why both insider trading and non-mandatory disclosures should be prohibited

MANAGERIAL AND DECISION ECONOMICS

Manage. Decis. Econ. 18: 667–679 (1997)

Why Both Insider Trading andNon-Mandatory Disclosures Should be

ProhibitedNaveen Khanna*

Michigan State Uni6ersity and Northwestern Uni6ersity, Michigan USA

This paper shows that insider trading reduces outside searchers’ trading profits and thus theirincentive to search for information. This reduces social welfare since allocation decisions aremade with less information. Non-mandatory disclosures are also socially undesirable foridentical reasons. Thus society would benefit if the rule to ‘disclose or abstain’ were alteredto just ‘abstain’. Also, since firms may not voluntarily restrict insider trading, governmentregulation is necessary. I investigate which economies are more likely to provide politicalimpetus to regulate. Where public corporations are primarily owned and controlled byentrepreneurs or large undiversified stockholders, pressure to regulate (or enforce existingregulation) will be lower. However, insider trading is more likely to be effectively regulatedwhere owners are largely diversified. Evidence is presented to show that the USA experi-enced just such a transformation in the 1960s and that this change accounts for stricterenforcement of insider trading regulations. This may explain both why regulation in the USAdeveloped in the manner it did, and why certain countries like UK, Japan, Germany andFrance, etc. do not yet have restrictions on insider trading. © 1997 John Wiley & Sons, Ltd.

INTRODUCTION

The debate about insider trading has been activefor over 30 years. Many scholarly papers havebeen written during this period which have con-tributed to our understanding of the differentdimensions1. The insights, while improving thequality of the debate, have made us aware of thecomplexity of the issues involved. Thus, it is notsurprising that no consensus has been reached inacademic circles about whether insider trading isgood or bad. In the meantime though, regulatorsand courts have moved towards restricting insidertrading. This paper demonstrates that the posi-tions of academics and courts are reconcilable andthat existing regulation, with one major change,may be optimal for maximizing social welfare.This particular change represents the next logicalstep for regulation and requires that the current

rule for Insiders to ‘Disclose or Abstain’ shouldbe strengthened to just ‘Abstain’. The reason isthat, because of the public goods nature of infor-mation, unexpected voluntary disclosures createsome of the same inefficiencies that regulationagainst insider trading is attempting to prevent.The paper also provides evidence that the presentform of regulation resulted from two fundamentaldevelopments in the economy of the USA duringthe early 1960s: (1) the increasing popularity ofboth diversified mutual funds; and (2) merger andacquisition activity2.

The more compelling arguments for allowinginsider trading are that it (i) makes prices moreinformative, which can increase both the liquidityin the market and allocational efficiency; (ii) leadsto more information collection by insiders, whichimproves social welfare whenever insiders are theleast cost producers of this information; (iii) al-lows for efficient recontracting between managersand firms which results in better usage of informa-tion by the manager; (iv) increases the value of

* Correspondence to: Michigan State University, 320 EppleyCenter, East Lansing, MI 48824-1121. E-mail:[email protected]

CCC 0143–6570/97/070667-13$17.50© 1997 John Wiley & Sons, Ltd.

668 N. KHANNA

the firm by reducing the contractual wage thatfirms need to pay to the manager as he/she makesup the rest from trading; (v) reduces outside searchby reducing outsiders’ trading profits, which isbeneficial as long as the outside information isredundant or too costly; and finally, (vi) permitslarge stockholders, which may include managers insome firms, to trade for liquidity reasons.

The main arguments for banning insider tradingare that when it is permitted (i) uninformed tradersface more adverse selection which leads them toconsider markets to be ‘unfair’ and reduce theirinvestments; (ii) managers get perverse incentiveswhich result in their taking value-reducing deci-sions; and finally, (iii) outside search is reducedleading to less useful information being collectedand being available for allocation decisions.

Regulation, as it stands now, has the followingmajor characteristics. Insiders are distinguishedfrom non-insider informed agents. Insiders areonly those informed agents who have a fiduciaryresponsibility to the firm3. Currently this definitioncovers managers, directors, other agents like ac-countants and investment bankers, large stock-holders of a firm and tippees4. In contrast,non-insider informed are like security analysts orinvestment firms that expend their own resourcesto discover non-public information about firmswith which they do not have fiduciary responsibil-ity. Insiders are required to either disclose orabstain from trading on non-public information,while other informed are not restricted5. Thus,there appear to be two fundamental criterion: thatthere should be no fiduciary responsibility andthat the non-insider investors should have ob-tained the information with their own resources.This distinction effectively rewards non-insidersfor their search and information collection.

Even though a simultaneous analysis of all thetradeoffs appears daunting, It will be shown thatthe basic elements are not as complicated. Byallowing insiders to trade, some of their informa-tion gets into price. This makes the price moreefficient in the sense that it reduces the uncertaintyabout the final outcome. However, this efficiencycomes at a cost. Because insiders are better in-formed when they trade, they introduce adverseselection in the market by making opportunistictrades. Thus one trade off which is important toan uninformed trader is whether he prefers in-creased efficiency at the cost of increased adverseselection.

This tradeoff becomes more complicated if oneassumes that the insider will not be the onlyinformed trader in the market; that non-insiderinformed traders also exist in the market. Nowallowing insider trading not only makes the pricemore efficient but can also make the market less‘unfair’ by reducing the amount of adverse selec-tion. This happens because introducing anotherinformed agent into the market makes it morecompetitive. This reduces the amount of tradingprofits each informed makes and possibly even thetotal profits of all informed traders6.

While this appears to be good news from theperspective of the uninformed investors, it is notnecessarily so. Because informed investors makesmaller profits, they reduce the amount of infor-mation they collect. This is socially undesirablewhen, for instance, outsiders have cheaper orunique search technologies, or if the information isused differently depending on whether the insideror the outsider gets it. Most research as well as thedirection of recent judicial decisions apparentlyrecognize that outsiders have an advantage ingathering and interpreting information beyond theindividual experiences of insiders. Some oftencited examples are information about economy-wide and international factors and the observationthat most mergers and acquisitions are usuallyinitiated from the outside7. With respect to insid-ers and outsiders using information differentially,I show that, in the current business environment inthe USA, the same information when gathered byan outsider is more likely to be used in sociallymore beneficial ways. An important implication isthat society may be better off if the outsidersearches even when he/she is the more expensivesearcher than an insider.

