Insider trading is one of the most controversial aspects of securities regulation,even among the law and economics community. One set of scholars favorsderegulation of insider trading, allowing corporations to set their own insidertrading policies by contract. Another set of law and economics scholars, incontrast, contends that the property right to inside information should beassigned to the corporation and not subject to contractual reassignment.Deregulatory arguments are typically premised on the claims that insider tradingpromotes market efficiency or that assigning the property right to insideinformation to managers is an efficient compensation scheme. Public choiceanalysis is also a staple of the deregulatory literature, arguing that the insidertrading prohibition benefits market professionals and managers rather thaninvestors. The argument in favor of regulating insider trading traditionally wasbased on fairness, which predictably has had little traction in the law andeconomics community. Instead, the economic argument in favor of mandatoryinsider trading prohibitions has typically rested on some variant of theeconomics of property rights in information.

JEL classification: K22, G30, G38

Keywords: Property Rights, Securities Regulation, Insider Trading, SecuritiesFraud.

1. Introduction

The law of insider trading is one way society allocates the property rights toinformation produced by a firm. In the United States, early common law permittedinsiders to trade in a firm's stock without disclosure of inside information. Overthe last three decades, however, a complex federal prohibition of insider tradingemerged as a central feature of modern U.S. securities regulation. Other countrieshave gradually followed the U.S. trend, although enforcement levels continueto vary substantially from country to country.

Prohibiting insider trading is usually justified on fairness or equity grounds.Predictably, these arguments have had little traction in the law and economicscommunity. At the same time, however, that community has not coalescedaround a single view of the prohibition; instead, competing economic argumentsproduced an extensive debate that is still active. Those law & economicsscholars who favor deregulation of insider trading typically argue that efficiencyis the sole basis for analyzing a legal regime, and that the prohibition lacks anyrational economic basis. Those who favor regulating insider trading typicallyrespond either by rejecting the claim that efficiency is the controlling criterionor by attempting to show that the prohibition is justifiable on efficiencygrounds. Most observers of the literature likely would conclude that neither sidehas carried the field, but that the argument in favor of regulation probably iswinning at the moment.

A. Overview of U.S. Insider Trading Law

Because the vast bulk of law and economics scholarship on insider trading refersto United States law, a brief overview of the current state of that law seemsappropriate. Insider trading, generally speaking, is trading in securities while inpossession of material nonpublic information. Under current United States law,there are three basic theories under which trading on inside information becomesunlawful. The disclose or abstain rule and the misappropriation theory werecreated by the courts under Section 10(b) of the Securities Exchange Act of 1934and Rule 10b-5 thereunder. Pursuant to its rule-making authority under ExchangeAct Section 14(e), the Securities and Exchange Commission (SEC) adopted Rule14e-3 to proscribe insider trading involving information relating to tender offers.(Insider trading may also violate other statutes, such as the mail and wire fraudlaws, which are beyond the scope of this article.)

2. The Disclose or Abstain Rule

The modern federal insider prohibition began taking form in SEC v. Texas GulfSulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969). TGS,as it is commonly known, rested on a policy of equality of access to information.Accordingly, under TGS and its progeny, virtually anyone who possessedmaterial nonpublic information was required either to disclose it before tradingor abstain from trading in the affected company's securities. If the would-betrader's fiduciary duties precluded him from disclosing the information prior totrading, abstention was the only option.

In Chiarella v. United States, 445 U.S. 222 (1980), and Dirks v. SEC, 463 U.S.646 (1983), the United States Supreme Court rejected the equal access policy.Instead, the Court made clear that liability could be imposed only if thedefendant was subject to a duty to disclose prior to trading. Inside traders thuswere no longer liable merely because they had more information than otherinvestors in the market place. Instead, a duty to disclose only arose where theinside traders breached a pre-existing fiduciary duty owed to the person withwhom they traded. Chiarella, 445 U.S. at 232. Accord Dirks, 463 U.S. at 653-55.

