Springer 2009
Journal of Business Ethics
DOI 10.1007/s10551-009-0068-2
Analyzing Insider Trading
from the Perspectives of Utilitarian
Ethics and Rights Theory
ABSTRACT. The common view is that insider trading is
always unethical and illegal. But such is not the case. Some
forms of insider trading are legal. Furthermore, applying
ethical principles to insider trading causes one to conclude
that it is also sometimes ethical. This paper attempts to get
past the hype, the press reports, and the political grandstanding to get to the truth of the matter. The author
applies two sets of ethical principles – utilitarianism and
rights theory – in an attempt to determine when, and in
what circumstances, insider trading is ethical. The views of
Henry Manne, an early proponent of insider trading, are
critically examined, as are the major arguments against
insider trading. Is insider trading good for the company if it
is used as a form of executive compensation which makes it
possible to pay lower salaries than would otherwise be the
case? Does insider trading cause the stock market to work
more efficiently? If insider trading does increase efficiency,
is that sufficient to call for its total legalization, or are there
other things to be considered? Several arguments against
insider trading have been put forth over the last few decades but there are problems with all of them. One of the
main arguments is the fairness argument. The problem
with this argument is that different people have different
definitions of unfairness. A closely related argument is the
level playing field argument, which advocates wider dissemination of information so that it is less asymmetric. One
problem with the level playing field argument is that it is
better applied to sporting competitions than to trading in
information. Some economists argue that forcing the disclosure of nonpublic information can actually result in
more harm than good and must necessarily involve the
violation of property rights. Other arguments examined in
this chapter include the fiduciary duty argument, the
problem of outside traders, the misappropriation doctrine
and the restrictions that insider trading laws place on
freedom of speech and press. The article concludes by
setting forth some principles or guidelines to determine
when insider trading should be punished and when it
should not.
Robert W. McGee
KEY WORDS: insider trading, ethics, utilitarian, rights
theory, level playing field, asymmetric information,
fiduciary duty
Introduction
Insider trading is generally perceived as evil or, at
least, unethical. The press and television show people being arrested and led away in handcuffs for
engaging in it. The media have nothing good to say
about the practice. Politicians enhance their careers
by being against it. Commentators make it sound
like all insider trading is illegal. Yet some forms of
insider trading are perfectly legal (Shell, 2001) and
some kinds of insider trading are not unethical. In
other words, there is a widespread misperception on the part of the public about insider trading.
The following pages discuss the two philosophical
approaches that have been taken to determine
whether, and in what circumstances, insider trading
can be considered ethical or unethical. I comment
on the various arguments that have been made over
the last few decades and give my opinion on the
strengths and weaknesses of the various positions that
have been taken in the literature.
Philosophical foundations
Utilitarian ethics
Two basic philosophical approaches have been used
to determine whether insider trading is ethical –
the utilitarianism and rights-based approaches. The
utilitarian approach, which is subscribed to by the
Robert W. McGee
vast majority of economists, views an action as being
good if the result is the greatest good for the greatest
number (Bentham, 1781/1988; Mill, 1861/1979;
Yunker, 1986). They would call it a positive-sum
game if the benefits exceed the costs or if the good
exceeds the bad.
The modern utilitarian position might be summarized by the following flow chart (McGee, 2007):
MODERN UTILITARIAN
ETHICS
conclude that breaches of fiduciary duty make
insider trading unethical. They would include it in
the equation when attempting to determine whether
the gains exceed the losses or whether the act still
results in the greatest good for the greatest number
even if there has been a breach of fiduciary duty. If
efficiency increased despite the fiduciary duty
breach, the argument could be made that the act was
still ethical from a utilitarian perspective. The
eclectic utilitarian view might be summarized by the
following flow chart (McGee, 2007).
START
Start
Yes
GAINS
>
LOSSES?
ETHICAL
No
Fiduciary
Duty
Breach?
Yes
Unethical
No
UNETHICAL
The flow chart illustrating the classical utilitarian
approach would be slightly different. Rather than
asking whether the gains exceed the losses, the
classical utilitarian would ask whether the act results
in the greatest good for the greatest number. But
the result would be the same. If the answer were yes,
the conclusion would be that the act is ethical. If the
answer were no, the act would be unethical.
A Posnerian flowchart would look basically the
same, except it would ask whether efficiency
increased. If the answer were yes, the arrow would
point toward the ethical box (Posner, 1983, 1998).
Any of these approaches might be labeled as pure
utilitarian approaches. But some utilitarians are more
eclectic. Although they generally apply utilitarian
theory, they sometimes consider additional factors.
In the case of insider trading, they might consider
whether there has been a breach of fiduciary duty. If
that were the case, they might conclude that insider
trading is unethical even if it would otherwise meet
the utilitarian test. However, it should be pointed
out that pure utilitarians would not arrive at this
conclusion. They would take breaches of fiduciary
duty into account but they would not automatically
Gains
>
Losses?
No
Yes
Ethical
One problem with the utilitarian approach is that
it is impossible to precisely measure gains and losses
(Smart and Williams, 1973). One may only make
estimates. Another related problem is that individuals
rank their choices, they do not calculate that Option
A is 20% better than Option B. If a consumer prefers
McDonald’s hamburgers to Burger King hamburgers,
it cannot be said that he likes McDonald’s
hamburgers 20% more than Burger King hamburgers, but only that he prefers McDonald’s hamburgers
to Burger King hamburgers. Furthermore, after he
has consumed a few McDonald’s hamburgers, he
probably prefers no additional hamburgers to a
McDonald’s hamburger because he is no longer
Analyzing Insider Trading from the Perspectives
hungry. Not only can individual preferences not be
measured, they also change over time. They are not
constant. Thus precise measurement is impossible.