I also show that the ‘equity issue’ has anotherfacet which, though overlooked, is important. Ishow that markets already exist for investors toavoid getting hurt by adverse selection: they needonly to reduce their willingness to pay by theextent of the expected liquidity costs and thus buyshares at a lower price. By so doing, investors donot bear the cost of adverse selection but insteadpass it on to firm owners. Here too the distinctionbetween the trading profits of the insider informedand those of the non-insider informed is pivotal.The owner of the firm is not affected by theadverse selection created by the insider since theowner can recover these trading profits by reduc-ing the manager’s contractual wage by an equiva-

© 1997 John Wiley & Sons, Ltd. Manage. Decis. Econ. 18: 667–679 (1997)

669INSIDER TRADING AND NON-MANDATORY DISCLOSURES

lent amount8. However, since the owner cannotcontract with the non-insider informed, he cannotrecover his profits and his wealth is reduced bythat amount. In fact, Khanna et al. (1994) estab-lish that the ability of investors to price protect inthis manner and that of the owner to recoverprofits from the insider but not from the outsiderbrings about a divergence between the owners’and society’s objectives. Thus, there will be situa-tions when society would like to ban insider trad-ing but firms would like to permit it. In thesesituations there is clearly a role for federally man-dated regulation9.

An overlooked but critical factor in the existingdebate is the connection between insider tradingand non-mandatory disclosures. By providingmore information to the market both make pricesmore efficient. However in so doing both reducethe value of information gathering to outsidesearchers. Thus, many of the arguments againstallowing insider trading extend to non-mandatorydisclosures as well. If the market believes there ispotential that some information will get disclosed,it will reduce its search effort for that informa-tion, leading to worse allocations. Thus, this pa-per recommends that the current law should notallow voluntary disclosures10.

Finally, I report evidence about the structuralchanges that occurred in the US financial marketsin the 1960s and 1970s. One, there was a increasein acquisition activity. Since most of the acquisi-tions were initiated by investors outside the firmand were extremely profitable, they were probablyinstrumental in convincing the courts about theimportance of outside search. Second, there was asimultaneous increase in the number of mutualfunds and in the size of their investments. Thisresulted in many more diversified stockholders.Since the interests of diversified stockholders aremore in line with society’s, their primary concernis about the size of the whole pie instead of thevalue of a single firm. In other words, if banninginsider trading transfers value from one firm toanother while increasing aggregate value, theseinvestors would prefer to ban. This is, however, incontrast to the concerns of undiversified owners.Since their wealth depends only on the value oftheir own firm they are hurt by transfers awayfrom the firm. The paper shows that insider trad-ing can reduce some important transfers, makingundiversified owners better off. Thus, it is notsurprising that there was little or no enforcement

of insider trading restrictions before the 1960seven though the rules existed in the books since1935. However, during the 1960s, as the politicalprocess became dominated by diversified stock-holders, there was a shift towards enforcing therestrictions against insider trading. This line ofargument may also explain why we do not yet seeinsider trading restrictions in a number of othercountries and why there is a sense that some aremoving in the direction of more regulation. As thefinancial markets in these countries become morelike what is in the USA, political pressure forinsider trading restrictions should increase.

THE MODEL WITH ONE FIRM

Given the nature of agents and tradeoffs, theframework under which insider trading needs tobe discussed must contain the following at-tributes. There must be two kinds of informedtraders, an insider and an outsider. The outsidermust expend resources to collect information inexpectation of making trading profits. The insidermay get some information by being on the job ormay collect information for a cost and then usehis own and the outsider’s information to makeallocation decisions. There needs to be at leasttwo firms. Each firm has an owner and a produc-tion technology that both depend on the informa-tion available to the respective manager/insiderand how he/she uses it. Each owner hires a man-ager/insider under a pre-specified contract.

Initially, through a simplified example with onefirm, I show the impact insider trading can haveon outside information generation and that ‘eq-uity concerns’ are unjustified since investors cantake care of themselves. I also show that society’stradeoffs are different from the firm’s owners andthus society cannot depend on the owners to baninsider trading but must outlaw it through legisla-tion. Later I extend the analysis to two firms.

The example starts with only one all equity firmand three points in time. At t=0, the ownerissues a total of N shares at a market clearingprice. Between t=0 and t=1, an outsider incursa cost C to search information about the firm,while an insider may get some information forfree by just being on the job. At t=1, there is anintermediate market in which the outsider cantrade on his information, so also the insider, if sopermitted. For simplicity, I assume that each in-


670 N. KHANNA

formed (the insider and the outsider) can trade atmost one share11. I also assume there are unin-formed traders who trade for reasons like liquid-ity or portfolio rebalancing, etc. The trades byboth the informed and the liquidity traders affectthe secondary market price and, thus, the tradingprofits of the informed. Since the price adjustmentreveals some of the outsider’s information, it al-lows the insider to make a better allocation deci-sion than he would have with his owninformation alone.

It is assumed that the insider’s allocation deci-sion is made at t=1 and gives a random terminaloutput at t=2 when the firm is terminated. Thefirm has the following production technology. Ifthe insider makes the allocation decision at t=1on the basis of only his own information, then theterminal per-share outcome at t=2 will be one of6−k, 6 or 6+k with equal probability of 1/3.Thus, the expected per share value at t=0 andt=1 is 6. However, if the outside searcher collectsinformation and trades on it, then the insider/manager can infer some of the outsider’s informa-tion from price adjustment and make a moreinformed decision. In this event, it is assumed thatthe per-share terminal output will be one of 6+h−k, 6+h or 6+h+k, with equal probability1/3. Since the expected return now is 6+h, theexpected increase in output from the additionalinformation of the outsider is h.

