t maker to informed t r a d i n g . Ass u m e a market
without m a rket m akers, as is the case in several Europ e a n coun­
t ri es . " T r a d i ng in such mark e ts occurs t hrough di rect matches
b e t w e e n buyer and seller'' with i n i t i a l l i quidity provi ded b y inves­
t o rs a n d noise t r a d e rs. 'v Would i nsi ders pr o v i d e gre a t e r o ddirional
l i q u i d i t y relative t o ana lysts? We contend t h a t the c i e 2 r a n s w e r is
no. First, insiders h ave only o n e subj ective v a i u a t i o n o f t h e corpo­
ration. \V hen the price equals this valuation, i n s i d e rs w i l l not
trade .'" In a compet i t i ve a n a l ys t s ' m a r k e t t h e re i s a w i d e range of
b i d - e1 s l-.: p�· i c e s ,
pusi t i \·e re l a t i o n b e t w e e n b i d -ask s p r e a d a n d i n s id e r o w n e rs h i p . . and f i n J i n g ' · no
rc l a t i n n between
spre ad and i nsidcr trading'' ) .
·· ' The P a r i s Bourse. for i ns t a n c e .
'' T h i s i s a t rad i ng system k nown as conril/ l tO I I S d o u h l.: u u criuu n w rkers ll'ir/; o w
dcsig n u rcd !uarker makers. The operation a n d c fl'c c t s o f t h i s s y s t e m a r c q u i t e s i m i l ar
to t h a t o r a c u n t i nuous m a r k e t w i t h designated m a r k e t m a k e r s . s,.:: c: S t o l l . s u pra n o t e
73.
" 1 S e c id .
.., I n d e e d . o n e s t u d y h a s fo u n d t h a t t h e s t ro n gest c \' i ck n c c of i n fo r m a t i o n - re l a ted
t r< t d i n g occurs a ro u n d u :1 e s p c c t c d e a rn i ngs ch�1ngcs. E l l i o l l ct a ! . . s u p r a n o t e 82, at
5 2 8-30. S i m i l a r l y . A l be r t S . Kyle shows t h a t i n a m o d e l with " ;1 s i n gl e risk n e u t r a l
70. a t
On jnsider Tmding
200 1 J!
d i ve rgi ng, s u bj ective va l u a ti o n s .''' c:o n s e q u e n t l y , t h e re is a m uc h
gre a t e r pro b a b i l i ty t h a t a t a n y g ive n t i m e a s u b - g r o u p o f a n a l y s t s
wi l l e s t i nBte t h a t t h e p r i c e deviate s fro m t h e va l u e . T h e r e fo re . 2ln
a na l yst s ' m a r k e t c r e a t e s gre a t e r o p p o r t u n i t i e s for t r ad i n g .
Sec o n d , i :1 s i dc r � a r e re l uc t a n t to h o l d stock i n ve ntories t h <1 t w i l l
e n able t h e rn L n p r o v i d e l i q u i d i ty beca use t h e y [: rc risk-ave rse �t rHJ
hold u n d i \·c r·� i r·
p o r t fcd i u s .'<: �rb c i r h u iTl a n cap i t a l is i n v e ::: l �..: cf i n
t h e corpt)rat i o i: . a n d t h t..: o n ! y \:vay t h e y c a n d ive rs i fy is h y p l a c i ng
their fi n a n ( i a l ca p i l a i c l sc \v h e re . For t his r e a �) o n , they \V i l i be re l uc­
.
tant to i n ve s t t h e i r s a '.,; i n gs i n the same c o r p o r a t i o n . A n a l y s t s . by
c o n t r a s t h o ld d i v e rs i fi e d p o r t fo l ios a nd a dj us t t h e i r p o r t fo l i os fre­
.
q u e n t l y \Vh i ch e n a b l e s t h e m t o provi de g r e a t e r l iq u i d i t y .
Third, i n s i ders h a v e l i m ited res o ur c e s r e l a tive t o t h e a n a lysts·
m ar ke t . S i nce the value o f i n s i de i nfo r m a t i o n i s u n ce r t a i n , it is d i f­
,
fic u l t to borrow aga i n s t s u c h i n form a t i o n . More o v e r , it is d i ffi c u l t
t o s e l l s u c h i n forma t i o n t o i nv e s tors d ue t o t h e i n he r e n t confl i c t o f
i n terest between i n s i d e r s a n d o u tsiders. O n c e i n s i de i n fo rm a t i o n i s
s o l d , i n s i d e rs c a n d i m i n i s h a n d e ven d e s t r o y its v a l u e by m a n i p u l a t ­
i n g corporate d e c i s i o n s a n d b u s iness a c t i v i t i e s . A n al ys t s as a group
have gre a t e r fi nancial r e s o urce s , a n d they are able to sell t h e i r i n ­
for m a t i o n t o i nvestors w i t h o u t t h e c o n fl i c t o f i nt e r e s t p r o b l e m . � ' I n
s u m , b e c a us e of t h e i r gre a t e r n u m b e r o f d i ffer i n g s u bj ec tive v a l u a ­
tions,
their
s uper i o r
fi n a n c i a l
resources,
and
their
diversi fi e d
holdings, a n a l ys t s w i l l p r o v i d e gre a t e r l iq u i d i ty t o fi n an c i a l m a rkets
than will i n s i ders.
C. jnsidcrs ·
J:xclusivi(v o r A n alysts ' Compelition
As s h own a b o v e . i n s i de r s cio not have an i n h e re n t adva n t age
ove r a n alysts i n s u pport i n g effi ci e n t and l i q u i d m a rkets. T n t ro d uci n s i d e r . r�t n d n rn n o i ��� t ra d e rs � a n d con1pc t i t i v c r1sk n e u t ra l n 1 a r k c t n1�1 k c rs . " L h c
o p t i m �t l t rn cl i n g k •:ci f n r t h e i n s ide r i n c reases w i t h v a l u dprice d i ffere n t i a l . A l b e n S .
.13 1 ) ( 1 (J8) ) .
'Jl S c � Farn:: . s u p r a n u l c 4 5 . a t 5 6 .
'" Carl t o n & Fisch e l . surra n o t e 1 4 . a t 368. 375-76.
'" O t h e r cun i'l i c t > of i n t e r e s t . h o w e v e r . s t e m m i n g from t h e com p l i ca t e d r e i a t i D n s h i ps
betwe e n a n �t l ysts aml m a n agers. m i g h t t a m p e r w i t h a n a l ys t s ' o bj e c t i v i t y . Sec
L a n g e v o o n . s u prr, n o te .5 . a t 1 0-W--44: Roni iVlichacly & K e n t L . Womack. Co n rl i ct , , f
Kyl e . Con t i n u u u s A u c t i ll n S a n d I n s i d e r Tra d i n g , 5 3 Eco n o m e t rica 1 3 1 ) .
Interest a n d t h e: C r e d i b i l i t y o f U n d e r w r i t e r A n alyst Reco m m e n d a t i o n s . 1 2 R e v . f i n .
S t u d . 653 . (J) 3
( I 0') 0 )
.
(fi n d i n g t h a t . recomme n d a t i o n s by u n d e r w r i t e r a n a l y s t s s h u w
s i g n i fican t e ': i d e ncc o f bias . . . suggesti n g · 'a pote n t i a l confi i c t o f i n te rest i n he r e n t i n t h e
d i ffe re n t funct i u n ' t in t i n ve s t m e n t b a n k e rs pe rform .. ) .
Virgin ia L m v Review
1 254
[Vo l .
8 7 : 1 229
ing the fac t that i ns iders e nj o y v i r t u a l e xcl us i v i ty o v e r i n s i d e i n fo r ­
m a t i o n compl e t e l y t i l ts t h e sc a l e i n fa v o r o f the a n a l y s ts .'!" G r a n t i n g
i n s i d e rs p rope rty r i ght s i n i n s i de i n fo r m a t i o n confe rs u p o n i n s i d e r s
a v i r t u a l e xc l u s i v i t y o v e r t h e p r i c i n g a n d p r oce s s i n g o f t hi s i n fo rma­
t i on .
The fact t h a t i n s i d e rs face n o s u b s t : ; m \ :_ : \ com p e t i t i o n d i m i n i s h e s
e ffi c i e ncy i n t\VO r ;:: a t rn s : t h e S<.l l c: \ -i f t"l r· E11 - :.; f>c_: c i fi c i n fo r n1 a t i o n a n d
t h e p rovis i o n o r e ffi c i e n t p r i c i n g a n d l i L: u i d i t v t o s p e c i fic s t o c k s . B e ­
fo re s ubs t a n t i a t i n g t h e s e c l a i ms , lww e '/ e r. w e: n e e d t o address two
p r e l i m i n a r y i ss ue s : why t h t: r e l e v a n t rn a rk d for d e t e rm i n i n g i n s i d ­
e r s · m a r k e t p O\w� r is e a c h s p e c i fi c s tuck . :: m el w h y i ns i d e r s a s a
gr o u p a r e l ess com p e t i t i ve t h a n a n al yc; t s as a grou p .
O n e m i g h t a rgu e t h a t d u e to s u b s t i t u t i o n a m o n g i n d i vi d ua l
s t o c k s , t h e d e m a n d for e a c h i n d i vi d u a l s tock i s perfe c t l y e la s t i c ,
a n d h en c e i t i s t h e s t o c k m a r k e t as w h o l e t h a t s h o u l d b e t h e foc a l
p o i n t o f t h e a n a l ys i s r a t h e r t h a n e ac h i n d i v i d u a l s t o c k . T h e m a i n
r e a s o n for t h e subs t i t u t i o n e ffe c t i s t h a t s tocks a r e f u n g i b l e­
c haracterized o n l y by r i s k a n d e x p ec t e d r e t u rn . C o n s e qu e n t l y, t h e
i n d i v i d u a l c h aracteri s t i cs o f a n y i nd i v i d u a l s tock c a n b e r e p l i c a t e d
s
b y p u rc h a s i n g a portfo l i o o f s e v e r a l ot h e r stocks." T h e r efor e , i n ­
vestors c a n s u b s t i t u t e i n e ffi c i e n t l y p r i c e d s t ocks w i t h i ns u ffi c i e n t
l i q ui d i ty for o t h e r stocks.
T h i s argum e n t runs i n t o two problems: The f i r s t i s t h e o re t i c a l
a n d t h e s e c o n d i s e m p i ri ca l . T h e t h e o r e t i c a l defi c i e nc y o f t h e p e r ­
fec t subst i t u t i o n arg u m e n t i s t h a t i t a s s u m e s a p e rfe c t l y e ffi c i e n t
m a rket a l re a dy i n e q u i l i b r i u m . Th i s t h e ory ad opts a s t a t i c v i ew o f
t h e m a r k e t a n d d o e s n o t c o n c e rn i t s e l f w i t h t h e process b y w h i c h
m a r k e t s a t t a i n effi c iency. A s e x p l a i n e d e ar l i e r , m ar k e t s b e c o m e e f­
f ic i e n t t hrough a dynarn i c p r oce s s t h a t i n volves s p o t t i n g d e vi a t i ons
b e tw e e n value a n d pri c e a n d corre c t i n g t h e m . T h e r e fore , from t h e
v a nt ag e p o i n t of i n fo r m a t i o n traders. t h e r e l e v a n t m a r k e t i s t h e
s p e c i fi c stock t o vv h i c h t h i s p r o c e s s i s a p p l i e d a t a n y g i v e n t im e .
T h e e mp i r i c a l flaw o f t h e pe rfe c t s u b s t i t u t i on argu m e n t s t e m s fro m
·;., For a d i llc r e n t m o d e l �i p p l y i n g t h e s�unt: i n ';i g h t to t h e i m p a c t o f i n s i d e r t r a d i n g o n
l i q u i d i t y . s e c N i c h o l a s L . C e o rg a k o p o u l o s . I n s i d e r T r ad i ng as a Transac t i o n a l Cost: A
M ar k e t M icrostructure J u s t i fi c a t i o n a n d O p t i m i z a t i o n o f I n s i d e r Tra d i n g R e g u l a t i o n ,
26 Co n n . L. Rev.
1 ( 1 993 ).
S e e D a n i d R. Fisch e l & D c ; vicl J . R o s s . S h o u l d t h e L a w Pro h i b i t " !V! an i p u l a t i o n "
i n F i n a n ci a l M a r k e t s ? , ! ( ) 5 I l a rv . L . R e v . 503 5 1 -l
.
( l 99 l ) .
2001 ]
On Insider Tmding
1 25 5
t h e fact t h a t i t i mplies n o corre l a t i o n b e t w e e n price a n d v o l u m e .
T h e m arke t pr i c e r em a i n s cons t a m ;·,:; g a rd i ess o f t h e q u a n t i t y o f
s t ocks t r ad e d . E m p i r i c a l s t u d i e s . h o wever. fo u n d m a n y incidents o f
·· pri ce pressure , ·' i n d i ca t i n g t h a t t h ere i s n o pe rfect subs t i t u t i o n
<l m o n g s tocks. In oth e r worcl s , t h e d e nn n d c urve fL)f specific s t o c ks
slopes d o ..,vn\vards t"roLr1 ! e ft � o rl �.: h t .
i n i i gh t o f t h e f�1 ct t h �-11. t h e re d u e � n t : l s\.� 1�: rr. t o b(� J.ie r fc c t substi­
t u t i o n a m o n g s tocks. �n: J give n t h e �1\ n �\ m i c precess b y which t h e
m a r k e t a t t a i n s e ffi c i e n c v . t h e i ns i d e rs · m a rk e t power s h o u l d be
m e a s ure d relative to t h e rel evant sto·:: k. n o t t h e m ar k e t :1s a w h o l e .
E v e n i f one acce p t s t h a t t h e re l c \·:m t m a r k e t is e 2 c h i n d i v i d u a l
s to c k , it may s t i l l be a rgued t h a t i m r < t - fi r m c o rn pe t i t i o n a m o n g i n ­
s i de rs w o u l d create a m a r k e t as co mpe t i tive as t h a t of t h e ana l y s t s .
This argume n t d e r i v e s from the fact t h a t i n m a n y fi r m s t h e r e are
n um erous i n s i d ers , and com p e t i t i o n 2 m o n g t h e m will p r o v i d e the
s a m e e ffi c i e n cy a n d l i q u i d i t y as c o m p e t i t i o n a m o n g a n a l y s t s . This
argument i s probl e m a t i c for s e v e r ed reasons. Fi r s t , in m a n y cases,
t h e employees a t the b o t t o m of the c o r p o r a t e p y r a m id only have
access t o small p i e c e s o f i nform a ti o n . T h e y d o n ot s e e t h e ful l p i c­
ture th a t c a n o n l y be s e e n by t h e m a n agers at t h e t o p . As a r e s u l t ,
t h e e m p loyees at t h e b o t t o m c a n n o t compete effe c t i v e l y w i t h t h e i r
m a n agers i n capturi ng t h e v a l u e o f the i n format i o n . I n t r a-firm
compet i t i o n based on e m p l oy e e s h o l d i n g diffe re n t p ie c e s of the
p uzzle i s i n fe ri o r t o compe t i t i o n a m ong < m a l ysts w i t h s i m i l a r s e ts of
i n form a t i o n .
the
S e co n d ,
i n t r a -fi rm c o m p e t i t i o n a rgu m e n t a s s u m e s t h a t i n t r a ­
fi r m c o m p e t i t i o n a m o n g i n s i de rs w i l l act ual l y occur. \-Vhen i n s i de r
t r a d i n g is op en to e v e ry o n e . h O\ve ver. t he m a n agers, w i s hing t o
rn axi mize their r e t u r n s . will i m pose V ct r i o u s restrictions on t h e i r
s ubor d i n ates to preve n t i. h e m fro m t r a d i n g on i n s i d e i nfo rm a t i on ,
thereby c ur t a i l i ng 2 n y po t e n t i <il i n t ra - fi nn c o m pe t i t i o n .
