Chapter 29
Insider Trading
Insider Trading: Definition
Inside information is material information
that is not available to public traders.
 Material information is information that
would cause prices to change if it were
widely known.
 Managers must either keep material
information secret or make it public.

Corporate Insider Trading
Corporate insiders should not trade stock
in their companies on nonpublic material
information.
 Insiders must report their insider trades to
the SEC. Initial purchases within 10 days
and subsequent trades within the first 10
days of the month following trades.

Corporate Insider Tradingcontinued
Have to return short-swing profits to
issuers (bought and sold in 6 months)
 Prohibit short positions in company stocks
 Needs corporate approval before trade
 Allowed to trade only during specific
intervals: trading windows

Practical Judicial Issues
Enforcement is very difficult (confederates)
 Surveillance by the exchange
 Enforcement by the SEC or Department of
Justice (DOJ)
 Often grant immunity to the last person in a
chain of informed traders in return for his or
her testimony.
 Encourage people report insider trading
(Offer up to10% of civil penalty collected )

Why Restrict Insider Trading?
Fairness
 Liquidity
 Corporate control issues

Fairness
Should reward traders for insightful
research, not personal connections
 Rebuttal: Firms will place restrictions in
their employee labor contracts if such
restrictions benefit them. Thus, no role for
government regulation.
 Rejoinder: Corporate directors are unlikely
to limit their ability in insider trading.

Liquidity
Effective restrictions against insider trading
make markets more liquid for uninformed
traders (low spreads)
 Rebuttal:

•
Competition among insiders will quickly reflect
their information in prices. It depends on the
number of insiders!
• Insider trading profits are indirect benefits that
will reduce direct compensation. Value
irrelevance.
Corporate control issues
 Insider-trading rules ensure efficient managerial
labor markets.
 Unrestricted insider trading makes insiders
reluctant to share information. Thus, directors
and shareholders find it difficult to evaluate
managers.
 Managers may make managerial decisions that
maximize insider trading profits.
 Insiders may front run.
Why Permit Insider Trading?
Informative prices
 Costs of enforcement
 Entrepreneurial incentives

Informative Prices


Insider trading makes prices more informative.
Rebuttal:
•
•
Restrictions on insider trading are effective only
against insider trading on information that will soon be
made public. Incremental value of more informative
price (from short-lived private information) is not large.
Unrestricted insider trading may decrease the
information in prices because unrestricted insider
trading diminishes managerial incentives to share
information.
Costs of enforcement
Unproductive to have laws that are difficult
to enforce.
 Selective enforcement problems.
 Rebuttal:

•
A law that is not effectively enforced is very
different from no law.
• For most people, ethical costs of breaking the
law are much greater than the expected costs
of prosecution.
Entrepreneurial incentives





Insider trading promotes entrepreneurial initiatives
of employees.
Buy stocks before their ideas are common
knowledge and sell them after they are priced.
Shareholders cannot create compensation
contracts that put their employees at risk of losing
substantial wealth. Insider trading creates such
contracts.
Employees self-select their compensation
schemes.
Rebuttals:
•
Relevant only for the long-term incentives