The informed traders make trading profits inthe following way. At the time of trading (i.e. att=1), the informed traders come to know theexact realization at t=2, while the uninformedknow only that the expected value is either 6 or6+h depending on whether the outsider willsearch. Consider the case where the outsidersearches. In this case, the informed will trade onlywhen their information reveals the terminal valueto be either 6+h−k or 6+h+k. If the unin-formed are willing to trade for 6+h, each in-formed will make a trading profit of k for everyshare he trades. Since each is restricted to trade atmost one share, each has an expected profit frombeing informed of 2k/3. However, it is unlikelythat the uninformed will trade at 6+h, since thedirection and number of shares traded by theinformed will reveal some of their informationand the price will move closer to its real value.Therefore, realistically each informed’s expectedtrading profit will be a lower amount of 2ak/3,with aB1. Thus, an outsider would be prepared

to search only if his search cost, C, is less than2ak/3.

When insider trading is prohibited, then thenumber of informed traders is reduced (to 1, inthis model). This reduces the total trades by theinformed and the extent of the resulting priceadjustment. This enables the informed outsider tomake a higher per share expected profit of say2bk/3, with b\a. Since expected profits arehigher, he is more likely to search for informationand more information will be generated12.

Since society cares only about real costs andbenefits (in contrast to transfers), society is betteroff with outside search as long as the expectedincrease in production, h, exceeds the cost ofcollecting the additional information, C. Thetradeoffs that the owner of the firm is concernedabout, though, are different and more involved.The difference arises because the owner is con-cerned about transfers as well. As will becomeclear later, one of the transfers that owners careabout is the outsider’s trading profit. What I willshow is that even when expected total outputincreases by h, depending on the expected amountof the outsider’s trading profit, the owner’s wealthmay either increase or decrease. Thus, if the ex-pected transfer to the outside searcher exceeds h,the owner will prefer to prevent outside searching.One way to do so is to allow insider trading, thusreducing outsider’s expected trading profit and theincentive to search for information.

I focus on these tradeoffs by identifying theireffect on the owner’s wealth. Since the owner willsell shares in the firm at t=0 to raise capital forproduction at t=1, a good candidate for themeasure of the owner’s wealth is the per shareprice at t=0. If he can sell at a higher price, hewill obviously prefer it. Thus he will allow or baninsider trading depending on which action giveshim the higher price at t=0.

I next identify the components that determinethe t=0 price. The first, clearly, is the terminaloutput. Since allowing insider trading reduces theoutsider’s profits, it reduces his search and thusexpected terminal output. For instance, if insidertrading completely knocks out the outsider, thenthe per share loss in expected terminal value willbe h and, if there are N shares outstanding, thetotal loss in the value of the firm will be Nh. Thus,if this were the only effect, the owner would baninsider trading so as to let the outsider search.However, unlike society, the owner worries also



about the outsider’s trading profits. Wheneveroutside searchers trade, they make profits againstuninformed investors. Potential uninformed in-vestors know at t=0 itself that, at t=1 they facethe possibility of trading against informed tradersand will, at that time, either buy ‘too high’ or sell‘too low’. Thus they will price protect themselvesagainst this expected adverse selection, by payinga lower per share price at t=0. Consequently,owners indirectly pay for the expected liquiditycosts of the uninformed traders. As an aside, thisargument demonstrates that society does not haveto regulate insider trading for ‘equity’ concernssince investors can price protect against sucheventualities13.

Like the outsider, an insider also makes profitsby trading against the uninformed investors. Sinceexisting research does not usually distinguish be-tween insider informed and non-insider informed,the profits of all informed are treated symmetri-cally. However, there is an important distinctionbetween the two, as the owner can contract withthe insider but not with the outsider. Thus, eventhough an insider also causes adverse selection inthe market and shareholders price-protect, histrading profits do not affect the owner’s wealthsince the latter can recover them by lowering theinsider’s contractual wages by that amount. Soeven though the price protection will reduce theowners wealth, giving the insider a lower wagewill increase it by the same amount and the neteffect will be a wash.

To show this algebraically, I first calculate theprice uninformed shareholders will be willing topay for a share at t=0 when insider trading ispermitted and C\2ak/3 (i.e., there will be nooutside search). This price, P0, will be the ex-pected value 6 if there were no adverse selectionfacing the uninformed traders. However, there isone informed trader, the insider, who will betrading and his expected trading profit is 2bk/3.Aware of this amount of potential loss at t=1,the uninformed will price protect to that extent att=0. Thus, at first glance, uninformed sharehold-ers should be willing to pay (at t=0) only N6−2bk/3 for all shares outstanding14. Thisobservation, though, ignores a crucial issue. Sincethe owner contracts with the insider, he can lowerthe insider’s contractual wage by the extent of hisexpected trading profits. This will increase ex-pected terminal value by 2bk/3 (since the manageris being paid less by the firm directly) and the

uninformed will price protect from a value ofN6+2bk/3. Thus, if the owner appropriately ad-justs the contract, the uninformed investors willbe willing to pay N6+2bk/3−2bk/3=N6 or 6per share, as if there were no price protection.This shows that the adverse selection generated bythe insider’s trades does not affect any agents’wealth15.

Now I can compare the tradeoffs that societyfaces and those faced by the owner. Both benefitfrom the improvement in production that comesfrom the outsider’s information. However societylikes an outsider to search as long as the expectedimprovement in output exceeds the additionalsearch costs. Owners on the other hand like out-sider’s information only as long as the improve-ment in production exceeds the outsider’s tradingprofits. Since trading profits and search costs neednot be related, society and firms may disagreeover insider trading restrictions16.