''" S e e . e . g . , Rich ard :-\ . G o u t h . The' l:::J fi c i c: n l \ Ll rk e t . Portfolio T h e o ry . a n d the
Downward Sloping D e m a n d H y p u i h ·c:<is. 6 1-: N . Y . U . L. R ev . 1 1 87 . 1 1 90-91 ( ! 99 3 ) ;
J o h n Li n t n e r , The A ggrega t i o n o r f n ,·esto r' s D i v e rse J ud g m e n t ' a nd Preferences in
Purel y Compe t i t i ve Sec u r i t y Markets. 4 J . Fin. & Q u a n t i t a t ive A n a lysis 347, 384-87
( 1 969 ) ; Joram Mayshar. On D i v e rg e n c e of O p i n i o n and I m p e r f e c t i o n s i n Capital
M arkets,
73 Am. Eco n . Rev. 1 1 4 . 1 22 ( 1 ')8.1 ) ( i l l usrra ting t h e
downward s l o p i n g
curvc ) ; A n d re i S h i c i k r, Du Demant.i C: u r,·es i•x S t ucl-:s S l o p e Down'). 4 1 J . Fi n . 5 7 9 .
588 ( J 986).
[Vol. 87 : 1 229
Virgin ia L m v Review
1 25 6
Th i r d , e v e n assuming a l e g a l r u l e b a rr i n g m an a g e rs fro m restrict­
ing i n s i d e r trading by t h e i r s u b o r d i n a t e s , i n t r a - fi rm c o m p e t i t i o n
l
w i l n o t be as effi c i e n t a s i n t e r - a n a l y s t compe t i t i o n .
I n tr a - f i r m
c o m p e t i t i o n w i l l h a r m the fi rm beca use i t u n d e r m i n e s t h e fi r m ' s
a b i l i t y to c o n t r o l i ts i n te llectual p r o p e rt y and i t s disclos ure p o l i c y .
;\ c l i n g t o rm:x i mize t h e i r g a i n s . e m p l o y e e s ·w i l l d i m i n i s h a n d e v e n
d e s t roy t h e v a l u e of i n t e l l e c t u a l p r o p<e: n y�s u c h < : s re:; e arch a n d
d c:e l c p m e n t results, t r a d e secre t s . �tnd �.e n s i t i v e n e goti a t i o n s--to
t h e fi r m by p r e m ature l y d i s c l os i n g t h i s i n fo r m a t i o n t o t h e m a r k e t
t h rough t r a d i n g . Furtherm o r e , t h e i n fo r m a t i o n fl ow w i t h i n t h e f i r m
w i l l b e h i n d e r e d , preve n t i n g v a l u a b l e i n formation from r e a c h i n g
the m an ag e m e n t i n a t i m ely fashio n . U n able t o r e s t r i c t i n s i de r t r a d ­
i ng b y e m p l oyees contract u a l l y , m a n agers w i l l waste r e s o u r c e s to
prevent trad i ng b y their subord i n a t e s by o t h e r means ( e i t h e r to
p r o t e ct t h e firm ' s i n te l l ectual p r o p e rty o r their o w n p o t e n t i a l p r o f­
i ts ) .
For i ns t a n ce , m anagers
may
fire
v a l u ab l e
employees
for
t r a d i n g o n i ns i d e i nfor m a t i o n u n d e r the false p r e t en s e o f i na d e ­
quate j o b p erforma n c e . I n b o t h c a s e s , t h e f i r m w i l l b e h a r m e d ,
e i t h e r d u e t o d a m age t o i t s i n t e l l e ctual property o r d u e t o t h e
wastefu l e n fo r c e m e n t e fforts o f t h e man agers.
Having dem onstrated that e ac h s p e c ifi c stock is the r e l e v a n t
m a r k e t and that i n tra-firm compet i t i o n i s i n fe r i o r t o c o m p e t i t i o n
a m o n g a n al ysts, w e c a n n o w p r e s e n t a n d a nalyze t h e t w o i neffi­
c i e n c i e s associ ated with gra n t i n g i n s i d e r s property r i g h t s t o i n s i d e
i n fo r m a t i o n .
1 . In efficien t Pro vision of Firm -Sp ecific information and the
Pro b lem of In tertwining Pricing and i'v!wwgemen t
To see the i nsiders' adverse i m t:JJ.ct on t h e p ro v i s i o n of fir n1s p cc ific i n formation, one must focus o n t h e stock p i c k e rs who value
i n fo r m a t i o n trading over l i q u i d i t y t ra d i n g .
As a result, s t o c k p i c k ­
e rs create a d e m a n d f o r firm-specifi c i n fo rmation . S e e m i ng l y , t h i s
d e m a n d may be satisfied e i t h e r b y an alys t s o r by i ns i de r s . F o r t h e
r e a s o n s d i scussed above, though , i n s i d e rs w i l l h o a rd f i r m - s p e c i f i c
i n forma t io n , and o n ly a n alysts w i l l s u p p l y t h is type o f i n formati o n
to s tock pickers. Assume t h a t i n s i d e r t radi n g i s a l lowed a n d a na­
l ysts e x i t the market, l e a v i n g the i nsiders as the sole source o f firm-
·n
Sec supra t e x t accompanying notes 70-7 3 .
On Insider Trading
20Cl l ]
1257
s pe ci fi c i nfor m a t i o n . E c o n o m i c t h e ory s uggests t h a t b e c a u s e i n s i d ­
e r s c a n c a p t u re t h e full v a l u e of i n s i de i n form a t [ o n t h r o u g h trad i n g ,
t h e y w i l l c h a rge s t o c k p i c k e r s s u pracom p e t i ti ve p r i c e s fo r t h i s i n ­
form a t i o n .
But
th e
c ase
han d
at
i n troduces
an
additional
' n t e re s t i n g t w i s t t o t h e s t a n d a r d s t o r y .
I n s i d e rs w i l ! d i s c l o s e i n s i d e i n fo rrn <! t i o n to t h e m a r k e t o n l v a fk r
t h e y h elve e x pl o i t e d i ts v a l ue t h ro ug h t r C�cl i l< g . R e a l i z i n g t h i s , stock
r i c k c: rs w i l l cease t o t r a d e o n i n fo rrmH i o n �\ n ci becom e . i n c o n trast
t o t h e i r i n i ti a l p r e fe r e n c e , l i q u i d i ty t r ad e r s . A n a tt e m p t to s t r i ke <1
d e a l be tween s t o c k p i c k e r s a n d i n s i d e rs t o h u y u n e x p l o i r e ci fi r m ­
SDeci fi c i nfor m a t i on w i l l fa i l fo r t w o re a s n n s : t h e i n h e re n t con fl i c t
j
o t i n t e re s t o f i n s i d e r s v i s- a - v i s stock p i ck e r s a n d t h e p u b l i c good
c h m a c t e r i s t ics o f i nfo r m a t i o n .
T h e first p r o b l e m s t e m s from t h e a b i l i t y o f i n s i d e rs t o d i m i n i s h
or e v e n d e s t r o y t h e v al u e o f t h e i nfo r m a t i o n s o l d b y a ffe c t i n g b u s i ­
n e s s d e c i s i o n s . I ns i d e r s c a n n o t pro m i s e n o t t o c h a n ge business
''
d e ci s i o n s o w i n g t o t h e ir fi d u ci a r v d u t i e s : ' t h e "'y can o n l v comm i t not
to t ra d e on i n s i d e i nform a t i o n . T h i s co m m i t m e n t w i l l n o t e l i m i n a t e
.I
..___..
J
t h e i r i n c e n t ive to d e s t ro y t h e v a l u e o f t h e i n fo rm a t i o n s o l d because
c h a n g i n g b u s i n ess d e c i s i o n s create s t i l l o t h e r o p p o r t u n i t i e s for se l l ­
i n g t h e n e vvly " p r o d u c e d " i n fo r m at i o n . To e l i m i n a t e t h e i n s i d e rs '
ince n t i ve t o destroy t h e v a l u e of t h e i nform a t i o n a ft e r i t s s a l e , i n ­
s i d e rs w i l l h ave t o m a k e t h e t w i n com m i t m en t s t o a b s t a i n from
t r a d i ng on fu t u r e n o n p u b l ic i nfor m a t i o n and to a bs t a i n fro m s e l l i n g
s u c h fu t u re i n fo rm a t i o n t o a d i ffere n t b u y e r . I n s i d e r s w i l l m a k e
t h e s e com m i t m e n ts o n l y i f t h e e x p e c t e d profi t from i ns i d e r t r a d i n g
is l o w e r t h a n t h e ex p e c t e d p rofi t fro m t h e s a l e o f t h e i n fo r m a t i o n .
H o w e ve r , w h e n e v e r t h e i n format i o n i s s o l ei w n u m e r ous i nves tors,
compe t i t i o n among them wiil res u l t i n a l o w e r aggre g a t e re t u rn
from t ra d i n g t h a n t h e r e t u rn t h a t t h e i n s i d e r c a n m a k e . Mo r e o ve r.
l i mi t i ng t h e sale to o n e g r o u p of b u y e rs w i l l p r e s e n t t h e v i r t u a l l y
i m p ossi b l e t a s k o f t ry i n g t o c al c u l at e t h e prese n t v a l u e o f a l i fu t u r e
t r a d i n g profi ts fro m fi rm - spe c i fi c in form a t i o n . Furtl1 e rm or e , sell i ng
t h e i nform a t i on to a s i n g l e b uy e r w i l l
j ust
re p l ace o n e t rue i n s i d e r
w i t h a n o t h e r " ar t i fi c i a l i n s i d e r , , , a n d , e v e n ass u m m g a o n e - t i me
"··· One
couiJ a rg u e t h a t i n s i de rs could o lTer �tock p i ck e r s compe n s a t i o n for future
c h a n ge s a ffe c t i n g t h e v a l u e of t h e i n fo r m a t i o n so l d . D o i n g
for i n s i d e rs who could
1 r a d i ng.
h ave
�u.
h o w e v e r . is i rr a t i o n al
ca p t u re d t h e e n t i re va l uc of t h e:' i n fo r m a r i o n t h rough
[ V o l . 8 7 : 1 229
Virgin ia L m v Re view
1 25 8
sale o f all fu t ur e fi r m - s p e ci f i c i n fo r m a t i o n i s poss i b l e , t he d e m a n d
of stock pickers fo r i nfo rm a t i o n w i l l s t i l l n o t be s a t i s fi e d .
T h e s e c o n d probi e m , t h e n a t ur e o f i n form a t i o n a s a p u b l i c g o o d .
i m p l i e s t h a t i ns i d e rs w i l l n o t be a b l e to capture t h e e n ti re v a l u e o f
t h e i n fo r m a t i o n b y se i l i n g i t . As a p u b l i c goo d t h e v a l ue of i n i'or­
m a t i o n is m ax i m i z e d w h e n i t i :�. d i ss e m i n a t e d to any person \\· h u
,
v d l u c s i t po s i t i �/ c l .y--- i n C) U r :: � � S t� . �t l l stock p i c k e r s . I n s i ci ,.: rs , h c; \\·­
s i n 1 u. l t an e o u s l y r e � t c h a l i the r o tt: n t i (d buyers o f t h e
i n forn1 a t i o n and c b (-trge t h e r! � . i ns i d e rs c a n reach s u b g r o u p s o f b uy·­
c rs . for c: x a m p l c , by a s a k tu a te l ev i s i o n s t a t i o n . b u t t h i s w i i ! n u t
g e n erate a r e t u r n gre a t e r t h a n t h e return from i ns i d e r t r a d i n g .
'vVh e n i n s i d e r t ra d i n g is p r o h i b i t e d , i n siders c a n n o t t r a d e o n
fi rm-sp e c i fic i n form a t i o n , n o r c a n t h e y s e l l s uch i nf o rm a t i o n . C o n ­
c vcr� c a n n o t
s e q u e n tl y , i ns i d e rs have n o i n ce n t i v e t o destroy t h e v a l ue o f fi r m ­
s p e c i fi c i n for m at i o n t h a t i s d i sclosed t o t h e m a r k e t . I n t h e abse n ce
of p r e e m p ti v e compe t i t i o n from i n s i d e rs , a n alysts w i l t e n ter t h e
m arke t . Lack i ng t h e a b i l i ty to i n fl u e n ce b u s iness d e c i s i o n s , a n a lysts
cannot destroy the value o f d i s c l osed i nform a t i o n . Moreover, o p ­
e ra t i n g i n a competitive m arket, a n alysts c a n n o t a p p r o p r i a te t h e
e n t i re v a l u e o f t h e i nfo r m a t i o n ; t h e y w ill o n l y rece i ve a c o m p e t i t i ve
r e tu r n o n t h e i r i nvestm e n t i n i nfor m a t i o n e i t h e r t hr o u g h t r a d i n g o r
t h ro ugh s a l e s t o s t o c k p ic k e rs . I n a n y case, a m arket for i n fo r m a ­
t i o n w i l l d e velop a n d t h e s t o c k p ic k e r s ' d e m a n d f o r i nfo r m a t i o n
w i l l b e s a t i s fi e d .'"
2. I n ejf/cie n t Pricing a n d Reduced Liqu idity
C o m p a r i n g i n s i de rs a n d analysts as t\vo a l t e rn a ti v e s u pp l i e rs o ! a
s e rvi ce-pro v i d i n g
e ffici e n t
pricing
and
l i q u i d i ty
to
a
s p e c i fi c
s tock--reve als that t h e i n s i ders. b e i n g r e l a t i v e l y i m m u nized from
compe t it i o n , w i l i provide i nfe rior s e rvice at a h i g h e r p r i c e .
A b s e n t rne a n i ngfu l com p e t i t i on , i n s i ders w i l l t a k e v a r i o u s a c ­
t i o n s t o e x p l o i t a n d p r o t e c t t h e i r u n i q u e m a r k e t p os i t i o n . F i rs t .
ins i de rs v<� il l ut il ize t h e i r posi t i o ns with i n their fi rms t o i n t1 u e n ce
·--·--
· ------ -----
l a t e r , t h e compe t i tive in formation m a r k e t a ffe cted by
a n alysts creat es a posi t i v e exte r n a l ity for s t ock pickers who v a l u e inve s t i ng ba:;ed on
rree l v disclosed i n form a t i on over l i q u i d i t y t rading. A l t hough the e ffici e n t m<l rkci
t h c o rv s u �!. g·: sts t h i s kind o f t n1 d i n g ca n n n t be profi t a b l e , m e re t rad i n g c r e a t e s u t i l i t v .