Another problem with utilitarian approaches,
related to the measurement issue, is that there is no
way to precisely measure total gains and losses when
some minority of individuals or groups benefit a lot
from some rule while the vast majority are harmed
(Shaw, 1999). For example, can it be determined
mathematically whether imposing a $5 tariff on the
importation of foreign shirts is a good public policy
if doing so protects the jobs of 10,000 textile
workers but forces 100 million domestic consumers
to pay an extra $5 for a shirt? Many empirical studies
have found that imposing tariffs results in a negativesum game, but scholars cannot agree on how negative the result is. Some studies conclude that two
jobs are lost for every job saved by some protectionist measure (Baughman and Emrich, 1985;
Mendez, 1986) while other studies conclude that
three jobs are lost for every job saved (Denzau, 1985,
1987). Much depends on the assumptions made and
the economic methodology employed.
Another problem with the utilitarian approach is
that it is not possible to compare interpersonal utilities (Kaldor, 1939; Rothbard, 1970, 1997). Different individuals place different values on things. We
may not automatically assume that the theft of a
dollar from a rich man results in less disutility than
the theft of a dollar from a poor man, because either
could use the dollar to buy a candy bar, which might
(or might not) give them both the same amount of
pleasure, depending on their personal preferences.
Perhaps the strongest criticism that can be made
against a utilitarian approach is that it completely and
totally ignores rights (Frey, 1984; Rothbard, 1970).
To a utilitarian, violating someone’s rights is irrelevant. All that matters is whether the good outweighs
the bad. The end justifies the means for a utilitarian.
That is an inherent and structural weakness of all
utilitarian approaches.
Although the eclectic utilitarian approach might
be considered superior to the classic utilitarian
approach (or maybe not), it still does not resolve the
property rights problem. The theory of property
rights is not concerned with total societal gains and
losses. An owner of property holds that property
against the whole world, so to speak. Whether the
result is the greatest good for the greatest number is
irrelevant. If society would benefit by confiscating
mom and pop’s grocery store or grandma Smith’s
ancestral home, a property rights theorist would
dismiss the argument as being irrelevant. All that
matters is whether mom and pop get to keep their
grocery store or whether grandma Smith gets to
keep her ancestral home.
The rights-based approach
The other approach to analyzing public policy issues
is that of rights. The question to be asked is whether
someone’s rights are violated. If someone’s rights are
violated, the act is automatically wrong, even if the
result would be a positive-sum game. The rights
approach may be illustrated by the following flow
chart (McGee, 2007):
RIGHTS-BASED ETHICS
START
Rights
Violated?
Yes
UNETHICAL
No
MAYBE
ETHICAL
The rights-based approach to ethics does not try
to answer questions regarding the ethics of nonrights-violating behavior. Whether prostitution,
gambling, or having sex with dead animals is ethical
is not something that the property rights approach to
ethics addresses. If such acts are crimes, they are
victimless crimes, which do not result in the violation of anyone’s rights. Thus, they should be permitted, even if they are unethical. The same might
be said for insider trading if, as some scholars suggest,
insider trading is a victimless crime (Manne, 1966,
1970a, b).
Robert W. McGee
Most western legal systems are a mixture of utilitarianism and rights theory. Welfare legislation is at
least partially based on utilitarian beliefs. The
General Welfare Clause of the U.S. Constitution
and the general welfare clauses of other constitutions
are also rooted in utilitarianism. The fact that some
individuals must be forced to subsidize the existence
of others is utilitarian based and necessarily violates
rights. But constitutions and laws sometimes protect
individuals’ rights, however defined. So legal systems are a combination of these two competing and
sometimes contradictory philosophies.
Another issue to be considered is whether
something that is immoral should automatically be
declared illegal. The answer to this question depends
on which philosophy of law one subscribes to. In a
theocratic state, what is deemed to be immoral is also
illegal. The law in such countries is a mirror image of
the theology being practiced in the community.
However, most countries these days do not subscribe to such a philosophy. Perhaps the best
approach to this issue would be to allow immoral
conduct as long as there are no victims or as long as
no one’s rights are violated. This position is the most
viable one in cases where the state is pluralist, where
the citizenry is not homogeneous, and where different segments of society take different positions
regarding what is ethical and what is not (Berlin,
1991, 2001).
Arguments for insider trading
The executive compensation argument
One of Henry Manne’s main arguments in favor of
insider trading is that it is a form of executive compensation for entrepreneurial efforts (Manne, 1966).
It is an alternative form of compensation that makes it
possible to pay a lower base salary. It is a way to save
on payroll costs and does not cost the company
anything, because all it involves is allowing an
executive to use inside information for personal gain.
The argument is good as far as it goes. To the
extent that it reduces the amount of cash outlay that
a company must pay to retain an executive, it is a
way to keep compensation costs down. But this line
of reasoning has been criticized.
One criticism is that allowing executives to trade
on inside information is not necessarily limited to
those who are entrepreneurs within the organization. Executives who do not have entrepreneurial
skills may also engage in insider trading and they may
do so at a time when the company is actually losing
money. Rather than being based on good performance, insider trading may be used to compensate
executives when the company is doing poorly. The
rewards are not necessarily tied to performance. For
example, if a company’s stock is about to drop in
price as a result of managerial incompetence, the
very insiders who caused the stock to fall can gain as
a result of their inside information by selling their
stock before information becomes disseminated to
the general investing public.
The efficiency argument
A modern variant of utilitarian ethics is the efficiency
argument. Something is ethical if it increases efficiency. One of the principal exponents of this strand
of utilitarianism is Richard Posner (1983, 1998), an
American jurist and also one of the founders of the
law and economics movement.
The efficient society is wealthier than the inefficient –
that is what efficiency means… (Posner, 1983, p. 205)
… the criterion for judging whether acts and institutions are just or good is whether they maximize the
wealth of society. This approach allows a reconciliation among utility, liberty, and even equality as
competing ethical principles. (Posner, 1983, p. 115)
Henry Manne also uses the efficiency argument in
his analysis of insider trading. Manne sees insider
trading as increasing efficiency, which means it
should be permitted (Manne, 1966). Salbu (1989,
p. 17) disagrees with Manne’s conclusion and argues
that insider trading actually makes the market less
efficient. His reasoning is based on the belief that
markets work less efficiently if exclusive access to
information is confined to small, powerful entities.
He argues that information must be spread among
numerous competitors in atomistic competition who
have equal access to information in order for the
market to be efficient.