Next I develop some algebraic expressions forwhen firms may want to allow insider trading andsociety wish to ban it. Consider the environmentwithout insider trading. Since the outsider in-formed does not compete with another informed,he will make the larger expected profits of 2bk/3.If CB2bk/3, the outsider will search and thepossible output per share will be of 6+h−k,6+h, 6+h+k with equal probability of 1/3.Thus the expected price is 6+h if there were noadverse selection in the market or if the ownercould recover the outsider’s trading profits. How-ever, since the owner cannot contract with anoutsider, the t=0 price per share will be 6+h−2bk/(3N)17. The owner will, thus, prefer the noinsider trading scenario only if the benefit fromoutsider’s search, h, is greater than the transfer tothe outsider, 2bk/3. Otherwise, he would like toprevent the outsider from searching by allowinginsider trading and reduce the outsider’s tradingprofit to 2ak/3. This will discourage the outsiderfrom searching whenever 2ak/3BCB2bk/3. So-ciety, on the other hand, prefers that the outsidersearches whenever Nh\C. Since 2bk/3 dependson the randomness in the production process, theliquidity and the proportion of uninformed in themarket, while search costs depend on the searchtechnology of the informed, C and 2bk/3 candiffer. Thus, there can be situations where 2ak/3BCBNhB2bk/3, when society likes to baninsider trading (since CBNh), but firms do not(since NhB2bk/3). For these parameters there is


672 N. KHANNA

need for public policy. This argument demon-strates that the efficiency argument made by Carl-ton and Fischel does not necessarily hold, sincefirms and society can disagree on whether insidertrading should be allowed.

The next section addresses other issues of im-portance. First, it shows that when entrepreneursare undiversified and there are legal and organiza-tional restrictions to information sharing betweentwo firms, owners may prefer to allow insidertrading to prevent outsiders to collect informationwhich may have greater value for their competi-tors. Because of their undiversified position, own-ers care about idiosyncratic effects and thus willtake action which increases the value of their ownfirm even though it hurts other firms by more.Diversified stockholders, on the other hand, areconcerned only about the aggregate effect on allfirms and will not take some of the actions thatowners will. This provides a compelling argumentfor why insiders should not search, even whenthey have superior search technology.

MODEL WITH TWO FIRMS

An important issue arises when there is more thanone firm. Now, one must also consider which firmcan use the information better and whetherCoase’s theorem will work both when the outsidesearches and when he does not. (Coase, 1961)

Assume there are two all equity firms A and B,each with N shares outstanding. Both have un-diversified owners who own a large portion, s, oftheir own firm and none of the other firm. As-sume that the remaining portions, 1−s of eachfirm, are held in a diversified portfolio and thepotential outside searcher holds a position in thisportfolio. For simplicity, assume that each in-vestor holds one share in the portfolio and thatone portfolio share is equivalent to one share of Aand one share of B.

Assume A does not allow insider trading. Nowunder the assumed parameter space where theoutsider’s cost of search is less than his expectedprofits when not competing against an insider (i.e.2ak/3BCB2bk/3), the outsider will search. Sup-pose, as before, his information makes firm A’spossible terminal outcome to be one of 6+h−k,6+h, 6+h+k with equal probability of 1/3while leaving firm B’s expected value at 6. How-ever, if the outsider gave his information to B

(after trading in the shares of that firm so as toget some return on his information) the terminalvalue of B will become 6+3h−q, 6+3h, 6+3h+q with equal probability while that of A willdrop to an expected value of 6−h. This wouldoccur if the firms have correlated profits by beingcompetitors and B can use this information muchmore efficiently than A.

Since the outside searcher has a stake in both Aand B, if he gets the information he can make aninformed trade and then reveal to the higher valueuser, B. If A insider gets it, then both society anddiversified investors will be better off if A sells itto B. However, that is not true of the non-diver-sified owner of A. He may choose to use it on Aitself, if his profit from so doing exceeds what hecan receive by allowing his insider to trade on itand then reveal it to B18. Also, anti-trust laws mayrestrict or even prohibit such transactions betweentwo competing firms. Comparative performancecontracts based on market share, expansion ratesetc. also pose impediments to informationsharing. Other means of information or technol-ogy transfers may also run foul of anti-trust regu-lations or corporate culture based and sustainedon the notion of competing against all rivals.Finally, there are enforceability problems withensuring that the selling firm does not use it (or apart) itself. Thus information transference from Ato B will, at the very least, not be as costless asfrom an outsider who has neither the above incen-tive problems nor any scrutiny from anti-trust 19.

I now study the decision of A’s owner whetheror not to allow insider trading. If insider tradingis permitted, the outsider is less likely to searchand the decision of what to do with the informa-tion is the insider’s. There is also the relatedquestion about whether the owner should encour-age the insider to collect more information i.e.over and above what he comes across costlessly.In this context, assume that the insider has toinvest CI to get information. Also assume, for thesake of argument, that the insider is the moreefficient collector of the information. Thus, CIBC and the insider will search if he is compensatedfor it. To focus the analysis, I assume that thereare two insiders, one who gets information by justbeing on the job but has no search technologyand the other, like a research department, whichwill search if paid to do so. Thus when the firmpermits the second insider to search and alsopermits insider trading then there will be competi-



tion between only the two informed insiders as theoutsider will find it unprofitable to search. Theresulting trading profit for each insider will, thus,be 2ak/3, and the insider will incur search costs aslong as CIB2ak/320.

To repeat, since I have assumed C\2ak/3, theoutsider will not search if insider trading is per-mitted21. However, if CIB2ak/3, the insider willsearch and the firm will get the additional infor-mation to improve its allocation decisions. I nextcheck what happens to the wealth of the variousagents with and without insider trading.

If the outsider collects the information, he willtrade one share of the firm he will give the infor-mation to. Since he is also a diversified share-holder he will give the information to the firmwhich has the highest value from holding it. Thenhe makes both the trading profit on the one shareand increases the value of his holding in thediversified fund. From the previous section, since2ak/3BCB2bk/3, the outsider searches onlywhen insider trading is banned and earns 2bk/3on his trade. As assumed, if the information isgiven to firm B, the per share value of A becomes6−h, while that of B becomes 6+3h. Assumingthat the value of a share in the diversified fund isthe sum of the per share values of the two firms,the terminal per share value becomes 26+2h−2bk/(3N).