U n d e r t h is v i e w . t h e se i n ve s to rs c a n b e laheied a s noise t raders.
9"1 As
will
be
explained
200 1 J
On Insider Trading
bu sin e ss activit i e s .
1w
1 25 l)
F o r i n s t a nc e . i ns i d ers m i g h t c a u s e t h e f i r m t o
e nte r a specifi c transact i o n . t h e n r e n e ge o n t h e a g r e e m e n t , a n d fi ­
n a l l y s e t t le t h e d i s p u t e , a l l fo r t h e s c l e p ur p o s e of c r e a t i n g b e t t e r
o p p o r t u n i ties fo r t ra d i ng . S i m i l a r l y . i n s i d ers m i g h t i ncrease the
1"1
vo l a ti l it y o f the stock by i n ve s t i n :2 in e xces s i ve l y r i s ky proj ec t s .
� r h i s k i n d of · ·· TT1 £J n a ge nte n t � · h u i· ts t h e· p ,·cc.l u c t i ve e fficie n c y o f the
fi n n . 1-\ n a i ysrs .
a ct i v i t i ;:s.
�:�
n e ss
o u t s i d e rs � h ::'t \'" t:::
n �� �
� i n 1 i i �1 r a b i l i t y
to
<1 ffc{: t b usi­
S e c o n d , i ns i d e r s w i ! l a t t e m p t t u !> rutect t h e i r p r i v i l eged posi tion
rir m - s p e c i !ic i n fo r m a T i o n . To t h i s end. they m a y e m p loy ex­
p e n s i ve and ove r-burden i n g m o n i t o r i n g d evices t o pre v e n t
over
u n de rli ngs f r o m u s i n g i ns i d e inform<. H i o n
i' ''
This k i n d of be havior
h a rms t h e p ro d u c t ive e fficiency o f the fi rm . A n a lysts, b y contrast,
c a n n o t p r e v e n t o t h e r a n alysts from h �: n d l i n g i n fo r m a t i o n as t h e y
s e e fi t .
F i n a l l y , i n s i d e r s wi l l e xp l o i t t h e i r p r i v i l e ged m a r k e t p o s i t i o n b y
m an i p u l a t i n g t h e t i m i n g o f disclosure o f fi r m - s pecifi c i n form a t i o n
111
t o i n cr e ase t h e i r p e rs o n al g a i n . 1 T h i s , i n t urn, will h a rm e fficient
pricing. To i l l us t r a t e t h is p o i n t , com pare t\VO sce n ar i o s . Tn t h e fir s t ,
'"' S e e , e . g . . Luci a n A rye Bebch u k & Christine
Jolls,
M a nage r i a l Va l u e D iversion
and S h are h o l d e r \Ve;d t h . 15 J . L. Emn . & Org. 487. 487-SS ( 1 999) ( h ncling t h a t agents
wili take b us i n e s s o p p m tu n i ti e s p re s c n t c; d to the firm a n d t u rn t h e m to t h ei r own
adva n tage ) : H a ft . supra note JS. at 1 056 ( po i n t i n g o u t tlu:t m cmagcrs may
" ma n i p u l a t e
1;; y t.: to p o � � ;; t i a l trad i n g pro fi t s ' " ) .
1 "1 Fran k H . i::: a s t<.: rhroo k . I n sider Tr�: d i n g . Secre t A ge n ts , Evid e nt ia ry P r i v i l eges,
and t h e P r o d u c t i o n of I n fo r m a t io n . ! 9�\1 S u p . C t . Rev. 309. 3 3 2; G i lson & K r a a k rn a n ,
s u pr a note 5 3 . at 6]2 ;� .2 2 ! (suting t h ; : t . i f ;d !nwed to t rilde on n <J n p u b l i e i n fo r m a t i on ,
busin ess decisions 'vi t h
an
managers n1i g h t n1 a ke even n ega t i ve
w:
n·�l
prese n t Y�l l u c
in vesLIT1�nts).
Currt..: n t l y � t o p r11 a n a gc rs e r!lploy con1 p l i a n c c p r o g r ( lnls t o s a t i s fy t h e i r fi d u c i a ry
d u t i e s in :ls:>uring the cumplia nce ul t h e i r corpu r a t i u n and empl oyees with l e g a l
rcst r i c t i u n s i n n1any �1 rcas ( s e c u r i t i e s l�l\\·�. �t n t i t ru � t l a \'v'. s e xu a l h a rass m e n t , a n d
the
l i k e ) . S e c . e . g . . I n r:� Care :1;:: r k ! n t ' l . [ n c . . D:: r i v a t i vc L t ig . . 6 9 8 A . 2 d 959, 962-63 ( De ! .
C h . I LJ96 ) . A l t h o u gh these p rugr:nn:; a r c t: m p l u v c d <1 n d t nforccd b y t h e corpora t i o n s ,
t h e i r e ffe c t i ve n e s s stt: m ' fro m t h e t h re a t o f cri m i n a l prusecution a s w e l l . Under
regi n1c ptnn i t t i n g i n � i ck� r t t!i d i n g . i t '.v l l l be: n 1 u c h
.nHJrc:
a
le£al
costly t o a c h i e v e a si 1n iTa r
level of c o m p l i a n c e fro m e m p l oy e e s .
"'3 See, e . g . , R a nga N a r<: ya n a n . l n , i c! e r t r a d i n g and t h e v o l u n tary d i sc l o su r e o f
i n fo r m a t i o n by fi rms. 24 J . B a n k i n g & F i n . 3 9 :\ . 395 (2000) (pos i t i n g t h a t " good news
is m o r e l i k e l y to be d i sclosed c a r l v t h a n bad n e ws .. ) : Charles M. Ya blon & Je n n i fe r
H i l l , T i m i n g Corpo;· a t e D i s c l o s ur e w t\l a x i m i z e Perfo r m a nc e - B a s e d Remuneration:
A Case o f Misal igned I n c e n t i ves?. 3 :5 \V::1ke Foresi L. Rev. 83, 86-87 (2000)
( d i�;cussing
d i sclosure
m cm i p u l a t i o n
bv
m :m a ge r s
tu
i n crease
t he i r
own
com pe n s a ti on ) .
[ Vo l . 87 : 1 22 9
Virgin ia Lmv Re view
1 260
a p i ece o f n o n p u b l i c i nfor m a t i o n i s d i sc l osed t o t h e p u b l i c . U n d e r a
r u l e o f d is c l o s e or a b s ta i n , firm s will o p ti m ize t h e t i mi n g o f d is c l o ­
s ur e t o p r o t e c t t h e i r v a l u e . A n a l ys t s op e r a t i n g i n a c o m pe t i t i ve
m a r k e t w i l l react to t h e n e w i n fo r m a t i o n a s q ui c k l y as p o s s i b l e .
T h e y will i m me d i a t e l y price t h � i n fo r m a t i o n a n d trade o n i t l e s t
� o m eo n e else beat them t o i t .
I n t h e s e c o n d sce n a r i o , a n i n �·; i c.k: r h c> l d s cl p i ,_::r.:: c: o r i ns i d e i n for­
m :.n i o n , toge t h e r w i t h t h e p mv e r t o c! c c i d c w h e t h e r a n d w h e n t o
d i sc l ose o r trade o n i t . I f d e l a y i n g. d i sc l os u r e provi d e s t h e i n s i d e r
w i t h b e t t e r t r a d i n g opportun i ti e s <m c.l i n cre a s e s h e r e xp e c t e d p r o f.
'"" c·
o n v c r s c 1. y , ·I tr pre m a t u re
I t s . s h e w 1· 1 1 postpone t h. e c1 1· s c 1 c :; ur�� d i s c l osure p rovides t h e i ns i d e r w i t h a b e t t e r o p p o r t u n i t y to profi t ,
s h e w i l l d i s c l ose prem a t u r e l y , e v e n i f d o i n g s o h a s grave c o n s e ­
q u e nces for t h e corpora t i o n . "" Here. t o o , the act i o n s \Vi i i h a rm n o t
o n l y e ffi c i e n t pricing b u t a l s o t h e p ro d u c t ive effi c i e n cy o f t h e f ir m .
·w h a t e v e r s t rategy i n s i d ers e m p l o y t o i n c r e a s e t h e i r p ro fi t s , t h e i r
a b i l i ty t o m a n i pu l a t e t h e t i m i n g o f d i sc l os u re a n d t r a d i ng i s h a rm ­
ful . E i t h e r t h e effi c i e ncy o f t h e
market is h i ndered per se, or
e ff�cie ncy i s promoted b u t o n l y a t t h e c o s t o f q u a s i -m o n op o l y p r i c­
i n g a n d h ar m t o p r o d u c t i ve e ffi c i e ncy. I n t h i s c a s e , t h e c o s t o f t h e
m ar k e t d is t o r t i o n s caused b y i ns i ders i s born n o t j us t b y t h e i nves­
tors t r a d i n g in t h e stock, but a l s o by all the econ o mi c a c t o rs w h o
r e l y o n effi c i e n t a n d l i q u i d f in a nc i a l m arkets.
In a dd i t i o n t o h a rm i ng e ffi ci e n t p r i c i n g and p r o d u c t i v e e f fi c i e n c y
i n order to capture s u p racom p c t i t i v e re n t s , t h e i ns i de r s ' excessive
m a rket power h a s t h e u n d e s i ra b l e e f f e c t o f d i m i n i s h i n g l i q u i d i ty i n
fi n a n cial m ar k e t s . As e x p l a i n e d e a r l i e r . p e r m i t t i n g i n s i d e r t ra d i n g
w i l l cause i n fo r m a t i o n t r a d e rs t o e x i t t h e m a r k e t a n d c o n se q u e n t l y
r e d u ce t h e n umber a n d v o l u m e o f t r a d e s . T h i s , i n t u r n , wi ll h a rm
l i q u i d i ty t r a d e r s , as i t w i l l r a i s e t h e cost and r e d u c e t h e s p e e d o f
e x e c u t i n g t r a n s ac t i o n s .
'"' S c e Ferbe r, s u p ra n o l e 1 3 , �It 623:
'"' K e n n e th
Privacy,
9 l
E.
Sco t t ,
Seligman. supra nute
I n s i d e r Trad i n g :
Legal Stud. 80 1 ,
8 1 4-8 1 :5
Rule
l O b-5 .
1 3 . a t 1 1 21 .
D i sclosure , a n d
Corporate
( i lJ80 ) ( d i scus,;ing t h <1 l t r a d i n g o n i n s i d e
i n fnrm a t i on m a y h a r m t h e corpor�l t i o n h v prov i d i ng i n form a t i o n a t t i m e s w h e n
accompl ish i n g t h e business goals
Gulf Sulphur
period
rc q uircs sccrecv) . One such e x a m p l e i s SEC v . Texas
1 968 ) . \\ h e r e i n s i d e rs t r a d e d o v e r an e x t e n d e d
Co . , 401 F . 2 d 833 ( 2 d C i r .
o f t i m e b e fore
publicly
d i sc l o s i n g
corporation ac q u i red a l l t h e l a n d . f cl . a t
the
0-+3-47.
d i scovcrv o f u r e a n d
b e fore
the
On
2001 ]
Insider Trading
126 1
Now t he choice becomes cle arer. Perm itting i nsiders to trade o n
inside i n form ati o n will drive an alysts o u t o f the m arket, bes t o w i n g
upo n i n s i de rs exclusive control over t h e p r o v i s i o n of effi c i e n cy a n d
liq u i dity t o fin an ci al m arkets. Restri cting i n s i de rs from trading on
i n s i d e i r; fo r m a t i o n . coup l e d with c o rp o r �1 t c: cl i s c ! o s ure d u t i e s . w i i l
a U O '.'.' c l TTi e_t r k e t o f a n a l ysts t o d c ve i o p . �/)\ "<'- :·.� 1 ! cit� vc i oped �1 n d co nl.­
p e t i t i v e iJ n a l y s t s � :n a r ket \:vi i i provide :� u p \: rinr e ffi c i !:: n c y a n d
lfln
s up�� r w r t ! l.] U t Cl t t y at a 1 ower c o s t .
D e c: r i t e t h e many vices o f gra n t i n g i n s i d ers the r i g h t t o trade o n
n o n p u bl i c i n fo r m a t i o n , it d oe s n o t necess<> ri l y m e a n t h at share ­
h o l de rs v\ i l l restrict inside r t rading if l e ft to t h e i r own devices.
S h a r e h o ld e r s . i n their capacity as iiq u i d i t y t r <:tders , might h ave dif­
fere n t c o n cerns. Liquidity traders do n o t l ose on average t o
..
•
1 •
•
1
1 •
insid ers and they d o n o t care abo u t aggre ga t e e fficie ncy per se . Li­
qui d i ty traders will m ake the same return w h e t h e r t h e m arket h as a
h igh level of efficie ncy or a low level of e ffi c i e ncy . As long as
s h a r e h o l ders can prevent insiders from d e s t roying the firm's v alue
( t h at i s , c o n trol t he age ncy probl e m ) , liqui dity traders do n ot per­
ceive ins i d ers' con trol of the pricing of information as a "cost . "
Liq uidity traders d o c are about liquidity , h O \vever. Liquidity
traders and n oise traders provide m arkets w i t h initial liquidity.
Trading by insiders provides additi o n al liquidity. Although lower
than the additi o n al liquid ity analysts can p rovi d e , the adde d liquid­
ity pro vided by ins iders in combin at i o n w i t h the initial liquidity
'''" Th e a na l y s i s so far was cond ucted from
a
m a r k e t p o i n t o r view, not from the
po i n t o f v i e w o t s h areho l d e rs. Our c o n c l u s i o n s h o l d true. h ow e ·.Tr. w i t h even greater
f o rce \·l h e n the s h are holders' p o i n t of v i e w is a d o p t e e\ _ G i ve n the <H:encv problem
b e t w e e n m a nage rs and s h a rehol ders, g r a n t i n g i n s i d e rs ,; _xcl usive co71 t r o i v e r t h e
o
ad d i t ion
t o t h e i r con trol over busi ness
a c t i v i t i es is pote n t i a l iy harmful for shar e h o l d ers. D i�pcrscd s h a r e h o l d e r s d o n o t
m o n i t o r m a n agers, a n d e n t ru s t i n g m a n agers w i t h t he r o l e u t m o n i to r i n g t h e m s e l ves is
a s u re r c c i p e for c o n t r o l fa i l ure s. Analysts, in const ras t . const<l n t ly follow stocks a n d
mon i to r t h e p e r formance o f m a n agers. See, e . g . . D i rks v _ SEC, 4 6 3 U . S . 646, 646
( 1 983) ( i ll u s t r a t i n g a bro k e r dealer who m a na ge J to track clown 21 fraud a l le g a t i on ) .
discl osure a n d
U S <�
of i n s i d e i n forma t i o n i n
A s w e p l a n t o argue i n a separate paper, b y pe rform i n g t h i s r o l e , analysts
a ge n cv
problem
be twe e n
man agers
and
shareholders.
and
t h us
m i t i ga t e
the
benefit
the
share h o l d ers. I n d e e d . a recent e m piri ca l s t u d y h a s fo u n d t h a t 92 '};, o f the corpora t i o n s
s t u d ied enacted p o l ic i e s restrict i ng i n s i d e r t r a d i n g , a n d 7 8 % a d o p t e d b l a c k o u t peri ods
J u r i n g w h i c h i n s i d e r trading is pro h i b i t e d . T h e l a t t e r p n i i c y res u l t e d i n a n a r rower
b i d - a s k s p read . See J . C . B e t tis et aL, Corporate pol i c i e s re•;r rict i n g trading by insiders,
57 J . f i n . Econ. 1 9 1 , 2 1 8 (2000). Th e se corp o r a t i o n s a r c most i i k e l y r e s t r i c t i n g i n s i d e r
t r a d i n g because it h a s a h a rmful e ffe c t on t h e i r s h a r c h o i d c rs a n d t h e i r com p a n i e s .