Analyzing Insider Trading from the Perspectives
His reasoning makes sense, to a point. However,
information does not have to be widespread in
order for the market to work efficiently. All that is
required for stock prices to move in the correct
direction is for a few insiders to act on their inside
information by either buying or selling. Once they get
the ball rolling, the rest of the market will soon follow.
Another factor that Salbu does not address is how
efficiency would be altered if the small group of
insiders were prohibited from trading on their inside
information. The obvious answer is that stock prices
would take longer to move in the correct direction,
because the insiders would never start the process of
price adjustment by buying or selling shares based on
their inside information. The market would have to
wait until the information leaked out to the market,
which could take some time. It certainly would take
more time to leak out if the insiders were prohibited
from getting the process started.
One philosophical criticism that could be made of
Manne’s argument is that he does not think ethics
should play any role in deciding whether insider
trading should be permitted. Basically, he says that
we should not consider ethics, we should only
consider efficiency. But efficiency is a variant of
utilitarian ethics, so Manne is applying ethical principles even though he argues that we should not
include ethics in the discussion of whether insider
trading should be allowed. It is a minor point, and
one that does not affect the decision as to whether
insider trading should be permitted. But it is,
nonetheless, an interesting point from the perspective of philosophy.
His efficiency argument basically states that
allowing insiders to trade on their inside information
causes share prices to move in the correct direction
sooner than would otherwise be the case. It is an
a priori argument, and there certainly is nothing
wrong with a-priori reasoning, although empiricists
would prefer to conduct empirical studies.
It makes sense that prices would move in the
correct direction sooner rather than later if insiders
were allowed to trade on their inside information.
One criticism that could be made of this line of reasoning is that the number of shares that insiders would
be able to trade may be so small that it would have no
effect on share price. If that is the case, insider trading
damages no one, because it has no effect on share
price. But in cases where the number of shares traded
is sufficient to have an effect on share price, it would
logically seem that insider trading would have a
positive effect on market efficiency, because it would
indeed cause prices to move in the correct direction
sooner than would otherwise be the case.
Another facet of this issue is that the actual
number of shares traded by insiders may be irrelevant. If financial analysts get wind of the fact that
insiders are buying or selling shares, that may be
sufficient to cause a movement in prices, because the
analysts would have a tendency to advise their clients
to do the same thing the insiders are doing (buying
or selling).
Not all ethicists agree with the ethics as efficiency
argument. Egger (1979) comes down quite firmly
against it, arguing that efficiency is not a substitute for
ethics. He is quite right, of course. Efficiency is not a
substitute for ethics. That is one of the strongest
arguments that could be made against the ethics as
efficiency argument. Performing an unethical act
more efficiently does not change the ethics of the act.
Likewise, it could not be said that an economy that
works more efficiently because it disregards property
rights makes the confiscation of property justifiable on
ethical grounds. Machan (1996) warns that placing
too much emphasis on utilitarian arguments might
blind us to the inherent deficiencies of utilitarian
ethics, leading us to draw incorrect conclusions.
But the ethics as efficiency argument is not totally
devoid of substance. It seems unethical to waste
resources. If there is a more efficient way to use
resources and someone chooses to use a less efficient
way, it seems like there is something wrong with
that decision, especially if the resources used are
those of an employer. Employees and other agents
have a duty not to waste resources, so operating at a
level that is less than efficient constitutes improper
conduct.
Hoppe (1993) argues that only the institution of a
strong property rights regime can lead to maximizing
efficiency, and thus, that economic efficiency can be
justified, but on the basis of property rights rather
than utilitarianism.
There is a counter-argument to the ‘‘efficiency
improves because of insider trading’’ argument.
Some commentators have argued that insider trading
causes some investors to withdraw from the market
because of the perception that only insiders can
profit from market transactions. If the extent of
Robert W. McGee
market withdrawal is significant, the market will
become less liquid, and thus less efficient.
But even if this argument has some merit, it must
be balanced against the market benefits of insider
trading, such as the fact that allowing individuals to
trade on insider information gives them the incentive to uncover information, which causes stock
prices to move in the right direction, causing the
market to operate more efficiently and causing
benefits to society in general.
Haft (1982, pp. 1053–1067) argued that a corporation’s internal efficiency is enhanced by engaging in insider trading. But Mendelson (1969,
pp. 477–478) argues that the cost of capital increases
if a company engages in insider trading. Assuming
that both Haft and Mendelson are correct, where
does that leave us? If the internal workings of a
corporation become more efficient while the cost of
capital increases, whether the corporation is better
off as a result depends on which factor is more significant. But even if it were possible to arrive at an
answer to this question, one must still consider the
effect that insider trading has on market efficiency in
the aggregate.
One reason for the continued disagreement on the
issue of efficiency is because it is exceedingly difficult
to conduct empirical studies on this point that are able
to take all factors into account and assign the correct
weights to each factor. Any empirical researcher must
necessarily work with incomplete information and
even the information that is available may not be
completely accurate. The set of accounting principles
chosen, shifts in exchange rates, and any other number of factors make precise measurement impossible.
The assumptions made also involve a degree of arbitrariness. There is no way to completely overcome
such structural deficiencies. And even if they could be
overcome, there is still the problem of starting from
the correct premise. Empirical studies that begin with
an incorrect premise tend to arrive at incorrect conclusions (Abdolmohammadi and Sultan, 2002).
But even if efficiency could be measured and
proved, that is not the end of the argument (O’Hara,
2001). Schotland (1967), one of Manne’s early
critics, argues that moral arguments such as fairness,
integrity and justice might trump economic arguments in the case of insider trading. In other words, a
case might be made on moral grounds to prohibit
insider trading even if insider trading does result in
more efficiency. But other scholars take the position
that economic arguments should trump moral
arguments (Ma and Sun, 1998). The Ma and Sun
arguments have come under criticism for being
unsound (Snoeyenbos and Smith, 2000). So it
appears there is room for disagreement on this point.
There are problems with the fairness argument, as
we shall see below. Those same deficiencies might
equally apply to arguments involving integrity and
justice.