Creation of this fiduciary duty element substantially narrowed the scope of thedisclose or abstain rule. But the rule remains quite expansive in a number ofrespects. In particular, it is not limited to true insiders, such as officers, directors,and controlling shareholders, but picks up corporate outsiders in two importantways. Even in these situations, however, liability for insider trading under thedisclose or abstain rule can only be found where the trader -- insider or outsider-- violates a fiduciary duty owed to the issuer or the person on the other side ofthe transaction.

First, the rule can pick up a wide variety of nominal outsiders whoserelationship with the issuer is sufficiently close to the issuer of the affectedsecurities to justify treating them as "constructive insiders," but only in rathernarrow circumstances. The outsider must obtain material nonpublic informationfrom the issuer. The issuer must expect the outsider to keep the disclosedinformation confidential. Finally, the relationship must at least imply such a duty.If these conditions are met, the putative outsider will be deemed a "constructiveinsider" and subjected to the disclose or abstain rule in full measure. See Dirks,463 U.S. at 655 n.14. If they are not met, however, the disclose or abstain rulesimply does not apply. The critical issue thus remains the nature of therelationship between the parties.

Second, the rule also picks up outsiders who receive inside information fromeither true insiders or constructive insiders. There are a number of restrictionson tippee liability, however. Most important for present purposes, the tippee'sliability is derivative of the tipper's, "arising from his role as a participant afterthe fact in the insider's breach of a fiduciary duty." Id. at 659. As a result, themere fact of a tip is not sufficient to result in liability. What is proscribed is notmerely a breach of confidentiality by the insider, but rather a breach of the dutyof loyalty imposed on all fiduciaries to avoid personally profiting frominformation entrusted to them. See id. at 662-64. Thus, looking at objectivecriteria, a court must determine whether the insider personally will benefit,directly or indirectly, from his disclosure. So once again, a breach of fiduciaryduty is essential for liability to be imposed: a tippee can be held liable only whenthe tipper has breached a fiduciary duty by disclosing information to the tippee,and the tippee knows or has reason to know of the breach of duty.

3. The Gap-Fillers

Chiarella created a variety of significant gaps in the insider trading prohibition'scoverage. Consider this standard law school hypothetical: Law Firm is hired byRaider Corp. to represent it in connection with a planned takeover bid for TargetCo. Alex Associate is one of the lawyers assigned to the project. Before RaiderCorp. publicly discloses its intentions, Associate purchases a substantial blockof Target stock. Under the disclose or abstain rule, he has not violated theinsider trading prohibition. Whatever the scope of the duties he owed RaiderCorp., he owed no duty to the shareholders of Target Co. Accordingly, therequisite breach of fiduciary duty is not present in his transaction. Rule 14e-3and the misappropriation theory were created to fill this gap.

4. Rule 14e-3

Rule 14e-3 was the SEC's immediate response to Chiarella. The rule prohibitsinsiders of the bidder and target from divulging confidential information abouta tender offer to persons who are likely to violate the rule by trading on the basisof that information. The rule also, with certain narrow and well-definedexceptions, prohibits any person who possesses material information relating toa tender offer by another person from trading in target company securities if thebidder has commenced or has taken substantial steps towards commencementof the bid.

Note that the Rule's scope is very limited. One prong of the Rule (theprohibition on trading while in possession of material nonpublic information) isnot triggered until the offeror has taken substantial steps towards making theoffer. More important, both prongs of the rule are limited to information relatingto a tender offer. As a result, most types of inside information remain subject tothe duty-based analysis of Chiarella and its progeny.