If insider trading is permitted, however, theoutsider will not search. Instead, since CIB2ak/3,the second insider will search and the informationwill become available to A. As assumed, the valueof firm A will be 6+h−k or 6+h or 6+h+kwith equal probability, while the value of B is notaffected and remains at 6. Thus, if insider tradingis permitted, the expected per share value of A is6+h, that of B is 6 and a diversified share isworth 26+h.

Comparing the value to each agent with andwithout insider trading, results in the following. Aprefers to have insider trading so as to preventoutside search. Ex ante, if neither A nor B knowhow the information will effect whom, B wouldalso prefer to prevent outside search. Like society,diversified shareholders, who do not care abouttransfers but only that the information be used bythe highest value user, suffer because their welfaredrops from 26+2h−2bk/(3N) to 26+h22.

This is occurring because firm A does not havean efficient means of revealing the information toB and also because the owners are undiversified.

If the owners were diversified, then Coase’s theo-rem would hold in that A will just disclose (credi-bly) the information (possibly even withoutgetting trading profits) because the value of hisper share holding in the diversified portfolio willbe higher by h. Being undiversified precludes this.Thus, diversified stockholders will be better offbanning insider trading and undiversified ownerswould like to encourage it. This conflict mayexplain both why regulation in the USA devel-oped in the manner it did, and why certain coun-tries like UK, Japan, Germany and France, etc.do not yet have restrictions on insider trading23. Ifthose who control the formation of corporate laware primarily the organizers of public corpora-tions then I would expect there to be no insidertrading prohibitions. Corporate organizers, who Iassume are non-diversified, would want the op-portunity to exploit insider trading. However, atransformation of those who control public policyfrom corporate entrepreneurs to diversified stock-holders would be accompanied by the institutionof insider trading sanctions. Later I present evi-dence that the USA experienced just such a trans-formation in the 1960s and that this changeaccounts for the advent of insider trading regula-tions.

NON-MANDATORY DISCLOSURE

The current law is disclose or abstain. The aboveframework suggests that any activity by the in-sider or the firm that affects outsider’s profits isdetrimental whenever outsider’s information isvaluable. The reason lies in the public good na-ture of information. Any party revealing the pri-vate information makes it valueless for all otherparties holding that same information.

The objective of the current evolution of insidertrading regulation appears to be two-fold. One, itis beginning to treat private information as theproperty of the agent who expends real resourcesto get it. This is borne out by the miss-appropria-tion theory successfully used in cases like Dirks,Clark, and Chiarella which exclude from insidertrading restrictions profits of outside searcherslike analysts, forecasters and others who haveused their own resources to use the information.Especially consistent with this interpretation is therestrictions against tippees who apparently havenot expended their own resources in the direct


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collection of the valuable information. This canbe seen as an attempt by the courts to encourageexpenditure on information gathering by outsidesearchers. This pre-supposes the belief that suchinformation is valuable. As shown in the paper,federally mandated restrictions against insidertrading can be socially desirable when outsideinformation is important.

Second, the regulation is concerned with thefairness issue. It apparently aims at reducing theamount of adverse selection faced by liquiditytraders by requiring insiders to either make allinformation public or to abstain from trading.Both reduce the potential of loss that a liquiditytrader faces when he trades. However, as shown,society does not need to intervene on behalf of theinvestors as they can do so effectively themselves.If investors expect to face liquidity costs by trad-ing against informed investors in the future, theywill take that into account by lowering their will-ingness to pay by the extent of their expectedliquidity costs. In so doing, these investors areensuring that the owner is the one paying forthese costs. Thus, investors do not benefit whenthe firm is required to disclose.

However, disclosure can result in a social lossas it has a similar detrimental effect on outsider’strading profits as does insider trading. In fact,disclosure is even more effective in destroying theprivate information of outside searchers. While,with insider trading outside searchers see theirprofits decreasing because with competition withother informed prices become more informative,with disclosure profits will go to zero as prices willbe fully revealing. This would destroy informationcollection. Thus, by this argument, disclosuresmust also be banned. The next section puts thesearguments in a more complete perspective.

INSIDER TRADING REDUCINGREDUNDANT SEARCH

The above arguments have ignored a possiblebenefit of insider trading and disclosures, thatthey reduce both redundant information gatheringand allow insiders to gather information wheneverthey have the lowest cost to do so. Thus, societymust achieve an optimum with respect to howmuch information outsiders may seek. Since oneof the criteria of this optimum is to minimizecollection of redundant information, there should

be an ex-ante determination of which kinds ofinformation the insider can collect more efficientlythan an outsider. These kinds of informationshould then be both collected and mandatorilydisclosed by the insider. However, any other typeof information not included in the ex-ante disclo-sure clause should not be disclosed even if theinsider or the firm stumble across it costlessly. Ifdisclosed, it will affect outside searchers profitsand search efforts leading to loss of valuableinformation. In short, the public policy should beto commit to disclose pre-determined informationand no insider trading or unexpected disclosures.This recommendation is surprisingly close to whatis observed in reality. Firms are required to dis-close certain pre-determined information in whichit has obvious cost advantage, like income state-ments, balance sheets, business plans, etc.

Algebraically, the expressions developed earlierchange as follows. Let p be the probability thatthe insider will get information of the type thatthe outsider has a cost advantage in searching.With disclosures, the outsider’s expected profitswill be p � 0+ (1−p)2ak/3B2ak/3. Since theoutsider expects lower profits, he will search lessand terminal value will be worse.

INSIDER TRADING AS AN INCENTIVETOOL

Another powerful argument for insider trading isthat it allows flexibility in contracting which leadsto a better use of information. The ‘use’ of infor-mation refers to both collection and as an inputto decision making. Examples in the literature arethe use of insider trading to simulate frequent renegotiation without incurring the costs of re-nego-tiation, and to reduce the effect of free riding onthe incentives of individuals working in teams.The argument is that the ability to make profitson individual effort leads to better contracts.