Manne’s 1966 book on insider trading drew a lot
of heat in the legal literature at the time. He has had
other critics as well, including Hetherington (1967)
and Ferber (1970). He responded to Ferber directly
(Manne, 1970b) and penned a more comprehensive
and generalized response to his other critics (Manne,
1970a).
The rights-based argument
The rights-based argument in favor of insider trading
is that property owners have the right to do whatever they want with their own property regardless of
what others think. Nozick (1974) would say that
they are entitled to use their property as they see fit.
Thus, the property rights approach is based on
entitlement theory.
It is a very strong argument. Why would anyone
not be able to use their property as they see fit,
especially if no one’s rights are violated in the process? It is an uphill battle to argue against the right of
individuals to use their own property as they see fit,
especially if no one’s rights are being violated.
The main problem with the property rights
argument in the case of insider trading is that it is not
always clear whose property is being traded on. If the
information belongs to the corporation, it is clear
that the corporation can do whatever it wants with
the property. It can give it away. It can allow
selected executives, or even non-executives, to trade
on it.
But not all inside information is owned by just the
corporation. One attribute of information is that
more than one person can own it at the same time.
Others, such as outside financial analysts, can obtain
this information without violating the property
rights of the corporation. When that is the case there
is absolutely nothing improper about using that
Analyzing Insider Trading from the Perspectives
information for their personal profit or that of their
clients. Ethical problems result only in cases where
the information is misappropriated.
For example, a financial printer who, in the
course of employment, learns of a pending acquisition or merger, acts unethically if he or she trades on
that information because the implied employment
contract to print information relating to the acquisition or merger includes the provision not to do
anything that would compromise the pending
transaction, and insider trading would have a tendency to do that. Likewise, an attorney for one of
the parties to the pending acquisition or merger
would be acting improperly if he or she traded in the
securities of one of the corporations unless granted
permission to do so.
Morgan (1987) examined the property rights
arguments and concluded that much of the insider
trading problem could be resolved if inside information would be treated as property. The owners of
that property could be determined and allowed to
trade their property without restriction. His conclusion seems to make a lot of sense.
Arguments against insider trading
Those who think all insider trading should be illegal
think so for a variety of reasons. Some merely say
‘‘It’s just not right’’ without further explanation or
elaboration. Others say it is inherently immoral to
trade on inside information because making a large
profit with such little effort is somehow wrong. A
third group says that there should be a level playing
field, and the playing field cannot be level when
some individuals enjoy informational advantages
over others. A fourth group takes the position that
insiders have some fiduciary duty not to benefit from
the information they have access to as part of their
position with the corporation. A fifth group subscribes to some kind of misappropriation theory,
which basically holds that the information they are
using for personal gain belongs to someone else, and
using the information results in a violation of
property rights or contract rights.
All of these views have received a wide degree of
support. However, upon closer analysis, each of
these views has major weaknesses. One weakness is
that those who advocate outlawing insider trading
resort to emotional appeals rather than sound economic or philosophical analysis.
Envy and the labor theory of value
There is often a certain amount of envy or jealousy
included in the subtext of their arguments (Schoeck,
1987). Many of those who would like to see all
inside traders punished have what Ludwig von Mises
has called the anti-capitalistic mentality (Mises,
1956). They just do not like the free enterprise
system, think it is inherently evil, and think that
individuals should not be able to make millions of
dollars with so little apparent effort. This latter view
is a subconscious application of the labor theory of
value, which was subscribed to by both Karl Marx
and Adam Smith and, in fact, every other economist
prior to the 1870s, when the labor theory of value
was replaced by the marginal utility theory and the
theory of subjective value (Jevons, 1871; Menger,
1871/1950; Walras, 1874).
The problem with applying the labor theory of
value to insider trading is that not all value comes
from labor. Things are worth whatever someone is
willing to pay. The amount of labor that went into
the product or service is completely irrelevant. Thus,
the fact that someone can make millions of dollars by
trading on information that was obtained with little
apparent effort has nothing to do with whether the
practice is immoral or whether it should be outlawed. If such a practice is immoral, some other
justification must be found.
The ‘‘it’s just not right’’ argument
This argument against insider trading is perhaps the
weakest of all arguments. It is also the most popular
if one were to take a nose count, according to at least
one commentator (Lawson, 1988, p. 775). Manne
mentions this argument in connection with one of
his female law students who, in class, exclaimed,
‘‘I don’t care; it’s just not right.’’ (Manne, 1966,
p. 233) It is akin to what Abraham Lincoln, the
former U.S. president said when discussing how an
attorney should argue a case in court. To paraphrase
Lincoln, ‘‘If you don’t have the law on your side,
pound on the facts. If you don’t have the facts on
Robert W. McGee
your side, pound on the law. And if you don’t have
the law or the facts on your side, pound on the
table.’’
This law student is pounding on the table, figuratively, because she does not have any facts or
ethical arguments to support her claim. Such facts
and theories are available. She just is not using them.
In order to condemn (or justify) insider trading, one
must apply some moral theory. She does not do that.
Appealing to the sense of the moral community, or
to emotion, is not sufficient.
Some legal scholars would disagree with this
conclusion. Wimberly (1985), for example, states:
‘‘But if emotion is not a proper source of business ethics, one wonders whence else ‘ethics.’’’
(Wimberly, 1985, p. 224, n. 102, as cited by Lawson,
1988, p. 776).
Perhaps emotion does have a valid role to play in
business ethics. However, the role should be minor,
at best, and emotion certainly is insufficient to carry
an ethical argument. Emotional appeals smack of
sophistry and have no place in any kind of intellectual discussion.
However, the female law student does have some
support for her position within the academic community. Werhane (1989, 1991) seems to think that
insider trading is inherently unethical, although
Martin and Peterson (1991) dispute her reasoning
process. Scheppele (1993) supports portions of the
law student’s position, but Allen (1993) did not find
her arguments convincing.
One might add another facet to this ‘‘It’s just not
right’’ argument. March and Olsen (1995, 1998,
2004) have done some work on the logic of appropriateness. Their argument basically states that human
action is driven by rules of appropriate action and that
these rules have become ingrained and organized into
institutions. People follow rules because they are seen
as expected, legitimate, or rightful. Individuals are a
part of a political and social community and certain
forms of behavior are expected.