1 262
[Vol. 8 7 : 1 229
Virginia L a w Revie1v
m ay s uffice to prov i de acce p t a b l e l i q u i d i t y i n a p a r t i c u l a r s t o c k . In
t h i s c a s e . l i qu i d i t y t raders may p r e fe r to gran t i ns i d ers p r o p e r t y
r ig h t s i n ins i d e info r m a t i o n i n e xch ange f o r l o w e r s a l a r i e s .
A s a n a l y z ed ahove , t h e n e g a t i v e e ffects of t h i s c o u rs e o f action
'
'
11>7
E ven ! I l 1 q u t c! J t y t r a d e rs c1 o n o t c a r e
burn oy t h e m a r K e t .
a b o u t dfi c i c n c y , e ffi c i e n t p r i c i n g i s i m p o rt a n t for t h e e c o n c m y as ;\
\v h o !t.: . ' E ffi c i e n t p r i c i n g is i m p ort a n t for t h e m a r k e t fo r corpc• r a t e
• e
arc
•
•
•
•
''
co n t ro l . r·u r m o n i t o r i n g an d con t ro l l i n g t h e m a n a ge m e n t age n cy
p ro b l e m . fo r t h e a l l oc a t i o n o f reso u rces i n T PO s a n d secon d <1 ry o f­
fe r i n rrs. a n d fo r o t h e r t r a n s a c t i o n s i n the e c o n o m -'v t h a t a re based
] 1 }'-J
on m a rKd p nces.
�
•
'
I II.
P O S I T i V E E XT E R N A LITIES O F T H E A NALYSTS' M A R K ET
The i n trod u c t i o n of a c o m p r e h e n s i v e m a r k e t perspe c t i ve e na b l e s
us to bring a n o t h e r p h e n o m e n o n t o l ight.
A
c o mp e t i t i ve a n a lysts '
m a r k e t offe rs seve ral types o f p os i t i ve external i ti e s , o f w h i c h we
w i l l focus on two: the i nfor m a t i o n m a r k e t and the i nves t m e n t
b a n k i ng i n d us t r y . I n the fol l o w i ng S e c t i o n s , we a n a lyze these p o s i ­
t i v e exter n alities a n d s h o w t h at t h e y would b e lost i f i n s i d e r tra d i n g
were perm i t t e d , e v e n s u bj e c t t o a contractual regim e . F o r t h i s rea­
son, we concl u d e t h a t t h e p r o h i b i t i o n o n i ns i d e r tradi n g m us t be
re t a i n e d .
Re:;ource
'"' S et.: Nav•.x:n Kh a n n a e t a ! . , l n s i d e r Trading, O utside S e a r c h , and
Alloca t i o n : Why Firms and Society Ma y D is a gree on I n s i d e r Tra d i n g R e s t r i c t i o n s . 7
Rev. F i n . S t u d . 5 7 5 . 5 7 5 ( 1 99 4 )
in fo r m e d o u tsi ders r e d uc e s t h e
insider
tra d i n g
i n fl i c t s
).
"'' F o l l o w i n g Uni1ed Slates
to
v.
t h a t eve n t h o u g h insid ers' compe t i t i o n with
.
quality of outsi de i n fo rm a t i o n , . a ! luwing
e q u i l i b ri u m
d i ffe re n t
" e n t re p r en e u rs m ay prefe r
opt i mal "
( sh o wi n g
"
"social
and
private
cos t s " :
com•.:qc;en t l y ,
a l l o w i n s i d e r t r a d i n g even when i t is n o t
,;o c i a l l y
0 'Hagan , 5 2 1 U . S . 642 ( 1 99 7 ) , some sch o l :us s u ggested
that t h e Su p r e m e Court's d e cision has transformed t h e p ro hi b i t i o n o n i n si d e r t r a d in g
i n t o a nk:re contractual default rule. S e e , e . g . , Saikrishna Prakas h , O u r Dysfu n c t i o n a l
I ns i d e r Tra d i ng Regi m e . 99 C o l u m . L. Rev. 1 49 1 , 1 5 06 ( 1 999). \V e d i s :.1gre e .
A
proper
r e a d i n g o r () Hagan i m p l i e s a k e y d i s t i n ct i o n be tween i n s i d e inform a t i o n i n t h,.: clciss!c
s c n se-in forr n a t i o n originating from the affected firm used by one o f i ts i n s i d e rs--and
a d i ffe r e n t tvpe of i nside i n fo rm a t i o n-i n formation generated by o u t s i d e rs who <tre
not e m p l oy e e s o f t h e affected fi rm. W h i l e the p r o h ibiti on on t ra d i n g i nvolving c l assic
i n side i n f or m a t i o n is cle arly m a n d a t o ry , and c a n n o t be contracted a ro u n d , t h e
pro h i b i t i o n o n t ra d i n g i n vo l vin g i n formation g e n e r a t e d b y o u ts i ders i s
c o n t mcting like any o t h e r property i ntere s t .
"" Sec K a h a n . s u p r a note
64,
subject
to
a t 1 005-1 7 ( d iscuss i n g a l l o f the cos ts o f i n e ffi c i e n t
m ar k e t s a n d the role of r e g u l at i o n s i n
curi n g t h e se
i ne ffici e ncies) .
On Insider Trading
200 .l jl
1 263
A. Th e Infomwtion Market
In the a n a l y s t s ' m a r ke t , some a n a l y s t s n e ve r disclose t h e i r i n ­
for m a t i o n direct l y . R a t h e r , t h e y u s e t h e i r i nfor m a t i o n a l advant age
through t r a d i ng. These a n a l y s t s u s u a l l y work for m aj o r i n s t i tu ti o n a l
i nves t o r s . O t h e r a n alys t s , h o w e ve r
.
d i s c lose t h e i r fin d i ngs to t h e
p u b l i c . O f t h e a n a l ys t s i n t h i s group. s o m e d i s c l o se i n form a t i o n o n
a re g u la r lxtsi:; as p a n o f t h e s e r v i c e t h e y o ffe r t o c l i e n t s , w h i l e oth ­
ers d i s c 1 CJs<; on i y part o f t h e i n fo rm a t i o n t h e y possess a s p a rt o f
pro m o t i n g a n d advert i si n g t h e i r se rvi c e s . T h e d i sclosure o f a n a l y t i ­
c a l i n fo r rn a t ion a l l ows m a r k e t part ici p a n ts t o j ud g e , e x p os t , t h e
.
q u a 1 1ty
h
ot- Lc
<:m a 1 ys t . , , ,,
·
T h e res u l t is t h e c re a t i o n of a n i nfor m a t i o n m a r k et. F i n a n c i al
newspapers, teie visi o n c h a nn e l s , radio s t a t i o n s , w e b s i t e s , a n d
o t h e r sources o ffe r a wide ra nge of fi n a nc i a l i n form a t i o n i n a very
accessible for m a t fo r free or for a low fee . It i s c o m m o n for a n a ­
lysts t o sh are t he i r i n fo r m a t i o n a l advan tage t hr o u g h i n t e rvi ews,
private columns, and c o m m e n t a ry o n t h e s e i n fo rm a t i o n c h a n n e l s .
A na l ys ts ' com p e t i t i o n . i n s hort, s u p p o rt s t h e d e v e l o p m e n t o f t h e
information m a r k e t , w h i c h leads t o a d d i t i o n a l p o s it i v e e x t e r n a l ­
i t i e s . Firs t , t h e i nfor m a t i o n market i m p roves t h e e ffi c i e n cy o f t h e
cap i t a l m a r ke t . E v e r y a n a l y s t who d i scloses h e r i n fo r m a t i o n a l a d ­
v an t age provides o t h e r a nalysts w i t h a d d i t i on al i n formation t h a t
assists t h e m i n improving t h e i r prici n g . S e c o n d , t h e i n formation
m a rk e t e n h a nces t h e l e v e l of i nv e s t m e n t activi t y in the c a p i t al
m a r k e t . As i n format i o n reaches a l arger s e g m e n t of t h e p u b l i c ,
m o re p e o p l e become a w a r e of fi n a n c i a l e v e n t s a n d b e c o m e ac ­
quain t e d with fin a ncial m a rkets. The l e v e l of understanding of t h e
i n v e s t m e n t p rocess i s i ncreased a nd t h e n e w k n owl e dge h e l p s b u i l d
c o n fi d e nce a n d trust i n t h e marke t . 1 1 1 Conseque n t l y , m o r e p e o p l e
become l i q u i d i t y traders ( a d d i n g t h e stock m a r k e t a s a n a l t e rn ative
for s a v i n g) and stock p ic k e rs (either re s p o n d i n g t o analysts' mar­
k e t i ng efforts and b uy i n g the i r s e rvices , o r u s i ng freely disclosed
i n form a t i o n as a basis for t he i r own i nd e p e n d e n t i n vestme n ts ) . I n -
between a n a lvsts'
" " F o : i nsta nce , t h e fi nanci<i l papers publ ish period i c comparisons
.
·
recom m e n d a t ions a n d stock prices.
'" Cf. Lawrence M.
Ausubei,
I n sider Trad i n g in a R a t i o n a l Expect a t io n s Economy.
80 Am. Econ. Rev. 1 022. l C23 ( 1 990) ( a rgu i n g t h a t con fid e nce i n the market is
i m p o r t a n t a n d that d u e to t h e e ffect o r d i m i n i s h e d in vestor confidence, " i nsiders a re
made better off'" if t h e y can · ' p recu m m i t not to l r<tde on their privileged i nform a t i o n " ) .
Virginia Lmv R e view
1264
[Vol. 87 : 1 229
creased i nvest m e n t a c t ivity i ncreases t h e dem and for a nalysts and
lowers the cost of capital for firm s .
I ns i ders who enj oy excl u s i v i t y o v e r i n s i d e i n format i o n t h w a r t t h e
development o f the i nfor m a t i o n m a r k e t . Abse n t c o m pe t i t i o n , i n ­
s i ders h ave n o i n ce n t i ve to q u i c k l y d i s c l o s e i n side i n fo r m a t i o n .
I n siders d o n o t c a t e r t o c l i e nts: t h e y g�1 i n only indi rectly from i n ­
c u � a s e d i n ve s t m e n t a c t i v i t v . M o rr_:: iy>c: r . i n s i de r s c a n n o t s e l l t h e i r
i n forrn a t i o n a l a d va n t a g e . S e vere c u n fl i c Ls of i n tc.rcst and asy1n111 e t ­
r i c i nform a t i on doom n e g o t i a t i on::; buw,:: c n insiders and pote n t i al
buye rs. S i m i l a r l y , an a t t e m p t to s.:: l i t h e i n fo rmation to t h e p u b l i c
( for e x a m p l e , t o a te levision c h a n n e l o r �\ newspaper) w i l l n o t g e n ­
e r a te a p rice e q u a l t o t h e v a l u e o f t h e i n fo rm a t i o n to t h e i n s i ders
because i n formation is a p u b l i c gooci . ' 1 ' I n sum, insiders, u n li k e the
a n alysts' market, are
unable
t o provide the positive e x t e r n a l i t i e s
t h a t e x i s t in a w e l l -developed i nforrnati o n market.
B. The lnvesmzent Banking industry
To see t h e effec t of t he a n alysts' m arket on t h e investm e n t b a n k ­
ing industry, a s s u m e t hat i ns i d e r trad i n g is p e rm i t t e d . F o r the
reasons explained above, the insiders will d rive the a n alysts out of
t h e market. Now suppose that a corporation wishes t o m a ke an
I P O . I ns iders will find i t d i fficult t o issue s h a res d i rectly t o i n v es­
tors. Investors will be skeptical o f p ur c h a s i n g sh ares s i n c e i ns i d e rs
have i ncentives to man i p u l a t e the corporat i o n ' s m a n a g e m e n t i n
order t o i ncrease t h e i r e a rn i n gs . 1 1 ' A ls o , t here are n o a n alysts t o
m o n i t o r corporations a n d t h e i r m a n agem e n t o r t o d i s c l o s e i n for­
m a t i on, so i nvestors wili
be hesi t ant to p u rchase s h a re s
in
a
corporation t h e y know l i t t l e a b o u t <:. n d which w i l l n o t be m o n itored
very care ful ly . 1 1" Insiders wi i l have lo e m pl o y a n inves t m e n t b an k t o
underwri te t h e offering i n order t o p e r s u a d e i nvest ors t o buy t h e
s h ares.
The investment bank w i l l have t o e m p l oy an a n a iyst in order to
n
pri ce the shares. The a a l ys t w i ll study a l l c u rr e n tly a v a i l a b l e i n ­
for m a t i o n a b o u t t he corpo r a t i o n , c o m pe t i tors, t h e i n dustry a s a
11'
See Robert Cooter & Tho mas U k n . Law and Economics 40-4 1 (2d ed. 1 997)
( n o t i n g that public goods are both n onexcl u cL ! h k a n d n onrivalrous).
11'
See supra notes 1 00-01 and accompanying t e :' t .
S e e supra n o te 106.
' 1'
200 1 ]
On Insider
Trading
1 265
w ho l e , and t h e e c o n o m y in g e n e ra l . S h e \Vi l l set a p r i c e for t h e
s h a r e s , a n d t h e y w i l l b e i s s u e d . F r o m t h a t p o i n t o n , t h e a na l yst h a s
n o u s e for t h e k n o w le d ge s h e a c c u m u l a t e d r e g a rd i ng t h e c o r p o ra ­
t i o n . T h e re i s n o p o i n t i n fo l l o w i ng t h e s t o c k b e c a u s e i ns i d ers w i l l
b e a t o u t s i d e rs b y c a p i t a l i z i ng o n n e w i ns i d e i n fo rm a t i o n . P r i ci n g b y
i n s i d e rs . n o n e th e l e s s . c a n n o t b e t r u s t e d �� " < l b a s i s fo r 3 seco n d a ry
o ffc r i n � d u e to t he c o n fl i ct o f i n t c re :� t p r 1 ; l � k m . C o n s c q uc n t i y . a
seco n d a ry o l l ·.: r i n g w i l l e n t a i l s i m i l a r c o s t s t o t h �t t o f t he i P O .
F u rt h e r n w r c: , w i t h o u t a n a lysts, i n s i d e rs w l l u o ffe r s h ares o f t h e i r
c o r p o r a t i o n w i l l a l s o h av e t o c o n v i nce i n v e s tors o f t h e i r a b i l i t y to
prcw i d e l i q u i di t y . I n s i d e r s w i l l be fo rc e d to p r o v i d e l i q u i d i t y a r ­
r a n ge m e n t s
in
order
to
a t t r ac t
i n v e s t ,J r s .