5. Misappropriation

The misappropriation theory grew out of then-Chief Justice Burger's dissent inChiarella. As an employee of a financial printer, Chiarella had access to tenderoffer documents being prepared for takeover bidders. Although Chiarella owedno duties to the investors with whom he traded, he did owe a duty ofconfidentiality to his employer and thereby to the bidders. Chief Justice Burgerargued that Chiarella's misappropriation of material nonpublic information thathad been entrusted to his employer was a sufficient breach of duty to justifyimposing Rule 10b-5 liability. Chiarella v. U.S., 445 U.S. 222, 240-43 (1980)(Burger, C.J., dissenting). Although Justices Blackmun, Brennan, and Marshallsupported the Chief Justice's argument, the majority declined to reach themisappropriation question because that theory of liability had not beenpresented to the jury. The Second Circuit nevertheless adopted themisappropriation theory as a basis for inside trading liability in U.S. v. Newman,664 F.2d 12 (2d Cir. 1981), and followed it in a number of subsequent decisions.See, e.g., U.S. v. Chestman, 947 F.2d 551 (2d Cir. 1991) (en banc), cert. denied, 112S.Ct. 1759 (1992); U.S. v. Carpenter, 791 F.2d 1024 (2d Cir. 1986), aff'd on othergrounds, 484 U.S. 19 (1987); SEC v. Materia, 745 F.2d 197 (2d Cir. 1984), cert.denied, 471 U.S. 1053 (1985).

Like the traditional disclose or abstain rule, the misappropriation theoryrequires a breach of fiduciary duty before trading on inside information becomesunlawful. It is not unlawful, for example, for an outsider to trade on the basis ofinadvertently overheard information. SEC v. Switzer, 590 F. Supp. 756, 766 (W.D.Okla. 1984). The fiduciary relationship in question, however, is a quite differentone. Under the misappropriation theory, the defendant need not owe a fiduciaryduty to the investor with whom he trades. Nor does he have to owe a fiduciaryduty to the issuer of the securities that were traded. Instead, themisappropriation theory applies when the inside trader violates a fiduciary dutyowed to the source of the information. Had the misappropriation theory beenavailable against Chiarella, for example, his conviction could have been upheldeven though he owed no duties to those with whom he traded. Instead, thebreach of the duty he owed to Pandick Press would have sufficed.

After two Circuit Courts of Appeals rejected the misappropriation theory, theUnited States Supreme Court took a case raising the theory's validity. See U.S.v. O'Hagan, 92 F.3d 612 (8th Cir. 1996) (also concluding that the SEC lackedauthority to adopt Rule 14e-3); U.S. v. Bryan, 58 F.3d 933 (4th Cir. 1995). JamesO'Hagan was a partner in the Minneapolis law firm of Dorsey & Whitney. In July1988, Grand Metropolitan PLC (Grand Met), retained Dorsey & Whitney inconnection with its planned takeover of Pillsbury Company. Although O'Haganwas not one of the lawyers on the Grand Met project, he learned of theirintentions and began buying Pillsbury stock and call options on Pillsbury stock.When Grand Met announced its tender offer in October, the price of Pillsburystock rose to nearly $ 60 per share. O'Hagan then sold his Pillsbury call optionsand common stock, making a profit of more than $ 4.3 million. Following a SECinvestigation, O'Hagan was indicted on various charges. The most pertinentcharges for our purposes are: (1) O'Hagan violated 1934 Act Section 10(b) andRule 10b-5 by trading on misappropriated nonpublic information; and (2)O'Hagan violated 1934 Act Rule 14e-3 by trading while in possession ofnonpublic information relating to a tender offer. The Supreme Court upheldO'Hagan's conviction on both counts. With respect to the misappropriationcharge, the Court validated the theory as being designed "to 'protect theintegrity of the securities markets against abuses by 'outsiders' to a corporationwho have access to confidential information that will affect the corporation'ssecurity price when revealed, but who owe no fiduciary or other duty to thatcorporation's shareholders.'"

B. The Argument For Deregulation

Henry Manne's 1966 book Insider Trading and the Stock Market must be rankedamong the truly seminal events in the economic analysis of corporate law.Manne (1966a) It is only a slight exaggeration to suggest that Manne stunnedthe corporate law academy by daring to propose the deregulation of insidertrading. The traditionalists' response was immediate and vitriolic. See, e.g.,Schotland (1967); Mendelson (1969); see also Manne (1970). In the long run,however, Manne's daring was vindicated in at least one important respect.Although it is hard to believe at this remove, corporate law was regarded asmoribund during much of the middle part of this century. Manne's work oninsider trading played a major role in ending that long intellectual drought bystimulating interest in economic analysis of corporate law. Whether one agreeswith Manne's views on insider trading or not, one must give him due credit forhelping to stimulate the outpouring of important law and economics scholarshipin corporate law and securities regulation during the 1980s and 1990s.