Sending (2002) claims that this theory is untenable
as a theory of individual action. His argument is that,
although the logic of appropriateness theory is able
to account for the claim that norms are constitutive
for actors’ identities, this view is inconsistent with
the position that agents and structures are mutually
constitutive. The theory also is not able to account
for the view that ‘‘changes in ideational structures do
occur and lead to changes in political practice.’’
(Sending, 2002, p. 443). We will not take any more
time to discuss this point because it is a minor one,
although it does relate to the topic at hand.
At the other end of the philosophical spectrum
one might apply the falsification theorem, which
basically holds that the truth of a proposition may
not be verified, but only negated (Burke, 1983;
Popper, 1972, 1974; Posner, 1979). This is an
application of the scientific method to the social
sciences. In other words, it is not possible to prove
that insider trading is ethical but only that it is
unethical in some cases. In those cases where it
cannot be shown to be unethical, one can assume for
the time being that insider trading is ethical until
some philosopher comes along to prove that it is not.
Lawson has the following comment to make on
this point:
Property rights theorists, whether of a Lockean or
social-efficiency bent, have a means of identifying at
least one major class of transactions deserving of moral
disapproval: trading on stolen goods. Beyond that, few
conclusions can be drawn, except that, as with most
ethical questions, the moral approach to insider trading that can attract a clear consensus has yet to be
advanced. (Lawson, 1988, p. 783)
The level playing field argument
Advocates of full disclosure, past and present, have
advanced essentially a single argument in support of
their position: It is every person’s duty to serve his
fellow men and to place their interests, if not above
his own, then at least on the same level. (Lawson,
1988, p. 743)
The level playing field argument has been around
for thousands of years. Cicero discussed it in ancient
Rome in his De Officiis, book III (Lawson, 1988,
p. 737). Aquinas, Grotius, and Pufendorf also discussed the need, or lack thereof, to disclose certain
facts to potential buyers (Lawson, 1988, p. 740).
They concluded basically that there is no moral duty
to disclose information that does not concern the
thing itself. For example, there is no duty for a grain
merchant to disclose to the residents of a starving
city the fact that there are one hundred ships filled
Analyzing Insider Trading from the Perspectives
with grain just one day away, but there is a duty
to disclose the defects in a building one is trying to
sell.
Pothier (1806) did not fully agree with Cicero’s
grain merchant example. By keeping quiet about
information that would soon cause the value of the
grain to drop dramatically, Pothier thought that the
merchant was acting unethically because he received
more than what he gave up.
The problem with that line of reasoning is that
both parties to every transaction always receive more
than what they give in exchange, at least in their
own subjective view. Otherwise there would never
be any trades. Trade is a win–win situation because
both sides to the trade value what they have less than
what they are trading to get. That is why they trade.
Pothier seems to believe that a fair trade is a zerosum game.
The level playing field argument has been used to
justify any number of economic regulations. Trade
cannot be free, it must be fair, whatever that means
(Bovard, 1991). People who have accumulated a
great deal of wealth during their lifetimes must have
it confiscated when they die so that those who are
less fortunate will be able to compete with the
children and grandchildren of the rich, who would
otherwise leave their wealth to their children.
Such thinking is one of the main reasons why
some countries have adopted punitive estate and
inheritance taxes (Buchanan and Flowers, 1975).
The level playing field argument has been applied to
insider trading to argue that all investors should have
the same information at the same time, regardless of
what they have done, if anything, to earn the
information.
The problem with this level playing field argument is that it is not possible or desirable to ever
have a level playing field in the realm of economics.
The level playing field argument is appropriate to
apply to sporting events but not to economics. It
would not be fair for one football team to have to
run uphill for the entire game while its opponent can
run downhill. It is not fair for one basketball team to
have a larger hoop to shoot at than its opponent. But
there is nothing unfair about allowing banana
farmers in Alaska to compete with banana farmers in
Honduras. Alaska banana farmers should not be
subsidized so that they can compete more effectively
with banana farmers from Honduras, and banana
farmers from Honduras should not have to comply
with punitive regulations or higher tax burdens to
make them less able to compete with banana farmers
from Alaska. Likewise, there is nothing unfair about
allowing experts who work 60 hours a week to
gather financial information as part of their job to
profit from that information. What is unfair is to
force them to disclose such information to people
who have done nothing to earn it.
Ricardo’s (1817) theory of comparative advantage
is at work here. Some individuals or groups are
naturally better at some things than others, and some
individuals or groups develop skills that are better
than those of their competitors. Penalizing those
who are better at something or subsidizing those
who are worse at something results in inefficient
outcomes and is unfair to some groups.
Comparative advantage works to the benefit of
the vast majority of the population. It allows specialization and division of labor, which Adam Smith
(1776) pointed out in his pin factory example leads
to far greater efficiency, higher quality, and lower
prices. Not allowing individuals to use their special
talents harms the entire community and the individuals who are being held back by some government law or regulation. Forcing a level playing field
on people is always harmful because it reduces efficiency and violates rights. Using the level playing
field argument to prevent individuals from using
their insider knowledge for personal gain does not
hold up under analysis. If insider trading is to be
made illegal and if inside traders are to be punished,
some other justification must be found.
The level playing field argument has an underlying premise that buying and selling is somehow
unethical when the information is asymmetric. But
information is often asymmetric in the business
world (Lawson, 1988, p. 733). One party to the
transaction often knows more about the value of the
item being sold than does the other party. A
knowledgeable antique collector knows more about
the value of certain objects than does the owner of
the property that is offering it for sale in a week-end
yard sale. Acquisition and merger specialists know
more about the underlying value of a company’s
shares than does the average uninformed shareholder. Executives of a company often know more
about the value of their company’s stock than do
non-employees.
Robert W. McGee
The fairness argument
The fairness argument, or rather the various variations of the fairness argument, contains elements of
the ‘‘It’s Just Not Right’’ argument, the envy
argument, and the level playing field argument. Yet
prominent jurists, including U.S. Supreme Court
Justice Blackmun, believe that insider trading is
inherently unfair (Chiarella v. U.S., 1980 at 248) and
other cases have also given the ‘‘inherently unfair’’
argument some attention (U.S. v. Carpenter, 1986/
1987).