However,
w h a t e ve r
a r ra n ge m e n t i n s i d e rs a d o p t t o p e rs uade i n ve s t ors t o b u y s h ar e s a t
t h e I P O , i t w i l l ge nerate n o p o s i t i v e sp i l l nve rs for o t h e r c o r p o r a ­
t io n s g o i n g t h ro u g h a n I P O . E a c h c o rp o r a t i o n w i l l h av e t o o ffer i t s
own l i q u i d i ty a s s u r a n c e s .
R e s t r ic t i ng i n s i d e r t r a d i n g , o n t h e o t h e r h a n d , w i l l a l l o w t h e a n a ­
l ys t t o use t h e k no w l e dge accum u l a t e d i n t h e I P O process b y
fo l lo w i n g t h e stock a n d p r i c i ng i t o n a n o n g o i ng b a s i s . Effi c i e nt ,
c o n t i n u o u s pri c i ng b y a nalysts i ntrod uces e c o n o m i es o f s c a l e a n d
s c o p e . F i rs t , t h e i nves t m e n t m ad e d u r i n g t h e IPO i s n o t l o s t . A n a­
lysts c a n u p d a t e t h e i r p ri c ing, b e a r i n g o n l y t h e i nc re m e nt a l c o s t of
t h e u p d at e . S e c o n d , t h e k n ow l e dge accu m u l a t e d i n t h e a n a l ys t s '
m ar k e t c a n be r e u s e d a n d d e p loyed i n t h e s e r v i ce o f i n ves t m e n t
b a n ks w h e n e v e r a n e w I P O s hares s i m i l ar ch a ra c t e r i s t ics w i t h a n
e ar l i e r I P O . T h e s e r v i c e w i ll b e o ffe red t o i n vestm e n t b a n k s o n
c o m p e t i t i v e t e r m s . T h i r d , i nvestm e n t b a n k s w i l l fi n d t h e process o f
a secon dary o fferi ng e a s i e r a n d c h e ap e r w h e n t h e s h ares o f t he
corporat i o n are a l re a d y traded i n a n e ff ic i e n t m a r k e t i n w h i ch
p r i ce s are d e t e r m i n e d b y a n a lystS . 1 1 ; I n d e e d . u n d e r c e r t a i n circum­
s t a n c e s . e v e n t h e S E C r e laxes t h e r e g_i s t ra t i o n a n d t h e d i sc l osure
r e q u i re m e n ts for s e c o n dary offe r i n g s Y' '· This is a c l e a r e x a m p le of
" ' S e c M e r r i t t B . Fox. S h e l f Regist r a t i o n . fntcgra t e c! D i ,;clos u re . a n d Un de rwri ter
D u e D i l i g e n c e : An E c o n o m i c A. n a lysis, 70 V a . L. Rev. l 005 . 1 008 ( 1 984): Je ffrey N.
G o r d o n & L e w i s A . Korn h a user. E ffi ci e n t !v ! a rk <.:ts. Cos t l .v I n form a t i o n . a n d
S e c u r i t i e s R c sc a rch. 6 0 N.Y. U . L . R e v . 76 1 . S I 0 ( 1 98) )
' " S e c fLl X . supr a n o t e 11 5 . at 1 008 (showing h o w t i l e Jll �i r k c t e ffi c i e n c y ra t i o n a l e
e x p l a i n s " s h e l f' . regi s t r a t i o n u n d e r R u k 415 o f t h e S e c u r i t i c ,; Act o r 1 93 3 ) : G o rdon &
K o r n h �1 u ser. supra n o t e 1 1 5 . at SJ 0 (ex3 m i n i n g t h e S E C ' s u�e of the effic i e n t m a r k e r
h y p o t h e s i s i n l·o r m u l a r i ng i n tegrated d i sc l o s u rc rc q u i r•: m c n h ) .
1 2 66
Virgin ia L a w RcvieJv
the red uced c o s t s o f
a secondary o fferi n g gen e r a t e d by t h e e x i s ­
t e n c e o f o ngoi ng efficie n t pricing by a n a l y s t s .
F u rt h e rm ore . i n a w e l l - d e v e l o p e d a n a l y s t s ' n1 a r k e t , i n ve s t o rs
w h o b u y s h a re s i n a.n I PO will concern t h e mselves only w i t h the
bu� i n c s s prospects of t he co rporation �me! the q u <d i t y of i ts rn a n ­
c� g.c n·� o.�' n t . E ffi c i e ncy a n d l i q u i d i t y i n t h e :�cco n d a ry rn a rk e t \'.: i i i he
p r u v i d=>J by t h e �.t n a l ys t s . --r h e existe nc�.: t_J f t h e a n a l y:) t s · rn a r k r.:: l c r e ­
C1 t e :=; e c , ' rw m i e s o f scale i n t h i s r e s p e c t a s we l l . O n c e the rn a rk c t i s
i n p l a c e . i t c a n absorb m a n y n e v·i I P Os a n d s ec o n d a ry offe r i n g s . B y
g u :na n t e e i ng effi c i e n t p r i c i n g a n d l i q uid i t y , the a n a l y s t s ' m a rke t
l o \v,· r<.: t h e c o s t of i s s u i n g s h <:l n.:s fo r a l l corporat i o n s , s p a r i n g e a c h
i n d i v i d u a l c o r p o ra t i o n t h e i l e e d to provide e ffi c i e n c y a n d l i q u i d i t y
o n i t s mvn .
A w<:: l l - d e v e l o p c d inve s t m e n t b a n k i n g i n d ustry, i n t u rn . a t t r a c t s
fi rms from c o u n t r i e s with i e s s d e ve l oped markets to i ss u e s h ares
and l i st t h e m i n the more d e v e l o p e d m a r k e t . The d e ve l oped ana­
l v s t s ' m arket and investment i n dustry in t h e U n i te d S t a t e s at t r a c t
__
fi rms from a l l ove r t he world . 1 17 T h i s process c a r r i e s w i t h i t m a n y
be n e fi t s : I t i n c r e as e s t h e a c t i vi t y a n d p rofits of t h e i n ve s tm e n t
b a n k i n g i n d u s try a n d its p e r i p h e r a l m ar ke t s , i t p r o v i d e s A me ri c a n
i n ve s t o r s w i t h a w i d e r r a n g e o f i n v e s tment opport u n i ti e s , a n d it i n ­
c r e a s e s t h e d e m a n d fo r t he se rvice s of a n a l y st s . N o n e o f t h e s e
pos i t i ve e x t e r n al i t i e s c a n b e realized wit h o u t an a n a l y s t s m a rk e t .
'
I V . T H E CASE F O R N EG ATlYE PROPERTY RIG HTS T N 1 >1S f D F.
[ NFORNl AT l ON
G i v e n t h e i m p o rt a n t pos i t i v e exte r n a l i t i e s gene r a t e d by a n a lysts '
c o m pe t i t i o n , a n d g i v e n t h a t n one of them would
arise i f i ns i d e rs
perm. i t te d t o a p p r o p r i a t e and exploit i n s i d e i n form a t i o n . w e
s ub rn i t t h a t e ffi c i e ncy d i c t a t e s that i n s i ders be b a n n e d from t r a d i n g
o n i n s i de i n fo r m a t i o n . Com b i n i n g t h i s conclusion wi t h t h e p r ope rty
were
, . \V h i k non-U . S . companies ra i sed only $7 b i l li o n i n t h e A me rican nu r k c t and " o f
t h e -+ 2 0 n o n - d o n1 e st i c co1 n p a n i e s regist ered \Vi t h the fJ . S . SEC:, n1 ost \Vt� r��� C a n ;:� J i a n "
i n l lJ8lJ. " i n 1 9')8 n o n - U . S . i ss u e rs o ffered m o r e t h a n ::5200 bi l l i o n i n t h e U n i ted
States . . . L i n d �1 C. Quinn, f n t e rn a t i o n a l Regulation o f Cross - B o rckr O i'fe r i n gs and
Listi ngs o f Securities- A W i ndow of Opport u n i ty, T n t c rn ational Securities M a rk e t s 2
( J 999 ) . I n 1 999. · · n1orc t h a n 1 . 1 00 n o n - U . S . c o rn p a n ie s frorn Sf, c o u n t r i �: s [ \vcrcl
regi:;tcrcd w i t h t h e S E C. ' ' J J .
On
200 L J
Ins ider Trading
1 2 67
r i�
o h t s e n t i t le m e nts fra m e w o rk , "" we p o s i t , for t h e fi rst t i m e , th a t
t h e c h a l l e n ge of i n s i d e r t r ad i ng presents a com pe l l ing case fo r a s -
sign i n g a " ne g a t i ve p r o p e r t y r i gh t " t o i ns i d e rs wi t h res p e ct t o
i n s i d e i n fo r m a t i o n . T h e e ffect o f a n eg a t i ve prope r t y r i g h t i s t o
de n y t h e g r a n t e e t h e pow e r t o a p p r o p r i ate a soci a l l y v a l u a b l e r e ­
:-; o u rc ,::-i n o ur cctse . i n fo r m a t i o n ---i n o r d e r t o a l l o w a m o re
e ffit: i c: n t r(: g i rn c to cL: vc l o p . I n t h e p :·csc n t c o n t e :� t . t h � b a n n n i n ­
s i d e r t r:;c! i n g acco m p l i s h e s j us t t h a t . \N i t h o u t t h e h a n . i n s i d e rs.
because o f their p r o x i m i t y to the ti r rn , would be able to appropri­
a te and e x p l o i t n o n p u b l i c i nform a t i on . T h i s a b i l ity w o u l d a d v e r s e l y
i rn p �tct t h e i n for m a t i o n m a rk e t a n c! t h e ;;' con omy o n t h e w h o l e . T h e
b a n o n i n s i d e r t ra d i ng-o r , as we s e c i t , t h e assign m e n t of <1 n e g a ­
t i ve prope rty r i g h t t o i ns i d ers-is n e ce s s a ry t o e s c h e w the
s u h o p t i rn a l reg i m e that w o u l d o t h e rwise d e v e l o p . As a r e s u l t o f t h e
..
ba n . m ore e ffici e n t i n fo r m a t io n m a r k e t s a n d fin a n c i al m ar k e t s c a n
evo lve .
T h e r e r e m a i n s t he q u e s t i on of why the p r o p e r ty r i g h t s h o u l d n o t
be assi g n e d p o s i t i v e l y t o a s p e c i fi c an a l y s t . Ex a n t e , i t i s i m p oss i b l e
t o d e te rm i n e w h ich a n a l y s t v a i ues t h e i n fo r m a t i o n a t i s s u e m o s t
h i gh l y . A l l o w i n g a n a l ys t s t o c o m p e t e over n o n p ub l i c i n fo r m a t i o n
i s , t h e refore . t h e o n l y v i a b l e way t o e nsure t h a t , o n a v e r a g e , t h e
a n a l y s t w h o places t h e h i g h e s t va l u e o n i nform a t i o n w i l l o b t a i n i t
firs t . B ecause a n a l ysts o p e r a t e i n a compe titive env i r o n m e n t t o
m a x i m iz e t h e re t u r n o n i n ves t m e n t i n i nforma tio n , t he a n a l ys t w h o
fi r s t o b t a i n s n o n p u bl i c i n form a t i o n wi l l h ave t o p ro c e ss t h e i nfor­
m a ti o n t o the market as q u i c k l y a s p o ss i b l e , l e s t she be beaten b y
o t h e r a n alysts \Nh o s e c k the s a m e i n for m a t i o n . Th e o p t i m a l prop­
erty re g i m e wi t h respect t o i n fo r m a t i o n -t h e q u i n t esse n t i a l p ub l i c
goo d---is o n e o f fre e competi t i o n -' '� T o e ffect t h i s regi m e , h owever,
it i s necessary t o a ss i g n a n ega t i ve property right to i n s i d ers t o ex­
c l u d e t he m from the group of l e gi t i m a t e appropr i a t o r s . A s we
1 1 ' 'f
h e c h a l le n ge o f in s i d e r u-a d i n g i ' w i ck l y re rceivcJ ::: ;; o n e o f e f fi c i e n t a ! l oc:J t i o n
o f p ropc n v righ t s i ;1 n o n p u b l i c i n for:;1 a t i o n . S e c genc:ra l l v G u i d o C i l a hrc:si & A .
D o u � i ;:s M c: i :l mecl . Pronertv R u l e s , L i a b i l i t y R u l es. and l n a l i c n a b i l i t v : O !·J c View u f
t h e (:;: t h c: J r: J ! . 85 Harv: L -Rev. 1 089, l ll15.:.. 1 5 ( 1 9 7 2 ) ( d i v i d ing prote c t i o n mode:; o f
i e g a ! 1; n t i t k m c n ts i n t o property r u l e s . l i a b i l i t y rules. a n d i n a l i e n a b i l i t y r u l e s ) .
11"
F o r d i 5cussi ''" o f t h e d i ffere n t :;spcct:> of idorm ation as a p u b l i c goc•cl a n d a
coi l c c t i vc good. sec K i m b e r l v D. Krawiec. Fairnc�;s. E ff i c i e n c y . a n cl Insider Tra d i m: :
Dc:collst ru�ti n g t h e C o i n o f t l� e EZe alm i n t h 1: i n fo r m a t i o n Age," 95 N w . U . L . R e v . 4-+3'.
4:+f .AS ( 200 l ) .
Virgin ia Lmv
1268
Review
[Vol.
87: 1 229
s h o w e d , t h e u s e o f a n e ga t i ve p r o pe r t y r i g h t i n t h e i n i t i a l s tage t o
n e u t r a l ize t h e i n s i d e r s · i n h e re n t a d v a n t age n o t o n l y i m p r o v e s t h e
e fficie ncy a n d l i q u i d i t y o f fi n a n c i a l m a r k e t s b u t a ls o g e n e r a t e s
v a r i o u s pos i t i v e e x te rn a l i t i e s t h a t o t h e rwise w o u l d n o t h a ve c o m e
to e x i s t .
\/ . [ �\ ' !
��:; I C '< S O F T i i E
A N .-\ LYS I S
l n a d d i t i o n t o p r o v i d i n g ; i n ·.:.: w e ffi c i e n c y j u s t i fi ca t i o n fo r t h e· b c t n
on i n s i d e r t r ad i n g . o ur Zl n J. I ys i s s h e d s n e w l igh t o n t wo u nre s o l v e� d
l egal p r o b l e rm : s e l e c t i \ c d i s c l os ur e <! n d w a r e h o u s i n g . O u r a n a l y s i s
a l l ows us to i l l u m i n a t e t h e c o n tl i c t ing g o a l s a nd t h e t e n s i o n s i n ­
v o l ved i n t h e s e i ss ue s . as w e l l as t h e p ar a m e ters r e l e va n t t o t h e
p o l i c y d e c i s i o n t h a t a t t e m p t s t o r e s o l v e t hese t e n s i o n s .