While tying payoffs to individual performancewill usually lead to improved effort, other com-pensation schemes may dominate insider trading.The reason why insider trading may not be agood indicator on which to base compensation isbecause it is a noisy indicator of insider informa-tion. The usual way in which this problem hasbeen studied is to let insider’s trade, observe theeffect this has on price and use the price as anindicator of the insider’s information. There are atleast two problems with doing this.



The first problem is that by making the man-ager’s contract depend on trading profits whichare determined in part by the liquidity in themarket, competition from other informed, etc.(variables over which the manager does not havecontrol), the manager’s compensation becomesmore risky. As per the principal-agent literature,this makes the outcome less efficient for the ownerof the firm as the manager is bearing unnecessaryrisk. The reason the agent is given the leastamount of risk necessary is because he is leastsuited to bear it. The reason the manager is givenany risk at all is to motivate him to take theappropriate amount of effort when his effort isnot directly observable but can be noisily inferredfrom an observable variable. However, makinghis compensation dependent on the observed vari-able is useful only if the variable is affected in areasonably predictable manner by the effort levelof the manager. If it is not then the outcome willbe sub-optimal since the manager will bear riskwithout any advantage accruing from it. That iswhat happens when insider trading profits or theintermediate price levels (after the manager hastraded) are used as variables on which the com-pensation contract depends. Since the manager’seffort is only one of a number of variables affect-ing the indicator, this is not a desirable way ofdetermining compensation. The more efficientway is to directly ask the manager what his in-tended trades are (by offering him a menu thatduplicates his expected trading profits, so he re-veals his intended trades truthfully) instead offorcing the owner to infer it from noisy indicators.This direct mechanism reduces the unnecessaryuncertainty the manager faces and improves thecompensation contract. That direct reportingdominates insider trading has been established inDye (1983) and Fisher (1992).

The second problem is when the manager ispermitted to trade, it becomes much harder tocontrol his actions. This is because insider tradingadds further uncertainty to inferring the man-ager’s actions and/or private information fromobservables. Also permitting insider trading willlead to perverse incentives. The manager willsometimes make inefficient decisions even in thepresence of incentive contracts designed to pre-vent such decisions. Bagnoli and Khanna (1992)show that while such perverse behavior can beconstrained through compensation contractsbased on phantom shares or non-tradable op-

tions, eliminating insider trading achieves moreand is thus preferred.

INSIDER TRADING AND PUBLIC POLICY

Although the statutory basis for prosecuting mod-ern-day insider trading violations, Rule 10b-5,was adopted by 1942, it was not until 1961 thatthe SEC began to enforce insider trading sanc-tions in a systematic fashion. It is argued that theadvent of insider trading prosecutions was a resultof two separate developments. One, the substan-tial increase in merger and acquisition activity inthe 1960s gave credence to the claim that out-siders can collect useful information with the rightincentives. The probable reason why such a claimachieved acceptance in the legal circles was thatsubstantial gains were made by stockholders dueto mergers and acquisitions usually orchestratedby outsiders. Since the average increase in theequity of the target was of the order of 30%, thiswas strong evidence that outside searchers couldsearch efficiently in some areas24. Second, therewas simultaneously a significant shift in the com-position of those who held the equities of USAcorporations. Specifically, I contend that duringthe 1960s the dominant force in the market forcorporate equities changed from corporate en-trepreneurs to diversified stockholders, and thatthis change accounts for the ‘sudden’ enforcementof insider trading regulations—regulations thathad been on the book for almost 20 years. Asomewhat similar argument is made by Haddockand Macey (1987) who suggest that enforcementof insider trading became more stringent when thelaw developed to ban corporate insiders fromtrading.

I will briefly although not completely reviewsome developments in the law of insider trading(see Netter and Seguin (1997) for a more completediscussion). Early application of Rule 10b-5 fo-cused on direct trading by insiders as defined bySection 16 of the Securities Exchange Act of 34:officers, directors and large stockholders with atleast 10% of outstanding shares. In Speed 6.Transamerica Corpn. Del 51, insiders were re-quired to either disclose all material inside infor-mation or abstain from trading. In the early1960s, SEC 6. Cady Roberts and SEC 6. TexasSulphur Company. expanded the definition of in-siders to Tippees and Tippers. These decisions


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made both passing out of inside information byeven non-trading insiders and the exploitation oftips by outsiders illegal. The 1980s saw two im-portant decisions in Chiarella and Dirks whichhelped define who could or could not trade onmaterial non-public information. These rulingsestablished a separation between inside informedand outside informed. The informed outsiderswere permitted to make profits on their informa-tion as long as their information was not know-ingly based on tippees. The relevance of themisappropriation theory to insider trading, whilenot pivotal in either case, was pursued to a limitedextent in the verdicts.

In the United States 6. Chiarella the SupremeCourt overturned a conviction by a lower courtunder Rule 10b-5 which had been upheld by thesecond Circuit. Chiarella, an employee of a print-ing firm was able to infer the identity of targetcompanies and make profits by buying their stockbefore a public tender offer. The main argumentused by the Supreme Court was that Chiarellaneither had fiduciary responsibility nor did hepersonally receive confidential information fromthe targets. Thus, there was no violation of Rule10b-5. However, though the majority opinion sug-gested in dicta that Chiarella ‘‘breached a duty tothe acquiring corporation’’, they declined to ruleon this misappropriation theory because it hadnot been submitted to the jury.

In Dirks 6. SEC, a security analyst receivedconfidential information from an employee of Eq-uity Foundation Corporation that many of theinsurance policies written by them were fake. Theemployee did not receive any consideration forthis exposure. To ascertain the truth of the allega-tions, Dirks passed on this information to a num-ber of institutional investors, who in turn soldlarge blocks of EFC stock. Subsequently, theallegations were confirmed and EFC went intobankruptcy. The SEC brought a disciplinary pro-ceeding against Dirks, charging that he had vio-lated Rule 10b-5 by giving the information to hisclients.