Perhaps the main problem with any fairness
argument is the inability to define fairness. What is
fair to one person may be seen as unfair to another.
Some people think it is unfair that some children are
born into rich families while others are born into
poor families. Perhaps it is fair and perhaps it is not,
depending on which underlying premises one is
relying on. Cho and Shaub (1991, p. 85) argue that
insider trading unfairly shifts the risk in favor of
insiders, which leads to disutility.
The fairness argument has been criticized for its
lack of content (Easterbrook, 1981, pp. 323–330)
and for its imprecision (Strudler and Orts, 1999,
p. 381). Strudler and Orts attempt to clarify the
concept of fairness as applied to insider trading by
relying on the standard deontological approach that
‘‘what makes an act morally justifiable is the respect
it expresses for the autonomy, rights, and dignity of
those persons affected by it, and not merely the
social welfare or the utility that the act produces.’’
(Strudler and Orts, 1999, p. 381) At least their
approach allows one to diverge from the strict utilitarian calculus, which is impossible to quantify in
any event.
A common statement using the fairness argument
is that it is inherently unfair that some are born rich
while others are born poor. One might just as easily
state that it is not fair that some people are more
attractive, taller, or more athletic than others. But
problems result whenever the attempt is made to
reduce or eliminate a perceived unfairness. Any attempt to level the playing field necessarily results in
violating the rights of those who are perceived to be
above average.
Should the fastest runners be forced to strap
weights on their ankles so that slower runners have a
better chance to win? Should rich people have their
assets confiscated so that their children will not be
able to inherit a fortune, thus placing them on a
more even keel with the children of poor families?
Confiscating justly acquired assets would necessarily
violate the rights of the people whose assets are being
confiscated. Forcing insiders to share their justly
acquired property rights in information would also
be inherently unfair to the people who own the
information. When one looks at fairness, perhaps a
better approach would be to look at the process
rather than the destination. If the process is fair, if
individuals are allowed to live their lives as they see
fit as long as they do not violate the rights of others,
there should be no need for the state to intervene.
Lawson (1988, p. 736) discusses Levmore’s
concept of fairness, which takes the position that a
transaction is fair when there is equality of information. Levmore would say that a transaction is
fair
…when insiders and outsiders are in equal positions.
That is, a system is fair if we would not expect one
group to envy the position of the other. (Levmore,
1982, p. 122, quoted by Lawson, 1988, p. 736)
There are several problems with this view. For
one, it would be impossible to determine in advance
if this standard would be met. It also would not be
fair to penalize insiders just because some group or
particular individual might be envious when there is
no justification for the envy. If one could violate the
property rights of the rich just because some people
are envious of the rich, it would not be long before
there were no rich people. One negative externality
of such a system would be the collapse of all market
economies, because there would be no incentive to
produce. Reducing or eliminating envy is not an
acceptable reason to violate the rights of insiders to
profit from their justly acquired property.
One might also point out that insiders nearly
always have better information than outsiders. It is
just a fact of life. The possession of better information is often justified, which means that forcing the
insiders to give their property rights in information
to outsiders just because the outsiders do not yet
possess the information would be inherently unfair
to the insiders.
Another variation of the fairness argument is that
it is somehow unfair to profit from dealing in insider
information because the insiders are big, rich, and
Analyzing Insider Trading from the Perspectives
powerful whereas the outsiders are small, weak and
powerless. While this might be true sometimes, it
definitely is not true all of the time. It may be true in
a minority of cases only. It is quite likely that the
outsider is a pension fund or insurance company
(Lawson, 1988, p. 774) or a Martha Stewart, a billionaire who just happens to know an insider.
One view of fairness that seems to have a great
deal of plausibility is the view that a transaction is fair
if it is the result of voluntary exchange and unfair if
the exchange is forced.
The fraud argument
Strudler and Orts (1999, p. 376) provide a good
example of the fraud argument. Let us say that the
president of some company is telling his shareholders
that the company is doing poorly and is offering to
buy up their shares when in fact earnings have
quadrupled. That seems like fraud. Individuals are
being fed false information deliberately with the
intent to defraud. The fact that the president of the
company is the one doing it just makes matters
worse.
There are laws against fraud. Shareholders are thus
already being protected. The problem is that the
Securities and Exchange Commission in the United
States adopted Rule 10b-5 with the assumption that
insider trading is a kind of securities fraud, which it is
not (Strudler and Orts, 1999, p. 377). In order to be
guilty of fraud, one must make a statement with the
intent to deceive. The company president did that,
and so is guilty of fraud. But most insider trades do
not go this route. Inside traders generally call their
stock broker and instruct them to either buy or sell
the shares. The party at the other end of the transaction – the party who either sells or buys those
shares – does so anonymously. The seller does not
know who the buyer is and the buyer does not
know who the seller is. Neither side made any
statements to the other side, either false or true.
Another example of alleged fraud is the Texas
Gulf Sulphur Company case (1968). In that case
some of the company’s officers, directors, and
employees learned that the company had a major ore
strike in Canada and traded on that information for
personal gain before announcement of the strike was
made public. Those individuals were in possession of
material inside information and were obligated to
disclose it or refrain from trading on the information.
Actually, it was in the company’s best interest not
to disclose the information immediately. Keeping
the information secret would make it possible to buy
up adjoining properties at lower prices than would
be the case if those land owners knew about the
strike. Keeping silent would also be in the interest of
existing shareholders.
Another interesting philosophical question is
whether the individuals who knew about the ore
strike were morally precluded from entering into
real estate purchases with adjoining landholders. It
seems like corporate officers or directors who
bought adjoining land would be breaching a fiduciary duty, since it would seemingly be a conflict of
interest. But whether mere employees who were not
also directors or corporate officers would be acting
unethically by gobbling up adjacent real estate is less
clear. Mere employees have no fiduciary duty to the
corporation. They merely must abide by the terms of
their employment contracts. Perhaps there is an
implied contract not to do such things. Or perhaps
no such implied contract exists. But if some implied
contract exists, existing contract law can deal with
that issue. There is no need to pass a law prohibiting
insider trading to deal with this case. Furthermore, if
the insider trading law defines inside traders as officers or directors and limits the definition to those
two categories, it is clear that mere employees do not
meet the definition of inside traders, and so would
not be subject to any law against insider trading.