A. Selective D isclosu re
F o r a v a r i e t y o f reaso n s , m a n y c o r p o r a t i o ns d o n o t a t t r a c t a n a ­
l ys t s ' coverage. '=" A n a lysts m a y o v e r l o o k corpora t i o n s b e c a use o f
t h ei r s i z e , c o u n t r y o f ori g i n , o r i nd u s t r y affi l i a t i o n . I n a l l o f t hese
c a s e s , t h e c o s t of ga t he ri n g a n d p rocessi n g private i nfor m a t i o n t o
t h e m a r k e t d oes n o t g u a r a n t e e a n y i n d i v i du a l a n a l ys t a s uffi c ie n t
r e t u r n t o j u s t i fy t h e coverage. T h e v a l ue o f t h e i n f o rm a t i o n i s d i s ­
p e rsed
in
the
s h ar e h o l de rs .
m arket
and
l os t
without
any
be n e fi t
to
the
W h e n i n s i d e rs a r e rest r i c t e d fro m t r a d i n g , t h e y m a y s e l e c t i ve l y
d i sclose n e w i nfo r m a t i o n t o a n a l ysts i n o r d e r t o i nc r e as e t h e re­
2
turns t o t h e s h a r e h o i d e rs . and, i n d i re c t l y , to t h e m s e l v e s . 1 ' 1n t h i s
w a y , t h e p r o h i b i t i o n on i n si d e r t ra di n g fost e rs t h e p ra c t i c e o f s e l e c ­
t i ve d i s c l o s ur e . N a t u r a l l y . t h e a n a l ysts \vh o receive t h e i n fo r m a t i o n
enj o y a t i m i n g adv a n t age o v e r t h e m a r k e t , w h i ch g u a r a n t e es t he m
"" Companies t h a t ra i l t u a t t r<1Ct a n a l ys t cove rage a rc col l o q u i a l l y c a l l e d --m�t rk e t
o rp h a ns . ' · Sec S a n ro rd R . K a v n < l r J r . & M i c h a e l Pe r e i r a . O r p h a n S t o ry , The D :t i l y
Deal (N . Y . ) . !\ u g. 2 9 . 200 ! . a t 2 2 .
.
'" I n l i g h t o r t h e - - p c r, o n a l b e n e ri t . t e s t s e t fo r t h i n Dirks v . S E C 463 u . S . 646
( 1 983 ) , t h e common v i e w was t h il t sckct i vc d i sclosure to a n a l ysts d ocs n o t v i ( ) l a t c
i n s i d e r t r a d i n g r e s t r i c t i o n s . a s i<lng a s t h e i n s i d e rs are n o t a t t e m p t i n g
to
g a i n pc rso n < l i
b e n e fi t fro m t h e d i s c l o s u r e . S e c . e . g . . P a u l P . B r o u n tas J r . . N u t c . R u l e lOb-5 a n d
Vol u n t ary Corporate D isclosures to S e c u r i t i e s A n a iysts. 9 2 C o l u m . L R e v . 1 5 1 7 . 1 5 29
( 1 992) ( "'The
Dirks
d e c i s i o n h;ls been w i d e l y const rued as a l lowing consicl c: r a b l c
l a t i t u d e i n c o q.1 o r a t c: d i o; c l p s u rcs t o analys t s . ' " ) .
On Insider Trading
2001 ]
1269
higher returns o n t h e i r i n ve s tm e n t in i n fo rm a t i o n . In exchange,
these a n al y s t s en gage in c o n t i n u o u s m o n i toring and coverage of
t h e relevant firm a n d p ro v i d e t h e fi rm \Vi t h b e t t e r l i qu i d i t y and
prici ng for its s h a r e s . In a d d i t i o n , t h e a n a l y s t s provide t h e firm with
better m o n i t o r i n g o f t h e rn a n a gc m c n t Rnd a v a i u a b l e external
C \' a l u a t i o n o f its p r o p o s e d b u s i n e s s s t r a t e gy . ' 22 Fi n a l l y , s e l e c t i ve d i s ­
c l o s u re
(i i :;<.:l use t o a n a l ys t s pi eces o f
se n s i t i ve i n forn1 a t i o n that C(t n n o t h e d i �_�\J us� � d in t h e i r Dure fo rn1 to
1 23
the w h o l e m a rket. S uc h d i sc l o s u r e i m proves e ffi c i e n t pricing and
r e d u c e s a n al y s ts ' n e e d t o e x p e n d r c s c ur c e s o n se a r c h i n g for firm­
sp e c i fic i n fo r m a t i o n .
F r o m a property r i g h t s p e rspectiv e . t h e practice o f s e l e c t i v e d i s ­
c l o s u re temporarily p u t s t h e r i g h t s t o inside i n fo r m a t i o n i n t h e
h a n d s o f a s m a l l g r o u p o f a n a l ysts ra t h e r t h a n immediately g r a n t i n g
t h e r i g h t s t o t h e m a rke t as a w h o l e . I n t h i s l i g h t , s el ective disclo­
a l lows
m a n age1n e n t
to
..
sure
s ub s t i t u t es
" i m m e d i a t e- a l i - an alysts ' -compe t i t i on "
vvi t h
a
'· t e m porary-selected - a n a l y s t s ' -exc l usivi t y . " Admi t t e d l y , t h e tempo­
r ary exclusivity gra n t e d to t h e s e l e c t e d a n a lysts generates t h e s a m e
i l l e ffects a s s o c i a t e d w i t h i nsider t r a d i n g , i n p a r t i c u l a r , reduced l i ­
q u i d i t y a n d h a r m t o a nalysts o u t s i d e o f t h e s e lected group. Yet, for
s m al l c o m p a nies w h o s e s h a re s are traded w i t h l o w l i q u i d i t y, i t is a
necessary step o n t h e w a y to com p e t i t i v e a n a l ys t coverage. I n t h i s
s e n s e , t h e exclus i v i t y g e n e r a ted b y s e l ective d i s c l o s u r e i s a n alogous
to t hat created b y p a t e n t or copyright p r o tection . I n a l l cases, t h e
l o s s associ a t e d w i t h t h e g r a n t o f temporary exclus i v i t y is presuma­
b l y outweighed b y t h e e ns uing l o ng-term b e nefits. The practice of
selective disclos ure is also a d va n tageous to s h a r e h o l d e rs because i t
e n a b l e s t h e m t o s u bs t i t u t e t h e p o t e n t i a l gains fro m i n s i d e r trading
i n t h e form of lower s a l a r i e s f or i mproved a n a l ysts' cove rage and
superior l i qu i d i t y and pricing.
Seemingly, a nalysts outside o f the s ele c t e d gro u p would i ose
when trading aga i n s t the s c k c t e d group, and t h u s , would avoid
trading in that stock. The S E C's n e w l y e n acted ban o n s e l ec t i ve
'" See D a n i e l R. Fisch e l , I n s i d e r Trading a n d l n ve � t m c n t A n a l ysts: An Economic
A n alysis of Dirks
v.
Securirics a n d f:'xclumgc Cununission. 1 3 H o fs t r a L. Rev. 1 2 7 . 142
( 1 984) (arg u ing that anal y sts w h o rece i ve n o n p u b l i c i n fo r m a t i o n from i nsiders ''have
i n ce n tives t o enga g e i n some s e a rch t h e mselves be fore m a k ing reco m me n d a t i o n s t o
t h e i r c l i e n t s . " t h u s perform i n g a m o n i t o r i n g !'u n c t i o n ) .
"' l ei . a t 1 4 1-42.
[Vol. 87: 1 22 9
Virgin ia L u w R e view
1 2 70
d i s c l o s u r e m a n d a te s e q u a l t i m i n g o f d i sc l o s u r e , a n d t h u s , p r o t e c ts
t h e ana l y s t s w h o are n o t p a r t of t h e s e l e c t e d group . ' ' ' Is t h e n ew
rule d e s i r a b l e ? T h i s rule i m proves comp e t i t i o n a m o ng a n a l y s t s ,
a n d t h u s , i t s e ffect o n l arge compa n i e s with w i d e c ove rage b y a n a ­
l ys t s a n d h i gh l i q u i d i t y i s c l e a r l y d e s i r a b l e . I n d e e d . w i t h r e s p e c t t o
s u c h comp a n i es t he n e w rule i s c o n s i ste n t with o u r a n ,l i ysis.
T h e p r o b l e m i �; the e ffe c t u t" t h e n e w rule o n s rn a l i c o m p : t n i l>;
\V i t h ! O\V l i q u i d i t y , con1 p an i 1.2 S t ha t t·:. i i l t u a t � r �l C � a n a l y s t s � coveret_s c .
T h e e q u a l i ty o f t i m i n g m a n d a te d hy t h e S E C p r o m o t e s po t e n t i a l
J cc c s s to a l l a n alysts b u t sacrifi ces a c w � t l access by a fe w s e k c t e J
a n a l ys t s . I t m ust b e b o rn e i n m i ne! , h ow e v e r , t h at t h e o u t- o f- t h e ­
i n n e r- c i r c l e a n a l ys ts w h o m t h e n e w r u l e p ro t e cts d e c l i n e d t o cover
t h e stock in the fi rst p l ac e . Th us. u n d e r t h e new e q u a l t i m i ng r u l e .
ful l- s c a l e c o m p e t i t i o n wou l d n o t l e ave a s u ffi c i e n t r e t u rn o n i n ­
ve s t me n t in i nf o r m a t i o n for a n y i n d i vi d u a l a n a l ys t .
M o r e o ve r , i n s te a d of t h e t h eo r e t ical e q ua l i ty t h a t the S E C is a t ­
t e m p ting t o p r o m o t e , t h e p r a c t i ce of s e l e c t i ve d i s c l o s u r e p re s e r v e d
p r a c t i c a l e q uality w i t h res p e c t t o t h e r i g h t to b e c o m e a n a c t u a l a n a ­
lyst o f t h e s t o c k since a l l a n a l ys t s c o u l d c o m p e t e o v e r o ffe r i n g t h e i r
s e rvices t o i ns id e rs . I n s i de rs w i l l p r e fe r
to
l i m i t t h e t i m i n g a dvan­
tage a n d i ncrease t h e i nn e r ci rcle in o r d e r t o l i m i t t h e a b i li t y of t h e
s e lected grou p t o expl o i t i t s exc l u s i v i t y a n d i mprove t h e a n a l y s t s '
cove r age . I n d e e d , i n s i d e r s ' a t t e m pts to l i m i t t h e p o w e r
of
the se­
l e c t e d gro u p c a n b e i n fe rr e d f r o m t h e g r a d u a l i nc r e a s e i n t h e
n u m b e r of c o r p o rations using " op e n c o n fe r e nce cal l s , · ' eve n b e fo r e
t h e p ro p o s e d regu l a t i o n t h a t m a n d a tes e q u a l t i m i ng . 1'' O p e n i n g a
"' Sec S E C R u l e s l OO ( a ) . l OO ( a ) ( I ) . a mi 1 0U ( a ) ( 2 ) . R e gu l a t io n F D . ! 7 C . F . R . � 243
( 200 ! ) . For a view �u pporting t h e e q u a l ti m i ng p r i n c i p l e . sec S e l i g m a n . s u p ra n o te 13 .
"' The S E C p u b l i s h e d t h e p ro pos e d F D R i n E x c h a n ge A c t R c: l c �1se N o . 4 2 2 5 9 , Feel.
Reg. Proposed R u l e V o l .
2000] 1 9 1 7
64
pg. 7 2 5 90
(2UOU ) . I"I'J irinred in [ T ra n s l'er
20. 1 999). A
Fed. Sec. L. Rep. ( C C H ) 'll B2.846 ( De c .
B i n d e r ! 9991 998 survcv
c o n d u c t e d by the N a t i onal I n v e s t o r R e l a t i ons I n s t i t u t e (" ' N l R I . . ) o f i ts m c m bc:r
c o m p a n ie s fo u n d t h a t 83 % of t h e cc, m p a n i es c o n d u c t con t e re n c e c a l l s for a n a l y s t s ( u p
fro m 7 3 '}0 i n 1996): 27 % o f t h e companies a l low i n d i ,·icl u al i n vestors t o part i c i p a te
a n d 1 4 °/c, i n vi te:: t he med i a
iO
pilrl i c i p a t e : 8 9 '/'u of t h e compa n i e s ( u p from
o6 °;(,
in
1 996 ) t a p e the i r con fe re n c e calls for l a t e r p l a yback 1 · i a t o l l - fi-cc n u m b e r ( 5 9 % ) o r t o i l
n u mber (34 % ) .
N a t ion al
I n vestor
R e l a t i o n s I n s t i t u t e . N I R J R e l e ases Foll o w - u p
S u rvey on the Grow i n g U s e o f Co m m u n i c a t i o n s Te c h n ologv i n
the Practice of
I n ve s t o r R e l a t i o n s . a t h t t p://www . n i r i . org/p u b l i c a t i o n s/;l l c: rt ,/ea05 1 8 98. cfm ( May 1 8.
1 99 8 ) . A n o the r 5urvey co n d u ct e d by N I R T in J u n e ! 999 fo u n d
th a t
84% o f the N I R I
corpo r a t e m e m be rs s u rveyed con d u ct c o n fe r e n c e c1 l i s wi t h a n <t iysrs: 5 5 '/i, o r t h ose
On
200 1 ]
Insider
Trading
1 27 1
co n fe re n ce ca l l t o a l l i n t e re s t e d i n vestors i ncreases d r a m a t i c a l l y t h e
m e m be rs of t h e ··selected g r o u p " a n d t h us e rod e s a l m o s t c o m ­
p l e t e l y t h e e x c l w; i vity p r o bl e m . "6 I n d e e d , the p r o p o s e d regu l a t i on
t re a t s a n o p e n c o n fe r e nce cal l as a m e t h o d s a t i sfyi n g t h e e q u a l t i m ­
' :'
i n g re q u i r e m e n t .
Of
s u rt�'
c o ur c; c .
h'-.:
1...\ l n
e v e n i n s m al l a n d i l l i q u i d co m p a n i e s . s e l e c t i v e d i sc l o­
<1 b u sc d b '.J i n s i de rs i n v i c� Li t i o n o f t h e c r i n1 i n a l
re s t i·i�t i u n u n i i 1s i d c r l r �uJ i n g a n d i n breach o f t h c i :· fi d t! c i c 1 ry du­
t i t: s . : > C \ i l l S 'r:> i ri n � w i t h ·' fa k e a n a l ys ts . . . t i o u i n !::: t h e " p a L\ c e '-""Q u a rd s . . .
rc:w M u i n g <t n a l ysts fo r favo rable re co m m e n d a t i o n s , ; :m d reward i n g
i n s t i t u t i o n a l i n vest ors fo r p a s s i v i ty ( " v o t e b u y i n g ' ' ) a r c j u s t a few
'c"
e.\Zi m p k s .
G iv e n t h a t se l ective d i sc l o s u re c a n e i t h e r p ro m o t e o r
d i m i n i s h e ffi c i e n c y . t h e q u e s t i o n becom e s : Is i t d e s i r a b l e t o b a n s e ­
lect i ve d i scl osure across t h e board a s t h e S E C ' s mle m a n d a t e s . o r
'-'
w o u i c! i t
be
-'
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I
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p re fe ra b l e t o e x e m p t s m a l l a n d i l l i q u i d c o m p a ni e s a n d
>
.,
l e t m a r k e t forces r e g u l a t e t h e m ?