Manne identified two principal ways in which insider trading benefits societyand/or the firm in whose stock the insider traded. First, he argued that insidertrading causes the market price of the affected security to move toward the pricethat the security would command if the inside information were publiclyavailable. If so, both society and the firm benefit through increased priceaccuracy. Second, he posited insider trading as an efficient way of compensatingmanagers for having produced information. If so, the firm benefits directly (andsociety indirectly) because managers have a greater incentive to produceadditional information of value to the firm.

6. The Effect of Insider Trading on the Price of Securities

There is general agreement that both firms and society benefit from accuratepricing of securities. The "correct" price of a security is that which would be setby the market if all information relating to the security had been publiclydisclosed. Accurate pricing benefits society by improving the economy'sallocation of capital investment and by decreasing the volatility of securityprices. This dampening of price fluctuations decreases the likelihood ofindividual windfall gains and increases the attractiveness of investing insecurities for risk-averse investors. The individual corporation also benefits fromaccurate pricing of its securities through reduced investor uncertainty andimproved monitoring of management's effectiveness.

Although U.S. securities laws purportedly encourage accurate pricing byrequiring disclosure of corporate information, they do not require the disclosureof all material information. Where disclosure would interfere with legitimatebusiness transactions, disclosure by the corporation is usually not requiredunless the firm is dealing in its own securities at the time.

When a firm lawfully withholds material information, its securities are nolonger accurately priced by the market. If the undisclosed information isparticularly significant, the error in price can be substantial. In the famous TexasGulf Sulphur case, for example, TGS discovered an enormously valuable mineraldeposit in Canada. When the deposit was discovered, TGS common stock soldfor approximately eighteen dollars per share. By the time the discovery wasdisclosed, four months later, the price had risen to over thirty-one dollars pershare. One month after disclosure, the stock was selling for approximatelyfifty-eight dollars per share. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir.1968), cert. denied, 404 U.S. 1005 (1971). Pricing errors of this magnitudeeliminate the benefits of accurate pricing. However, requiring TGS to disclosewhat it knew would have reduced the value of the information and thus theincentive to discover it.

Manne essentially argued insider trading is an effective compromise betweenthe need for preserving incentives to produce information and the need formaintaining accurate securities prices. Manne offered the following example ofthis alleged effect: A firm's stock currently sells at fifty dollars per share. Thefirm has discovered new information that, if publicly disclosed, would cause thestock to sell at sixty dollars. If insiders trade on this information, the price of thestock will gradually rise toward but will not reach the "correct" price. Absentinsider trading or leaks, the stock's price will remain at fifty dollars until theinformation is publicly disclosed and then rapidly rise to the correct price ofsixty dollars. Thus, insider trading acts as a replacement for public disclosure ofthe information, preserving market gains of correct pricing while permitting thecorporation to retain the benefits of nondisclosure. Manne (1966a, p.80-90)

Texas Gulf Sulphur provides anecdotal evidence for this effect. The TGSinsiders began active trading in its stock almost immediately after discovery ofthe ore deposit. During the four months between discovery and disclosure, theprice of TGS common stock gradually rose by over twelve dollars. Arguably, thisprice increase was due to inside trading. In turn, the insiders' profits were theprice society paid for obtaining the beneficial effects of enhanced marketefficiency.