Another interesting question, raised by Strudler
and Orts (1999, p. 379), is whether anyone is acting
unethically if the corporation buys back some of its
own shares or if the corporation gives certain
employees or directors permission to trade on the
inside information. If one begins with the premise
that the corporation owns the rights to the information, it seems clear that anyone who has permission to buy shares is not acting unethically. And
there is no fraud involved, because no one is making
any statements with an intent to deceive. The trades
are made anonymously through brokers.
The O’Hagan case has muddied the waters somewhat when it comes to determining what constitutes
fraud and what does not [United States v. O’Hagan,
521 U.S. 642 (1997)]. This case has been examined by
many and criticized by most (Painter et al., 1998;
Robert W. McGee
Thel, 1997). The misappropriation theory, which is
discussed in O’Hagan, has also been criticized (Salbu,
1992a, b). More on that later.
In the O’Hagan case a partner in a law firm who
was involved in the merger traded in the shares of
the target of his firm’s client. What he did was
clearly improper, but was it fraud?
The U.S. Supreme Court held that it was fraud
because he had misappropriated information in
connection with trading in securities. The fact that
he was an outsider with regard to the corporation in
whose stock he traded rather than an insider did not
matter to the court. The attorney did not make any
affirmative misrepresentation or wrongful nondisclosure to the person with whom he traded the
shares. Yet he was found guilty of fraud anyway.
Strudler and Orts (1999, p. 379) point out that this
case ‘‘stretches the concept of fraud beyond any
easily identifiable limit.’’
The company would have a cause of action
against the attorney for breach of fiduciary duty.
There are already laws on the books to deal with this
kind of thing. But to stretch the definition of fraud
to include an outsider who did not utter any misleading statements with the intent to defraud has
been criticized as going too far.
One problem with the fraud argument, in some
cases of insider trading, is that it is not always possible
to find a victim. Some scholars (Parkman et al.,
1988) have debated whether it is the owners or the
traders who are the real victims of insider trading.
Where there is no victim there cannot be a fraud. So
even if the fraud argument is valid for some cases of
insider trading, one cannot say that it is valid for all
insider trading cases.
The fiduciary duty argument
Moore (1990) believes that the fiduciary duty
argument is the strongest argument that can be put
forth to outlaw insider trading. The underlying
premise of the fiduciary duty argument is that officers and directors have some fiduciary duty to their
shareholders, which requires them to fully disclose
any and all significant information that shareholders
could benefit from knowing (O’Hara, 2001). The
argument is good as far as it goes, but it has
been criticized for being incomplete. The strongest
criticism is that the fiduciary duty argument applies
only to officers and directors. It does not apply to
outsiders, nonemployees, and employees who have
no fiduciary duty to shareholders. The O’Hagan case
is one example where the court strained to find
some fiduciary relationship (Strudler and Orts, 1999,
p. 380).
However, some courts have found that a fiduciary
duty exists between nonexecutive employees and
the corporation. In the Texas Gulf Sulphur case
(1968), for example, the court held that geologists
can have a fiduciary duty to their employer not to
trade in the company’s securities where they have
material non-public information.
The fiduciary duty argument has been criticized
on other grounds when applied to insider trading
cases. Traditionally, people who have a fiduciary
duty have a duty to the corporation, not the shareholders (Strudler and Orts, 1999, p. 390). Thus, if
shareholders are harmed as the result of some
director, officer or employee trading on insider
information, they cannot use the fiduciary duty
argument to claim compensation, because there is no
fiduciary duty in this case.
The fiduciary duty argument cannot be used in
cases where it is an outsider rather than an insider
who trades in the securities. It also cannot be used in
cases where an insider sells shares to someone who
was not already a shareholder in the corporation,
because officers and directors owe a fiduciary duty
only to people who are already shareholders. The
fiduciary argument is also not valid against officers or
directors who buy or sell the corporation’s bonds,
because bondholders are creditors, and there is no
fiduciary duty to creditors (Strudler and Orts, 1999,
pp. 391–392). Langevoort (1982) raises the question
of whether there is a fiduciary duty to individuals
who have stock options.
If one closely analyzes the fiduciary duty argument, one quickly sees that it is a less than complete
and comprehensive argument. The relationship
between employees and the corporation is based on
contract. There is no duty other than to deliver
according to the terms of the contract (Lawson,
1988, p. 773; Macey, 1984, p. 33). Where the
employer allows the employees to trade on corporate information, in effect it has given them property. Where the corporation prohibits employees
from trading on inside corporate information, any
Analyzing Insider Trading from the Perspectives
trading that results is a breach of contract. One area
where problems can result is in cases where the
corporation neither forbids nor allows insider trading, because the contract and property rights regimes
are not well-defined.
The misappropriation argument
Even if insider trading results in net benefits to
society, thus meeting the utilitarian ethics test, there
are instances where insider trading is unethical. One
such example is in cases where someone trades on
information they are not legally or morally entitled
to trade on. For example, in the Chiarella case, a
financial publisher who was hired to publish sensitive documents relating to a pending merger was
able to guess which companies were parties to the
merger. He traded on that information by purchasing stock.
In such cases there is an implicit understanding
that the information given to the printer is to be kept
confidential and that the printer is not to trade on
the information. The parties to the merger have a
property right in information. When the printer
traded on that information he violated their property
rights.
Attorneys who deal in non-public information
they learned during the course of representing their
client might also be unethical if the client did not
give the attorney permission to use the information
for profit. One could think of other cases where
information is misappropriated. But the problem
with the misappropriation theory as applied in the
United States is that the insider trading cases that
have been decided are not logically consistent. It is
difficult if not impossible to predict which trades will
run afoul of the law and which will not. There is
confusion regarding when insiders, tippees, and
other professionals have a duty to refrain from using
the information they have for profit (Karmel, 1998,
p. 85).