J
A complete b a n w i l l m i n im ize t h e occ urrence of a b usive s e l e c­
t i ve d i sc l o s ur e w h i l e s i mu lt a n e o u s l y destroying t h e be n e fi ts t h a t
c o u l d be accrued
to
lective disclosure.
from e ffi c i e n t se­
one be l ie v e s
d o m i n a t e s e ffi cie n t
s m a l l a n d i l l i q u i d c o m p a n i es
Such a
result could be
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t h at abusive s e l e c t i ve d iscl osure considerably
c o m p a n i e s ( u p from 2 9 % i n 1 998) a l l o w i n d i v i d u a l i n vr�stors to p a r t i c i p a t e a n d
invite
42 'Yo
t h e m e d i a t o l i s t ::: n ( u p fro m 1 4 % i n 1 998). )\la t i on a l I n vestor R e l a t i on s
I n s t i t u t e . Newlv Ct>mplctc d S u rvey Confirms G re a t e r O pe n n es s i n Confcr::: nce C a l l s
and
Acce l e r a t i n g
e:!Ob l 09lJ . c fm
Use
(June 1 8.
uf
T e c h n o l ogy .
at
h t t p ://www. n i r i .org/p u b l i c ; : t i o n s/ale ns/
1 9 '! 9 ) . A s u r v e y conducted in F e b r u a ry 2000, :t ft c r t h e S E C'
proposed FO R was p u b l i s h e d . fo u n d t h a t 83 % o f the c o m pan i e s c o n d uct c o n fere nce
c a l ls lor an a ly s t s . N a t i o n a l I n v e s t o r Re l a t i o ns I n s t i t u t e . M o s t Corporate Co n fe re n ce
C a l l s ,-\ rc N u w O p e n
Ill
I n d i v i d u a l i n vestors · a n d t h e M e d i a , at h t t p ://www.n i ri . o rg/
29. 2000). Of t h o s e compa n ies. 82 'X, ( u p from
5 :5 % i n ! 9lJlJ ) a l l ow i nd i v i d u a l i n ve stor·s to p a rt i c i p a t e a n d 74 'Yo i n v i t e t h ·� m e d i a ( u p
f w m -+ 2 % i n 1 9Y9) . ! d .
" " J d ,: a l l v . i n s id e rs would u s e such a s t ra te�v o n l y w h e n t h e re i s n o n e e d t o p ro v i d e a
p u h i i ca t i o ns/a l c rto;/ea022900.cfm ( fc h .
s c k c r e d gm u p or a n a l vs t s wi t h s u pracon;pc t i t i�·c ren ts. Reach i n g t h i s st:1gc is
a
gr;�du;�! prnccs,;. i n i t i a l ! v . t h e s t ock is n e g l e c t e d a n d s e l e c t i v e d i sc l o s u re is n e e d e d t o
a t t ract coverage. As p ri c i n g a n d l i q u i d i t y a re g r a d u a lly i m pr o v i n g . cl ue t o t h e 'e l e c t e d
g r o u p CO\'Cra gr: . more an a l y st s a n d o 1 h c r i n for m �H i on t ra d e rs :n1cl l i q u i cl i t y t ra d e r s arc
a t t ra c t e d
t o t h e s t o c k . re ac h i n g
the p o i n t when t h e re i s n u need
d i ,clos u rc � n v m ur c . T h e S E C r u l e w i l l pre v e n t t h i s process.
12 7
fo r se l e c t i v e
Sec T h e S E C ' s D i s cuss i o n of P,e gu l a t ion FD, 1 7 CFR � S 240, 243. 249 ( 2 000) .
"' See L111 g c v u o r t . s u p r a n o te :5 , a t 1 040-44.
: : , S e c J n h n C. C\J ftec J r .. Is Selective Disclosure Now Lawfu l ? . 1 9 97 l'·i . Y . L.L J ul y
3 1 . I 'J'J 7 . a t 5 ( d e t a i l i n g t h e a b uses o f s e l e ct i ve d i sclos u re ) .
f
' •
I
J
Virgin ia L o w Re vielV
1 272
[Vo l .
87: 1229
s e l e c t i v e d i sc l o s u re . J u d g i n g from t h e d r a m a tic incre a s e in t h e use
of open c o n fe r e n ce cal l s , it s e e m s c l e a r t h a t for small c o m p a n i es ,
s e l e c t ive d is c lo s ur e is m e r e l y an i n t e r i m s t a g e on t h e w a y to a c h i e v ­
i n g compe t i ti ve a n a l y t i c a l c o v e r a ge .
\ ! t o w in g t h e m a r k e t t o r e gu l a t e s e l e c ti v e d i s cl o s u r e by s m a l l
-;-
a n d i l l i q u id com p m: i t:: s wi l l c r e a t e a sy::. t ,� m t h a t preserves e ffici e n t
s c k c L i \'C cl i scl c:': ure w h i l e d i ::; co1. .i i'�l � i n g : r b us i ve s e l e c t i v e cl isclc­
' ' . ...,_..., , I .' •• .,.,l. 1!' c· C�'1 h r' !I ;I I \ . r ) f t I' '-'
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e f l"i c i c n t l y rests o n i r :; a bi li t y to e fficien t l y e n force fi d uc i a r y d u t i es
a n cl i n s i d e r t r a d i ng r e s t r i ct i o n s . G i -v·cn t h �t t e n forcement i s t h e k e y
i ssue , t h e p o t e n t i al fo r a buse o f s e l ec t i ve d i sc l o s u r e i s n o d i ffere n t
t h a n t h a t o f a n y o t he r fi d u c i a ry duty o r i ll e g a l i ns i d e r tra d i n g . For
i ns t a n ce , i n s i d e rs can b u y i ns t i t u t i o n a l i n ves to rs ' p a ssi v i t y through
many o th e r p r e fe r e n t i a l d e a l s 1 "-for e x a m p l e , p r i v a t e p l a ce m e n t of
p r e fe rr e d s h a re s-wi t h o u t res o r ti n g to se l e c t i ve disclosure. To be
s ur e , in the c as e o f selective discl osure , it i s diffi c u l t t o prove a
b r e a c h of fi d uc i ary d u t i e s due to t h e i n he r e n t prese n c e of m i x e d
m o t ives. Y e t , n o c o m p l e t e b a n i s i mp osed o n s u c h t r a n s a c t i o n s . I n ­
deed,
a l ongs i d e
the
legal
sanctions,
other
non-legal
market
m e c h a n is m s , s uch as t h e m ar k e t for corporate cont ro l , the m ar k e t
f o r managers , a n d r ep u t a t i o n , w o r k t o reduce such m an i festati o n s
of the age ncy probl e m . 1 ·''
'"' T h e r e is s t i l l a r i s k t h a t s rn �t l l f i r m s w i l l be a b u s i v e . We c o n t e n d t h a t s e l e c t i ve
d i sclosure ge n e ra l es i m p o rt a n t be n e fi t s fo r s m a l i b u s i nesses-b e n e fi t s t h a t o u t we ig h .
in our
op i n i o n ,
the t h r e a t o f a b u se . More o v e r. t h ese
m a r k e t t o c o n t r o l t h e p o t e n t i a l f o r a b usive c o n d u c t .
benefits justify
relying o n t h e
'31 S e e , e . g . . E d w a rd B . R o c k . C on t ro l l i n g t h e D a r k S i d e o f R e l a t i o n a l I n v e s t i n g , 1 5
Cardozo L . Rev.
987.
l a rge (for exam p l e .
989 ( ! 994) ( d iscussi n g s i t u a t ions w h e r e ' · an investor acqui res
9.5 % )
i n t e r e s t i n t h e firm a t
a
a
d i s cu u n t i n exch ange for p ro t e c t i n g
i n c u m b e n t m a n agers fro m d i s p l a ce m e n t o r . more ge n e r a l ly. from t h r e a t s t o t he i r
a u to n o my ' ' ) .
"' S e c ge n e r a l l y Fra n k H . E a s t e r brook & D a n i e l F i sc he l . The P r o p e r R o l e o f a
Targe t ' s M an a ge m e n t i n Respo n d i ng to a Te n d e r O ffe r. ':!4 H a rv. L. R e v .
( e x p l a i n i n g t h e r o l e o f t h e m a r k e t for c o r p o ra te
control);
an cl t h e M a r k e t for C o rp o r a t e C o n t ro l . 73 J . Po l . Eco n . l l O
F a m 8 , A g e n cy Pro b lc:: ms a n d the T h c o rv of t h e F i r m .
1 1 6 1 ( 1 98 1 )
H e n r y G . Manne,
88
( 1 965)
Mergers
(sam e ) ; E u ge n e F.
J. P o l . E c o n . 288 ( 1 980)
B. Rock, S a i n ts a nd
( e xp l a i n i n g t h e r o l e o f t h e m a r k e t fo r m a n agers ) : E clw8rd
S i n n e rs: How Docs
Ddawarc
C o r p o r a t e Law W o r k 'l . .\4 U CLA L. Rev.
1 009 ( 1 997)
( e xpl a i n i n g the r o l e of r e p u t at i o n ) : Zoh a r G o s h e n . V o t i n g and t h e E c o n omics o f
Corporate
S c l f- D e <J l i n g:
Theory
Meets
Reality.
at
h t tp://papers .ssrn .com/sol3/
papers. c fm ') ab s t r a c t_icl .=229263 ( J u l y 20. 2000) ( u n p u b l i s h e d m a n u s c r i p t ) .
On Insider Trading
2001]
1273
S i m i l a r l y , regardl e s s o f t h e possi bi l i t y f o r s e l e c t i v e d isclosure, i n ­
s i d e rs c a n c i r c u m ve nt t h e p ro h i b i t i o n o n i n s i d e r t ra d i n g b y u s i n g
n o n - i n s i de r col l a b o r a t o r s . T h i s s t ra te g y i s d i ffic u l t t o d e t e c t . T h e
r e s p o n s e i s t h a t as l o n g <.l S t h e l e g a l s a n c t i o n s c re a te a s u fficie n t d e ­
t e rr e n t t o c o n t r o l a n d l i m i t t h e n um hc r o f v i o l a t i o n s , a n a n a l y s t s ·
ll1 ct r l\. r2 t c a n fu n c t i o n . E n !o rce m c n t d \i·, ··; n o t h a ve t o b e p e rfe c t ; i t
j us t h as t o be s u ffi c i e n t l y c: lfe c t i v e:
l•
�t !-i"c· r d a n <l l y s t s a s u ffi ci e n t
p r o fi t m a rgi n . j u d g i n g fro m t h e fl u u r i :; h i n � C i l l < l i y� t s · m a r k e t i n t h e
U n i te d S t a t e s , t h e e n force m e n t s y s k m c u r r e n t l y m e e t s t h is s t a n ­
dard.
B. \Va rd;ousing
W a re h o u s i n g is a p r a c t i c e t h a t e n a b k�s b i d d e rs t o ga i n c o ntrol o f
a targe t corporati o n b y e nl i s t i n g t h e
h·� l p o f
a group o f rel a te d i n ­
vestors. 133 T h e b i d d e r d i s c l os e s h e r i n t e n t i o n t o a s e l e ct e d group o f
rel a t e d i n ve s tors w h o b u y t h e s h a re s o f t he t a rge t c o r p o ra t i o n . \.;"
W h e n t h e t e n d e r o ffer is a n n o u n ce d , t h e g r o u p t e n ders t h e s hares
1'o
This g r o u p ' ' \v a r e h o u s e s "
t o the bidder fo r the p re m i um o ffc r e cL
t h e s h ares f o r t h e b i d d e r i n exch a n ge f o r t h e t a k e o v e r p r e m i u m . 136
W a re h o u s i n g i n creases t h e p r o ba b i l i ty of a s uccessful t ak eo v e r
b y a v o i di n g h o l d o u t s a n d shorte n i n g t h e t i m e n ee d e d f o r s h ar e ­
h o l ders'
respo n s e . 137
Whether
this
kind
of
s t r at e gy
i n cr e a s e s
13·' See R oge r J . D e n n i s . Th i s Li t t l e P iggy W r.: t l t t o iVLnkc:: t : The R e g u i <1 t i o n o f Risk
Boeskv, 52 Alb. L . Rev. S4 l . 1)7'J n . :204 ( l 9S S ) .
'" See S t e p han i e F. B a r k h () i z . Cnm rne n t . i n � i d e t· Trad i n g . t h e C o n t e m po ra neous
T r a d e r. and the Corporate Aeq u i r·� r: E n r i t l e m c n t to Profi ts D isgorged by the S E C . 40
A r b i t r a ge aft e r
E mory L.J. 537, 5 6 1
''' Joel Seligm a n ,
( 1 99 1 )
The
.
R e fo r m u l a t i o n
uf Fed e nd
Non p u b l i c I n fo r m a t i on . 73 G c o . L . J . 1 ( )3 3 , I 1:14 ( i 1.JS5 J .
S e cu r i t i e s
Law
C o n c e rn i ng
1 '' ! d . il l 1 1 34 ("To t h e b i d d e r . · w a r r.: h u u s i n g · m a v ·Iuck u p · t h e ta r g c t · s s h ares i n
fri c n cl l v h a n d s : to t h e i n s t i t u t i o n . ll' c l r e h o u s i n g u l"fcrs t h e op port u n i t y for a swi ft
p r e m i u m w h e n the s h ares
ar c
resold in the t e n d e r o i le r . " ) . G i v e n the
c ons e n t
of t h e
b i d d e r t o t h e purchase. t h e re is no b r e a c h n f f i d u c i �l r\' c.l u t v t o w a r d s t h e s o u rce o f t h e
i n format i o n . Conse q ue n t l y , t h e r e i s n u fra u d . a n d n o
v i o la t io n o f R u l e l Ob-5 o f t h e
p r c i c t i c c t h m u gh R u l e 1 4e - 3 ( a ) o f t h e S E C.
r e q u i r i n g n o bre a c h o f fi d u c i a ry cl u t \' . Si nce fra u d i s n o t re q u i r e d . t h e va l i d i ty o l Rul e
S E C. Howe v e r , t h e S E C r e s t r i c t s
this
1 -le-3 was c h a l l e n g e d . The S U ]l r e m e C o u rt d i d n o t respond
S t a t e s v . o · H a ga n .
the
issue
re q u i r e s
521
to
t h e chal lenge. U n i t e d
U . S . 642 . 672 tL I 7 ( 1 99 7 ) ( ' · We l e a v e f o r a n o t h e r cl a y . w h e n
d e c i s i on .
the
l cgi t i m ac\·
· wa re h o u s i n g ' . . . . " ) .
of
Rule
l 4e-3 (a)
as
app l i e d
to
' '' S e t: Macey. supra n o t e 6. a t 1 8- i 'J : S e l i g m a n . s u p r a n o t e 1 3 5 . a t 1 1 34 : Bark ho l/..
s u p ra note 1 34 . a t 5 6 1 n . l ..\6
c· wa rc:lwusi n g
lessc n [ s J t h e n um b e r or possi b l e hos t i l e
1274
Virgin io L mv R c 1 :ielV
['lol.
