( )Critical Perspectives on Accounting 2000 11, 105]110doi:10.1006/cpac.1999.0375Available online at http://www.idealibrary.com on

CIVIL LAW VERSUS CRIMINAL LAW REMEDIESFOR INSIDER TRADING: THE CASE FOR THE

PLAINTIFF

MARTIN WALKER1

Department of Accounting and Finance, The University of Manchester,Manchester M13 9PL, UK

Introduction

Michael Keenan’s paper seeks to establish three main points:

1. That insider trading decreases market efficiency;2. That insider trading is an immoral practice; and3. That external preventive regulation of insider trading can be effec-

tive.

In establishing his third point, Keenan assumes that insider tradingregulations can be costlessly enforced, i.e. he does not consider thecostliness of alternative enforcement regimes, nor does he consider thedistributional consequences of such enforcement costs.

The purpose of the present paper, is first to comment on the variousanalyses of Keenan, and then to provide an argument against the useof the criminal law as a basis for regulating insider trading.

Does Insider Trading Decrease Market Efficiency?

Keenan’s analysis of the consequences of insider trading for marketefficiency begins by carefully distinguishing the notion of informational

( )efficiency from the more fundamental notion of allocative i.e. Paretoefficiency. This is an important distinction, but it is a distinction thatdeprives Keenan’s efficiency argument against insider trading of much ofits force. If one could establish that insider trading leads to Paretoinefficient outcomes, then this would be a cause for concern, and wouldgive grounds for considering whether some form of insider tradingregulation could generate improved outcomes.

However, Keenan simply demonstrates that tolerance of insider tradingcauses share prices to respond less quickly to private information. Keenan

Received 4 March 1997; revised 1 June 1998; accepted 20 December 1998

105

1045-2354/00/010105+06 $35.00/0 2000 Academic PressQ

M. Walker106

does not explain why, on allocative efficiency grounds, anyone shouldbe troubled by such outcomes.

( ) ( )Leland 1992 presents a preliminary formal analysis of the Paretoefficiency arguments for and against insider trading regulation. His anal-ysis considers the effects of insider trading on three classes of in-vestors: inside investors, outside investors, and liquidity traders2. Theanalysis shows that insiders gain from insider trading, and the othertwo classes of investors lose. Total welfare may increase or decreasedepending on the sensitivity of real investment to the current stockprice.

( )The Leland 1992 analysis is, in my opinion, a more useful startingpoint for the efficiency analysis of insider trading than Keenan’s. How-ever, both analyses are incomplete, because they contain no rationalefor corporate secrecy. It is primarily because companies value commer-cial secrecy that potential insider trading problems arise in the first

( )place see Dye, 1985, 1986 for useful discussions of proprietary informa-)tion . Any analysis of insider trading which fails to allow for the need

to protect proprietary information is bound to be incomplete.A useful feature of Keenan’s analysis is the distinctions he draws

between various temporal aspects of the generation and release ofinformation to the market. Keenan’s definition of information efficiencyfocuses on the length of the interval from the time a piece of informa-tion becomes available to at least one investor, to the time when theinformation is reflected in share prices. This in turn leads Keenan toadopt the speed of response to new information as the defining featureof information efficiency. Other commentators on insider trading, thatare referenced by Keenan, have tended to confuse the speed of re-sponse issue with the issue of how soon a piece of information entersthe market. These commentators have focused on issues such as howsoon a piece of information is generated by at least one investorand/or how soon a piece of information becomes reflected in shareprice. Keenan is correct in pointing out that the timeliness with which apiece of information enters the market is not the same thing as thespeed with which market prices adjust to an item of information.

Is Insider Trading an Immoral Practice?

Keenan’s ethical argument against insider trading is based on a moralprinciple which he refers to as the ‘‘principle of respect for individualautonomy’’. It would be helpful to have a precise statement and expla-nation of this principle. Unfortunately the paper provides no such state-ment, although it does provide a statement of the correlative rights andduties which, according to Keenan, are implied by the general principle:

‘‘If A and B are moral agents, and Z is an act..... the correlative dutiesand rights derived from that principle can be expressed as follows:

Civil versus criminal law 107

if A has a duty to B that A should do Zthen B has a right against Athat A should do Z‘‘.

To illustrate the ethical principle he advocates, Keenan argues that in apatient/doctor relationship

‘‘a doctor has a duty to a patient to obtain informed consent to treatthe patient, and the patient... has a right against the doctor to theinformation necessary for that consent’’.

Thus by analogy, Keenan argues:

‘‘an insider has a duty to an outsider to obtain the latter’s informedconsent to trade, and the outsider has a right against the insider thatthe latter disclose all price-relevant information necessary for that con-sent‘‘.

But is this analogy valid? If a person is ill, then he/she has little choicebut to consult a doctor. Moreover the patient, or at least the patient’sinsurers, pays the doctor for advice on his/her condition. In other wordsthe patient/doctor relationship is a principal/agent relationship. This isentirely different from the arms-length transaction of corporate securities.Nobody is forced to invest in corporate securities, and nobody whoowns corporate securities is forced to trade in them; buy and hold isalways an option. What potential investors need to know is the rules ofthe trading game they are getting into when they choose to invest incorporate securities. If they know that a particular security exchangepermits insider trading then they can decide for themselves whether ornot to invest and/or trade in the securities traded in that exchange.Moreover, in competing for securities business, the various exchanges ofthe world, have an incentive to devise rules that will provide investorswith the confidence to trade in their particular exchange. In other words,corporate security trading is an economic service, and it is the responsi-bility of the exchanges themselves to provide the optimum combinationof cost, liquidity, and investor protection.

Can External Preventive Regulation of Insider Trading be Effective?