Another criticism of the misappropriation theory
is that fraud must be involved. Traditionally, fraud
involves a statement that is deliberately misleading
with the intent to defraud someone. Also, there must
be a victim in order to have fraud. Thus, where
there is no fraud, or where there is no victim, the
misappropriation theory should not be applied. If it
is, it is being misapplied.
What is wrong with insider trading?
Lekkas (1998) provides a brief summary of the
arguments that have been made for and against insider trading. Bainbridge (2000) also summarizes the
pro and con arguments and provides a bibliography.
Their arguments against insider trading include: the
previously mentioned level playing field argument;
the belief that unequal access to information is
somehow unfair; insider trading encourages greed;
trading on inside information is theft of corporate
property; insider trading is a kind of fraud (Strudler
and Orts, 1999); insiders who profit from the use of
inside information are breaching their fiduciary duty.
The main argument supporting insider trading is
efficiency. Trading on inside information causes
information to be released into the marketplace
sooner rather than later, thus causing stock prices to
move in the right direction quicker than would
otherwise be the case. Studies by Meulbroek (1992),
Cornell and Surri (1992), and Chakravarty and
McConnell (1997) support this position. Another
argument in favor of insider trading is that inside
information is property, and preventing individuals
from trading their property violates their property
rights.
Bernardo (2001) sees the right to trade on insider
information as a contractual problem of allocating
property rights between shareholders and stakeholders. Allowing insiders to deal in insider information has also been viewed as a kind of
compensation, a salary supplement or a bonus to be
given as a reward for performance.
Henry Manne (1966) was the first to do a detailed
study of insider trading and his study has become a
classic. He concluded that insider trading does not
result in any significant injury to long-term investors
and causes the market to act more efficiently. He has
called it a victimless crime (Manne, 1985), as there
are no identifiable victims. Those who sell their
stock anonymously to a broker would have done so
anyway, so they are no worse off then they would
have been if the inside trader had not traded.
Jeng et al. (2003) conducted an empirical study
that reached basically the same conclusion. They
Robert W. McGee
estimated that the expected costs of insider trading to
noninsiders were about ten cents per $10,000
transaction. Allen (1984), Leland (1992), and
Repullo (1994) conducted studies concluding that
insider trading was beneficial to other shareholders.
The insider trading law does not consider the
possibility that an inside trader may profit from
inside information by not trading. For example, if the
insider knows that the stock price is likely to go up,
he can refrain from selling the shares he already
owns. Likewise, if he knows the stock price is likely
to fall he can refrain from buying shares. These
activities are not prohibited by insider trading laws
but they are examples of insiders profiting from
nonpublic information.
One conceptual problem with insider trading is
determining ownership of the property in question.
Information can be viewed as property, but it is not
always clear who owns the right to use nonpublic
information. The misappropriation theory tries to
solve this problem but commentators are not in
agreement about whether this problem has been
solved. Quinn (2003), Weiss (1998), and Seligman
(1998) think that it has while Swanson (1997) and a
plethora of other commentators (Quinn, 2003) think
it has not. The property issue is one of the keys to
solving the problem of whether insider trading
should be outlawed or regulated, yet it is unclear in
some cases who can claim an ownership right to the
property or when it has been misappropriated.
Concluding comments
Several studies show that insider trading results in a
positive-sum game. There are more winners than
losers. Thus, it is ethically justified from a utilitarian
perspective, at least in the cases where the result is a
positive-sum game. However, gathering reliable data
to conduct such studies is hampered because some
insider trading activity is illegal (Bainbridge, 2000).
Also, it is not always possible to know whether the
result is a positive-sum game, even after the fact.
That is one of the insoluble structural deficiencies of
the utilitarian approach. Thus, utilitarian ethics is not
a good tool for analysis of insider trading cases.
Not all insider trading results in violation of
anyone’s rights. In many cases, insider trading is
merely the exercise of property rights. Thus, from a
rights perspective, it cannot be said that there is
necessarily anything wrong with insider trading. It
depends on whether anyone’s rights are violated in a
particular instance. That being the case, any laws that
countries adopt that outlaw all forms of insider
trading are bad laws. There should be no blanket
prohibitions of insider trading because such laws
violate property rights, the right to sell or trade on
information.
The presumption should be that all capitalist acts
between consenting adults should be legal and
unregulated. The only exceptions should be in cases
when someone’s rights are violated or where some
fiduciary duty has been breached (which is a form of
contract rights violation). In cases where rights have
been violated, the perpetrators should be punished.
There are already laws on the books that prohibit the
violation of rights, in most cases. In cases where a
fiduciary duty has been breached, there are already
laws on the books, or should be. There is no need to
have a special law for breaches of fiduciary duty that
involve insider trading. Breaches of fiduciary duty
are breaches of implied contract, and existing laws
are adequate to deal with such contract rights violations.
One thing that is disturbing is the worldwide
trend toward blanket prohibitions of insider trading.
European Union countries have laws that outlaw
some forms of insider trading that might be beneficial (European Union, 1989; Gevurtz, 2002).
Countries that want to become EU members must
pass laws prohibiting insider trading, which they
might do without adequate thought to the effects
such prohibitions might have on property rights and
their economies. The Organisation for Economic
Cooperation and Development (OECD) and the
World Bank have published numerous studies that
indiscriminately show insider trading in poor light
without making distinctions between beneficial
forms of insider trading and insider trading that is
fraudulent or results in the violation of property
rights. These studies do not distinguish good insider
trading from bad insider trading. Some of these
studies are listed in the reference section (OECD,
1999, 2003a, b, 2004; World Bank, 2001a, b, c,
2002a, b, c, d, e, f, 2003a, b, c, d, e, f, g).
If one truly wants to adopt policies that benefit
society without violating property and contract
rights, it is necessary to closely examine the effects
Analyzing Insider Trading from the Perspectives
the proposed policy will have on all groups. As
Frederic Bastiat (1850/1964) once said, the only
difference between a good economist and a bad
economist is that the bad economist confines the
analysis to the visible effects. A good economist
would also examine the effects that are not as visible
but may be foreseen. One might say the same about
ethicists.
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