The Supreme Court held that Dirks had notacted illegally since he did not have a fiduciaryduty to either the corporation or its shareholdersand also did not aid any violation by the insiderfrom whom he obtained the information, since theinsider had not acted from an improper motive.

More recently, in USA 6. O’Hagan (1997), thesupreme court by a vote of 6–3 handed a win to

the supporters of the misappropriation theory.O’Hagan made $4.3 million in 1988 by trading inPillsbury shares, when it was in the process ofbeing acquired by Grand Metropolitan.O’Hagan’s law firm was advising the acquirer,and though O’Hagan was not directly involved inthe negotiation he apparently tricked anotherlawyer at his firm to reveal the details of thetransaction. O’Hagan was found guilty, eventhough he had no fiduciary responsibility to thefirm in whose stock he traded, for using informa-tion that he had not independently gathered.

The law has developed in a way that does notprohibit non-insiders from trading on privilegedor non-public information per se. Rather the reg-ulations focus on how such information was ob-tained. If the information was obtained(produced) as a result of deduction, investigationor intuition, then trading is not prohibited. Onlyif the information was obtained wrongfully (aspreviously defined) would the trader be in viola-tion of the law. Such a regime is consistent withthe conclusions of this paper.

OTHER DEVELOPMENTS:

In this section I provide some evidence to supportthe claim that the nature of share holding byinvestors changed towards diversified funds andthat a surge in acquisition activity coupled withthe advent and growing popularity of the tenderoffer also occurred. Both these structural changescontributed to the evolution and enforcement ofinsider trading laws.

Prior to the 1960s, few Americans held com-mon stock directly. The boards of most USAcorporations at the time were dominated by largeblock-holders, many of whom were members ofthe firm’s founding family. Indirect support isprovided by the evidence that the number of USAcitizens holding common stock grew from 6.5million in 1952 to 31.0 million in 1970. Thissuggests that the separation of ownership andcontrol that Berle and Means talked about in the1930s became a reality for many USA firms in theearly 1960s.

Coincidentally, there was also an unprece-dented proliferation of mutual funds during thisperiod reflecting the growth in institutional in-vestors is a reflection of the growth in the numberof diversified investors in the 1950s. Between 1940



and 1966, mutual fund assets increased from $450million to over $38 billion, and the number ofinvestors in these securities went from fewer than300 000 to more than 3.5 million25. The totalinstitutional holdings of NYSE stocks were $9.7billion in 1949, $97.7 billion in 1964, and $109.7billion in 196526. Institutional ownership ofNYSE firms grew from 30% in 1963 to 45% in1973. Institutional trades grew from 30% of themarket to 65% over the same time period27. Insti-tutional investors, and thus diversified stockhold-ers, were becoming a powerful force.

Finally, in 1963 the SEC reported in its SpecialStudy of Securities Markets, ‘‘The tremendousgrowth in the securities markets over the pasttwenty five years, and most particularly the in-creased public participation, imposed strains onthe regulatory system and revealed structuralweaknesses’’. The commission of this study atteststo the public perception that the USA capitalmarket experienced a significant change in thedecades of the 1950s and 1960s28.

Bradley et al. (1983) cite similar data to explainthe advent of the tender offer as a viable takeoverdevice. The interfirm tender offer was virtuallyunknown prior to the decade of the 1960s. How-ever by the end of the decade, the tender offer hadbecome the most popular means of effecting achange in the control of large-scale corporations.Bradley et al. argue that the advent of the tenderoffer was due to the increase in the diffusion ofthe ownership of USA corporations that occurredin the 1960s. Since many of these tender offerswere apparently hostile, it is also consistent withoutsiders having more useful information. With-out extremely valuable information it is hard tojustify why outsiders would make unfriendly at-tempts to acquire another firm.

SUMMARY AND CONCLUSIONS

This paper argues that many of the documentedreasons for allowing or disallowing insider tradingare not relevant to deciding whether insider trad-ing should or should not be permitted. When theissues are filtered down to basic tradeoffs, insidertrading cannot be justified. It reduces informationcollection by non-insiders which, in turn, reducesallocational efficiency and thus the value of afirm. Insider trading also makes manager’s incen-tives harder to control. The same effects are

present in a policy of ‘disclose or abstain’ becauseof the public goods nature of disclosure. Thus, theoptimal position for society is to restrict insidersfrom both trading and voluntary non-contracteddisclosures of non-public information, i.e. a policyof ‘Abstain’. The last point is relevant even wheninsiders may be the cheaper producers of informa-tion.

The analysis in this paper shows, insider tradingreduces the informational content of securityprices, and leads to sub optimal use of informa-tion. The same is true for voluntary disclosures.For these reasons both insider trading and volun-tary disclosures should be banned. Mandatorydisclosures however should still exist and coverthose areas where the firm has a cost advantage insearching for or getting information. Other argu-ments for and against insider trading have beenshown to be incomplete or unimportant.

The paper shows that while society may benefitby banning insider trading, there are private in-centives for undiversified owners of firms not toban insider trading. Thus, in a society where acoalition of corporate entrepreneurs dictates thelegal regime, we would not expect to see insidertrading prohibitions. However, if the politicalprocess were to be dominated by a coalition ofdiversified, non-controlling stockholders, wewould expect to see insider trading prohibitionsimposed. This paper’s results are consistent withtwo developments that occurred in the last 30years. There was a transformation in the USAcapital and that this metamorphosis was responsi-ble for the ‘sudden’ enforcement of insider tradingprohibitions that had been on the books for over20 years.

NOTES

1. Much of the earlier literature is summarized inCarlton and Fischel (1983) and Netter and Seguin(1997). One of the first articulations of the benefitsof insider trading is Manne (1966). The majorjustifications for outlawing insider trading are setout in Brundy (1979) and Wang (1982). The morerecent papers are Fisher (1992), Leland (1992),Fishman and Hagerty (1992) and Dye (1983),Khanna et al. (1994).