S7: 1 2 2 9
m arket fo r corpcm1te c o n trol i s s u bj ec t to gre a t
debate.1'' T o ailow us to a n a i yze t h e m ore d i fficult case , we wi ll as­
sume, arguen do, t hat t h i s strat egy promotes e ffic i ency in t he
m a r k e t for corpora te con trol.
Li q u id i ty t raders who fol i O\\ t h e buy a n d h o l d strategy wi i l n ot
b e h a rmed by w a re h o u s i n g . S i n c e i i q u i d i r y n :1 c.l c rs d o n o t re a c t t o
e t ttC le ncy i n t h e
i n ro r n1 a t i o n a n d c h a n g i n g p r i_ c·: :� _ t h e y \\· i l l n o t s c: l l t o t h e s e l e c t e d
gro u p . R a t h e r , t h e y v�i i t c o n t i n u e 1 0 h o l e! u n t i i r h t' r e n de r o ffc ;· i s
a n n o unced. I t i s t h e a n a l ys t s \vh o <He h a r m e d . As prices rise d ue t o
t h e buying o f t h e s e l e c t e d g r o u p . ; w ,d ysts. b -..: i ng ign o r a m abo u t t h e
rote n t i a l takeover and be ing u n :::: b i c t o d i ffere n t i a t e noise tr2cl i n g
fro m w a r e h ou s i n g , wil l i n t e rpre t t h e price incrc clse as overvalua­
t i o n . A n a l y s t s w i l l then s e l l the s h a res only to discover t h a t t h e y ar e
losing takeover p re m i u m s . Anal y sts wi l l not rece i ve a n o rm a l re­
turn o n their i nvestment in i nform ation, and t h e y wil l rou t i ne l y
u nderperform t h e m a r ke t .
l n o t h e r words, t h e a n a l ysts' m a r k e t i s i n d a n g e r from a d i ffere n t
k i nd o f "insiders"-"outsid e rs, . . w h o hold valuable private i nfor­
m ation about the corporat i o n . The '' o utside private i n fo rm a t i o n " i s
n o t produced w i t h i n the corporation b u t h a s an e ffect o n the valua­
tion o f the corporation. From the an alysts' p o i n t o f view, it m akes
no difference whether these " i ns ide rs/o u t s i de r s " trade i n violation
of a fid uc i a ry duty to the b i dd e r or wi t h t h e bi dder's blessing; i n
bo t h cases, the analys ts w i l l l o se . ' ' ' To the extent that takeover
premiums cons ti tu t e a subs t a n t i al part o f a n ormal market r etur n ,
wo u l d t e n d e r . e n a b l i n g b i d d e rs to m a k e su r<: t h e y wo u l d b e
t e n de r ed t he n c c c ss a .ry a moum o f s w c k to g a i n co n t r o l of t h e t a rget corpora t i o n . " ) .
' '' Co m p are
R o n a l d J . G i l s o n . A S t ruct u r < t l t\ p p rmtch : o Curpora t i o n s : T h e Case
A g a i nst D e fensive Ta c t i cs i n Teil d e r Of!ers. :: :; S t a n . L. Rev. 8 1 9. 846 ( 1 98 1 ) ( a rg u i ng
t h a t " d e fe n sive t<tctics. i f succc: s s lu i . c i rcumvr: n t t h e mcch a n i s m by w h .i e h t h e
.
corporate structure c o ns t ra i n s m a n :1ge r i a l d i suc: t i on a n d . t h e re fo r e . < m: i m p rope r . ) .
a n d Lucian A. Bebchuk, Commen t . T h e C«sc for Facil i t a t i n g C o m p e t i n g Te n d e r
O ffers. 95 1-Iarv. L. R e v . 1 0 2 8 , 1 03 0 ( 1 982) ( a rg u i n g t h a t takeovers oft e n r e s u l t i n a n
i ncrease i n : he compa ny's v a l ue a n d t h a t m<:�: ;_, ge m c n t � h o u l d n o t :1ttcmpt t o s t o p the
e f fu r t . b u t r a t h e r should rac i i i t a t e c o mp e t i n g bids t o secure the b e s t o ffer fu r t h e
s h a r e h o l d e r s ) . w i t h Easte rbrook & Fisc h e l . s u pra n ut e 1 3 2 . at l l 64 ( a rg u i n g t h a t legal
rules " a l l owing the t a rget's m a n ;;gc m e n t t u c ngage in d e fe n s ive t a c t i cs i t< response to
a t e n d e r o [fer d c c rea:;e s h a re h o l d e rs we l fa re ·· ) .
..,., See J i l l E. Fisch. Start i\-la k i n g S e n se : ;\ ;1 !\ n :1 ly�is a n d P rop o s a l for lnsiclc:
T r a d i n g R e g u l a t i o n . 26 G a . L . R e v . 1 79 . n rc ( L ')() l ) (rejecting t h e fOCL!O' on t h o::: m c t h ud
hy w h i c h a t r a d e r acquire s non p u b l i c i n fo r m : t t i o n a n d protK• � i n g t o pr e m i s e l ! a h i l itv
o n a n i t,sici e r's d u ty t o t h e m a r k e t p l a c e: ) .
s h are h o l d e rs t h a t
? fl(_J_ 1
'l
_,, _ J
1275
On insider Trading
c o n s i st e n t l y l o s i n g t h e s e p re m i u m s
wi l l
d r i ve t h e a n a ly s t s o u t o f t h e
m a rke t . O n l y if t a keover p r e m [ u m s c o n s t it u t e a n i n s u b s t a n t i a l p a r t
o f t h e n o rm a l m arket r e t u r n c a n ware h o u s i ng be t o l e ra t e d b y a n a iysts.
Om a n a l y s i s poi n ts t o a t e n s i o n b e t w e e n p ro m o t i n g e ffici e n c y i n
� h e 1 n �:_ r k e t fo r c o r p o r a t e c o n t r o l a n d p r o rn o l i n? e ffi c i e n c y i n t h r.?.
,� (t fn i L �-t l n: a r k c t . f f t h e se !cctc J g ro u r· ) i s cunlDOS•.; Li o f a n a l "i::; ts a n d
� \' t.: J-�._-· �t n ct l ys t c 2 n c o rn p e t e ove r p r o v i d i n g \\'�;_ re h o u s i n g servi ces t o
b i d d e rs . ware h o u s i n g i s n o t h arm ful t o Ll1e c a p i t a l m a r k e t . i f, how­
C \T L the s e l e c t e d group d o e s n o t i n c l u de a n a l y s t s . a n d a n a l y s t s
h <·: vr: n o C'pportu n i t y t o compete over t h e p nJ'.· i si (Jn of ·ware h o u s i n g
s e rv i ct� S to b i d d e rs , t h e t e n s i o n m u s t be resol ved i n favor o f re­
s t r i c t i n g ware h o u s i n g . I n creased t a k e o ve r c o s t s for b i dd e r s a n d
l o vve r r e t urns t o a n a l ys t s a r e b a l a nc e d o n e i t h e r s i d e o f t h e sca l e .
G i ven t h e m y r i a d benefi ts t h e a n a lys ts ' m a rk e t produces, t h e s c a l e
.__
'
¥
s h o u l d t i p i n t h e a n a l ys t s ' favor. 1 10
I n d e e d , on e might a s k w h y i t m a t ters w h e t h e r t h e b i d d e r h ers e if
c o n f i d en t i a l l y accu m ul a t e s t he s h ares o f the t arget o r w h e t h e r a
gro u p a c t i n g o n h e r be h a l f d o e s s o . S i n c e i n both c as e s t h e a n al y s t s
wi l l l o s e , w h y r e s trict d irect w a r e h o u s i n g ? TrUt� , a n a l ysts w i l l l os e
in b o t h c a se s If t a k e o v e r p r e m i u m s c o n s t i t ut e a s u b s t a n t i a l p a r t o f
.
the i r ret urns, a n a l ysts w il l need protection fro m b i d d e r s ' c o n fiden­
tial acc u m ul a ti o n o f the t a rget s h ar e s . I n i t i al accum u l a t i o n o f t h e
s h ares o f t h e t arge t , h o w e v e r , i s i m p o r t a n t for t h e b i dd e r . Firs t ,
h ol d i ng a b l ock o f s h a r e s , a foo t h o l d , p l ac e s t h e b i d d e r i n a b e t t e r
posi t i o n t o s u c c e e d i n t h e takeover. S e co n d , a b l oc k o f s hares t h a t
w a s bough t for a l o w p r i ce p r o v i d es t h e b i d d e r w i t h a h e dge o n h e r
search c o s t s . In t h e c a s e of l os i n g t h e t a rget t o a n o t h e r p o t e n t i a l
b i d d e r . t h e fi rst bi d de;: \vi l l make a p r o fi t w h e n t e n de r i ng the b l o c k
to t h e n e w b i d d e r. 1 1 1 I n d e e d , h e re t o o , t h e re i s t e n s i o n b e t w e e n
"" S e c i'v! acey. s u p r a n o te 6 . a t 2 0 . M acey argues:
i'<o d e fi n i t i o n of p u b l i c i n terest expl a i n s ruk
l 4e --3 . The () 1 1 /r c o n cc i va h k
e \: p b n a t i o n i s t h e p r i v a t e i n terest e x p l a na t i o n ofl'c r c d bv H ad d ock : m d �:bccy:
the r u k benefits corporate i nsiders w h o s e po l i tical i n ll uc n cc w i t h i n t h e S E C is
to the d i saggrega tc d , u n o rganized s h a r t: h u l d i n g p�..) p u l a t i o n
h a r m e d bv t h e rule.
hi . ( e m p h a s i s ;:� d el e d ) . Our e x a m i n<H i o n o f t h e ruk: ;;ugge s t s that t h e toc u s s h o u l d be
o n t h e D W t c c t i o n o f m a r k e t a n a l v s ts .
'" Sc� R o n a l ci J . G i lso n . S e c k i � g Comp<::t i t i \··� B i d s V e rsus Pure P <- I S'-'i v i t y i n Te n d e r
C llc r D c fen:;e, 3 5 S ta n . L. R e v . 5 l . 5 2 ( 1 982).
v�:s:. ly superior
I
I
[Vol .
Virginia Law Review
1276
t)7: 1 22 9
p r o m o t i n g t h e e fficiency o f t h e m a r k e t fo r corp o r a t � c o n t r o l a n d
t h e effi c i e ncy o f cap i t al m ar k e t s . T h e W i l l i ams
Ac{L
r e s o l ves t h i s
t e n s i o n b y m a n da t i n g t h a t p o t e n ti a l b i d ders discl ose t h e i r i n t e n t i o n
aft e r accu m u l a t i n g five perce n t o f t h e t arge t s h a re s . Th i s r u l e p r o ­
v i d e s b i d d e r s w i t h so m e foo t h o l d wh i l e p r o t e c t i n g a n a l y s t s from
l o s i n g t h e i r a n t i c i pat e d t a l-; e o v e r p re m i u m s . Th i s b a l a n c e is e l i '>
t or t c d by w a r c h m1s i n g . I n r h i s l i g h t w a re h o u s i n g j u s t c i r c u nl\c n h
t h c r e s t ri c t i o n o n t he b i d d e r ' s o w n accum u l a t i o n , a n d t h us w i i i !><.; ,
u n d;::; r t h e c o n d i t i o ns e x p l a i n e d e a r l i e r , eq u a l l y h a r m f u l t o a n a l ys t s .
.
C O N C LU S I ON
Fra m i n g t h e q ue s t i o n as w h e t he r to award p r o p e r t y r i g h t s i n i n ­
side
i nfo r m a t i o n
to
s h are h o l d e r s
or
m a n agers
has
i e cl
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c o m m e n ta t o rs t o c a l l fo r c o n tr a c t u a l r e s o l u t i o n o f t h e m a t t e r . A s
w e s h owed i n t h i s A rt i c l e , t h e b in a r y fra m i n g of t h e q u e s t i o n h a s
o b s c u r e d a t h i rd , s u pe r i o r o p t i o n : award i n g t h e p r op e rt y r i g h t to
m a r k e t a n a l ys t s . W h e n m a r k e t a n alysts a r e taken i n t o acc o u n t , i t
b e c o m e s appare n t t h a t t h e c h o i ce b e t w e e n i ns i de r s a n d m a r k e t
a n a l ys t s e mb o d i e s a b r o a d e r p o l i cy c h oice b e t w e e n a n i n e ffi c i e n t
a n d a n e ffi c i e n t i nfor m a t i o n m a r k e t . G r a nt i n g t h e p r o p e rt y r i g h t t o
i ns i d e r s w i l l l e a d t o a m a r k e t w i t h v e r y l i m i t e d i n t e r - i n s i d e r c o m p e ­
t i t i o n ; c o n fe rr i ng i t u p o n a n a l ys t s w i l l c r e a t e t r ue c o m pe t i t i o n .
vVe a l s o showed t h a t c o m p e t i t i o n a m o n g a n a l ys t s w i l l p r o v i d e
s u p e r i o r e ffi c i e ncy a n d l i q u i d i ty t o fi n a n c i a l m a r k e t s r e i a t i ve t o i n ­
s i d e rs . T h e i m proved e ff ic i e ncy a n d l i qu i d i t y w i l l p r o m p t g re a t e r
i n v e s t m e n t i n fi n a n c i a l m a r k e ts , a n d t h e y w i l l a t t ra c t i n t e rn a t i o n a l
comp a n i e s to i n ve s t i n t h e U n i te d S ta t e s . F ur t h e r m o r e , c o m p e t i ­
t i o n a m o n g an a l y s t s g e n e r a t e s s ub s t a n t i a l p o s i tive e x t e rn a i i t i e s for
the i nform a t i o n m arket and the i n v e s t m e n t b a nk i ng i n d u s t r y . N o n e
o f t h e s e pos i t i ve e ffec ts i s l i k e l y t o a r i s e u n d e r a p u r e l y c o n t r a c t u a l
r e gi m e . O n l y a vi brant a n a l y s t s ' m ar k e t s c a n p r o d u ce t h e m .
F i n a l l y , t h e broad m a r k e t perspective w e deve l o p e d i n t h i s A r t i ­
c l e helped i l l u m i n ate t w o p a r t i c u l a r aspects o f i ns i d e r t ra d i n g :
s e l ec t i ve d i sc l o s ur e a n d w a r e h o u s i n g . I n b o t h i n s t a n c e s , w e d e m o n ­
s tr a t e d t h a t a n y a t t e m p t t o r e g ul a te t h e s e practices m u s t t a k e i n t o
a cco u n t t h e impact o f t h e p r o p o s e d regu l at i o n o n m a r k e t a n a lysts
' " 1 .5 U . S . C . � �
78m (d)-(e)
&
78(d )-(f) ( 1 988).
2001 ]
On Insider Trading
1 277
and that failure t o d o so w i l l u n derm i n e t h e efficiency of t h e regu­
l atory scheme .
We believe that t h e n ovel market perspective w e developed i n thi s
A11 i c l e m ight fi n a l l y b r i ng a n e n d t o o n e o f the longest lasting puz­
z l e s i n Law and Economics scho lars h i p : the b an on i n s ider tradi n g .