Keenan’s third section examines the effectiveness of three alternativeregulatory regimes:

1. No public disclosure of private information, and insider tradingpermitted;

2. Mandatory disclosure of all private information;3. Mandatory disclosure of insider information by any insider wishing

to trade.

M. Walker108

Keenan argues that regulatory regime 3. is the only one which satisfiesthe three effectiveness criteria:

1. Consistent with increased market efficiency;2. Consistent with improved business ethics;3. Consistent with maintaining firms’ incentives for generating price

relevant information.

The first two criteria follow from the analysis of the first two sectionsof Keenan’s paper. We have already questioned Keenan’s arguments forthese criteria. Keenan does not explain why it might be desirable forfirms to have incentives to generate price relevant information. Conven-tionally arguments in favour of such views have been established by

(appeal to the desirability of achieving Pareto efficient outcomes see e.g.)Lev, 1988 , but Keenan abandons this criterion for economic efficiency in

the first section of his paper.In spite of these quibbles, I still find the argument of this section

interesting, because it highlights a major problem associated with theuse of mandatory disclosure rules for regulating insider trading. Holdingthe private information production decisions of firms constant, manda-tory disclosure might serve to reduce insider trading. But the mandatorydisclosure rules can also affect the type and amount of informationproduced by firms on private account. Moreover, the extent to whichsuch private information production decisions are affected, will varydepending on commercial circumstances. In particular a requirement todisclose all value relevant information can be damaging to firms ininstances where the information is also commercially sensitive.

Insider Trading: Arguments for a Civil Law Approach

( ) ( )Neither Keenan 1992 nor Leland 1992 consider the costs of enforcinginsider trading regulation. Also neither of the authors consider theincentives for companies and security exchanges to devise private meansfor protecting outsiders against insider trading.

In thinking about insider trading it is important to bear in mind thatcompanies are man-made institutions. Moreover the corporate form en-joys important legal privileges, such as limited liability and the right, incriminal law courts, to be afforded the same legal protection as ahuman being. An increasing number of commentators are becoming

(concerned about the power and influence of corporate entities see e.g.)Wilks, 1997 , and it would be my view that any legal mechanisms that

privilege the corporate form should, in the interest of a free society, beclosely scrutinised with a view to their possible abandonment.

Insider trading is a problem associated with the corporate form. Otherforms of organisation, sole proprietorships, and partnerships for example,do not suffer from this problem.

It is not clear to me why the corporate form should be granted animplicit subsidy, relative to other organisational forms, by way of the

Civil versus criminal law 109

use of the criminal law to regulate insider trading. If insider dealingmakes it more difficult for corporate entities to raise capital then itshould be up to those entities to devise intelligent ways around theproblem, appropriate to their own needs and circumstances. Companiesand stock exchanges which devise the best solutions will be the onesthat survive in the long run.

I have three other concerns about the use of criminal law in thiscomplex area:

1. It seems to me quite likely that the really big operators, and thereally smart insiders will be less likely to be caught, and lesslikely to be successfully prosecuted. The legal principle of ’’beyondreasonable doubt‘‘ makes it difficult to secure convictions, espe-cially in jury trials involving complex commercial information;

2. The presence of insider trading criminal laws will blunt the incen-tive for companies and security exchanges to search for alternativedevices to protect investors. Suppose, for example, that advancesin psychology and biological science made it possible to devise anear perfect lie detector. Then such devices could be used toproduce evidence which would be admissible for trying civil lawsuits, which are judged on the basis of the balance of probabili-ties.

3. A blanket ban on insider trading for all forms of company, and allforms of security exchange, may be seriously inefficient. Leland’s( )1992 preliminary analysis indicates that the total welfare effect ofinsider trading regulation will vary according to the sensitivity ofinvestment to current share prices. Once one admits issues ofproprietary information into the analysis, the net efficiency gains/losses from insider trading regulation become even more contex-tual. A civil law approach would allow different corporate forms,and company-type and/or security exchange specific trading rulesto be established. For example we might see two systems ofsecurity exchange established: one concerned to build a reputationfor its ability to regulate insider trading, another which was moresuited to high-risk, closely-held companies with large amounts ofproprietary information. To some extent we see such choices al-ready being made by companies shopping around exchanges forthe one which offers the best combination of regulatory, disclo-sure, and compliance costs, versus secondary market liquidity, andaccess to capital.

Notes

1. The author is a Professor of Finance and Accounting in the Manchester School ofAccounting and Finance, at The University of Manchester.

2. Insiders are economic agents who, by virtue of their privileged position have access tovalue relevant information that is not directly observable by other agents. Outsiders

M. Walker110

are agents who trade intelligently with knowledge of the presence of insiders. Liquidity(traders are agents who trade for exogenous reasons i.e. their trading strategy does

)not take into account the presence of insiders , possibly for reasons relating tointer-temporal smoothing of income flows.

ReferencesDye, R. A., ’’Disclosure of Nonproprietary Information‘‘, Journal of Accounting Research, Vol.

23, 1985, pp. 123]145.Dye, R. A., ’’Proprietary and Nonproprietary Disclosures‘‘, Journal of Business, Vol. 59, 1986,

pp. 331]366.Keenan, M., ’’Insider Trading, Market Efficiency, Business Ethics and External Regulation‘‘,

Critical Perspectives in Accounting, 11, 71]96.Leland, H. E., ’’Insider Trading: Should it be Prohibited?‘‘, Journal of Political Economy, Vol.

100, 1992, pp. 859]887.Lev, B., ’’Toward a Theory of Equitable and Efficient Accounting Policy‘‘, The Accounting

Review, Vol. 63, 1988, pp. 1]22.Wilks, S., Conservative Governments and the Economy’’, Political Studies, Vol. 45, 1997, pp.

689]703.