2. This claim supports the argument presented inHaddock and Macey (1987), that the Chiarella andDirks decisions were the result of political pressurebrought by market professionals who felt threat-ened by the expanding scope of insider trading


678 N. KHANNA

sanctions. Some of the arguments and data pre-sented in the current paper suggest that the marketprofessionals were supported by a growing body ofdiversified investors who wanted to restrict insidertrading so as to encourage greater search by themarket professionals. The data suggests that onlywhen the body of diversified stockholders becamelarge, was there a movement towards enforcinginsider trading regulation which had been in thebooks from decades before.

3. See Netter and Seguin (1997).4. In fact, except for the large stockholders, all other

categories are agents who will necessarily becomeprivy to non-public information about the firmeither through their employment with the firm orthrough their contatct with employees of the firm.

5. There are other restrictions that apply jointly to allinformed or even all traders as well. These are notimportant to the discussion here.

6. Manne also has a similar claim, though for some-what different reasons. While Manne (1966) sug-gests that the regular traders will get hurt, myanalysis shows that, with insider trading, adverseselection will reduce for all traders.

7. Morck et al. (1988) find that boards of directors arerelatively efficient in recognizing and responding tosituations in which a firm is doing poorly relative toits industry. However, they show that it takes in-volvement of outsiders to recognize and respond tosituations in which an entire industry needs to berestructured.

8. There is an issue as to whether the amount ofinsider trading is observable. However, I do notfocus on that aspect.

9. This divergence in objectives weakens the claim inCarlton and Fischel that since firms do not baninsider trading society should not interfere.

10. The reader must distinguish between voluntary dis-closure and mandatory disclosure. As I argue later,a firm should collect and mandatorily disclose in-formation at which it has a cost advantage. Herethe information under consideration is the kindwhich outsiders can, on average, collect morecheaply. If the firm volutarily discloses some of thisinformation whenever it happens to come across it,it will reduce the effort outside searchers will makeleading to inferior allocations and social loss. Seesection 3.

11. An alternative way is to assume risk-aversion. Thenoptimal trade size will be endogenously determined.However, this additional complication does notalter any main results.

12. See Kyle (1985) Admati and Pfleiderer (1988) andKhanna et al. (1994) among others for expressionsfor a and b. Both get b\a, the important propertybeing used in this paper. Also note that while herethe outsider makes the expected profit of 2bk/3,this represents the profit made when there is onlyone informed trader in the market. Thus, if theinsider was the only informed (when insider tradingis allowed) he will also make expected profit of2bk/3.

13. It has been argued in that such adverse selectioncan lead to higher discount rates and thus reducedinvestment. Later discussion will demonstrate thatthis cannot be an issue when the informed trader isan insider. It may also not be true when the in-formed is an outsider because the additional liquid-ity costs result in higher outsider trading profitsand thus more information collection resulting inbetter allocation decisions. Thus, it may well hap-pen that even when adverse selection is high, so isthe value of the outsider’s information and, on net,investor’s wealth goes up. This should result inmore, not less investment.

14. Remember, each informed is permitted to tradeonly one share at t=1. Thus, the total adverseselection is 2bk/3.

15. The same argument will hold even when CB2ak/3,and there is an outside searcher. Now each in-formed will make expected trading profit of 2ak/3,for a total of 4ak/3, The firm can recover 2ak/3from the insider by changing his contract, but willlose 2ak/3 to the outsider. Uninformed investorswill price protect for all of 4ak/3, but the firm willlose only 2ak/3.

16. Thus the argument of Carlton and Fischel (1983)that if firms choose not to ban insider trading,society should not regulate is not necessarily cor-rect.

17. The division by N is because the expected cost ofadverse selection, 2bk/3, is spread equally over Nshares. Thus each uninformed price protects to theextent of 2bk/3N.

18. I am assuming that making trading profits is theonly way in which the informed can get returnsfrom their information. This is obvious over-sim-plification. For instance, acquiring a firm is anotherway an outsider can be compensated. However, thetradeoffs and other conclusions still hold if insidertrading increases the pre-takeover price of targetshares.

19. I am in no way suggesting that the anti-trust lawsor comparative performance contracts are ineffi-cient. That is well beyond the scope of this paper.

20. Modeling insiders’ trading profits in this mannerpermits me to separate the diversification effectfrom the production effect and focus on the trade-offs directly. A more elaborate analysis will notaffect the basic conclusions.

21. When the outsider is given a holding in the diver-sified fund, his incentives will change. In additionto trading profits, he will also get profits fromdirecting his information to the right firm. Forinstance if the insider of one of the firms will getthe information with probability of 1/2, then A willget it with that probability. Since the information ismore valuable to firm B and the outsiders can giveit to that firm, the expected marginal benefit fromthe outsider searching and getting the information,instead of an insider, is h/2. The outsider will nowsearch as long as CB2ak/3+h/2N. I ignore thiscomplication as it does not affect any basic conclu-sion.



22. This assumes that h\2bk/(3N). However, for largeN this will hold trivially.

23. Carlton and Fischel (1983) report that in Japaninsider trading is considered normal, that Hong Kongintroduced restrictions in 1974 but later repealedthem, and UK and France do not restrict insidertrading in any serious manner, though that may beslowly changing. This evidence is consistent with thearguments forwarded in this paper.

24. Though some claim that the premium was due togetting rid of entrenched managers, this also supportsthe need for outside searchers to identify this prob-lem.

25. John A. Grimes (1966) Review and Outlook, TheWall Street Journal, 6, December, p. 18.

26. Staff Reporter (1966). Institutions’ Share of BigBoard Declines Slightly in 1965. The Wall StreetJournal, 3, February, p. 3.

27. Committee Print (1973). The Role of InstitutionalIn6estors in the Stock Market, Committee on Financeof the USA, Washington DC.

28. Report of the Special Study Securities Markets(1963). Letter of Transmittal, Securities and Ex-change Commission, Washington DC, April 3.

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why both insider trading and non-mandatory disclosures should be prohibited

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