Despite this and similar anecdotes, empirical justification for the deregulatoryposition remains scanty. Early market studies indicated insider trading had aninsignificant effect on price in most cases (Schotland, 1967, p.1443). Subsequentstudies suggested the market reacts fairly quickly when insiders buy securities,but the initial price effect is small when insiders sell. Finnerty (1976) In animportant study, Givoly and Palmon (1985) found that while transactions byinsiders were followed by a strong price effect, identifiable insider transactionswere only rarely based on exploitation of nonpublic information. If they arecorrect, then the market efficiency rationale for deregulation loses much of itsforce: insider trading simply is not communicating inside information to themarket. These and similar studies are problematic, however, because they reliedprincipally (or solely) on the transactions reports corporate officers, directors,and 10% shareholders are required to file under §16(a). Because insiders areunlikely to report transactions that violate rule 10b-5, and because much illegalinsider trading activity is known to involve persons not subject to the §16(a)reporting requirement, conclusions drawn from such studies may not tell us verymuch about the price and volume effects of illegal insider trading. Accordingly,it is significant that a more recent and widely-cited study of insider trading casesbrought by the SEC during the 1980s found that the defendants' insider tradingled to quick price changes Meulbrock (1992). That result supports Manne'sempirical claim, subject to the caveat that reliance on data obtained from SECprosecutions arguably may not be conclusive as to the price effects ofundetected insider trading due to selection bias, although Meulbroek's studyaddressed that concern by segmenting the sample into sub-sets, one of whichwas less likely to be contaminated by selection bias, and finding that the resultsdid not differ significantly across the subsets. Finally, the SEC's chief economisthas reached the perhaps debatable conclusion that pre-announcement price andvolume run-ups in takeovers are most likely attributable to factors other thaninsider trading (Rosenbaum & Bainbridge, 1988, p.235).

In theory, of course, the supply/demand effects of insider trading shouldhave only a minimal impact on the affected security's price. A given security"represents only a particular combination of expected return and systematic risk,for which there is a vast number of substitutes." Gilson and Kraakman (1984,p.630) The correct measure for the supply of securities is not simply the total ofthe firm's outstanding securities, but the vastly larger number of securities witha similar combination of risk and return. Therefore, the supply/demand effect ofa relatively small number of insider trades should not have a significant priceeffect.

The price effect of undisclosed insider trading is an example of what Gilsonand Kraakman (1984, p.630) call the "derivatively informed trading mechanism"of market efficiency. Derivatively informed trading affects market prices througha two-step mechanism. First, those individuals possessing material nonpublicinformation begin trading. Their trading has only a small effect on price. Someuninformed traders become aware of the insider trading through leakage ortipping of information or through observation of insider trades. Other tradersgain insight by following the price fluctuations of the securities. Finally, themarket reacts to the insiders' trades and gradually moves toward the correctprice. The problem is that while derivatively informed trading can affect price, itfunctions slowly and sporadically. Given the inefficiency of derivativelyinformed trading, the market efficiency justification for insider trading losesmuch of its force.

7. Insider Trading as an Efficient Compensation Scheme

Even Manne (1966a, p.110) admitted that price effect is not a strong argumentagainst a bar on insider trading. Instead, Manne's deregulatory argument restedmainly on the claim that allowing insider trading was an effective means ofcompensating entrepreneurs in large corporations. Manne (1966b, p.116)distinguished corporate entrepreneurs from mere corporate managers. The lattersimply operate the firm according to predetermined guidelines. Because the firmand the manager know what the manager will do and what his abilities are, salaryis an appropriate method of compensation. By contrast, an entrepreneur'scontribution to the firm consists of producing new valuable information. Theentrepreneur's compensation must have a reasonable relation to the value of hiscontribution to give him incentives to produce more information. Because it israrely possible to ascertain the information's value to the firm in advance,predetermined compensation, such as salary, is inappropriate for entrepreneurs.

8. Insider Trading as Entrepreneurial Compensation

Manne (1966a, p.116-19) asserted insider trading is an effective way tocompensate corporate agents for innovations. The increase in the price of thesecurity following public disclosure provides an imperfect but comparativelyaccurate measure of the value of the innovation to the firm. The entrepreneur canrecover the value of his discovery through buying the firm's securities prior todisclosure and selling them after the price rises. (Manne (1970) later implicitlyretreated from the distinction between entrepreneurs and managers, whichvitiated some of the criticisms directed at his thesis. Because Manne did notretreat from the more general claim that insider trading was an efficientcompensation scheme, most of the criticisms discussed in the next sectionremained viable.)

Carlton and Fischel (1983, p.869-71) suggested a further refinement ofManne's compensation argument. They likewise believed advance paymentcontracts fail to compensate agents for innovations. The firm could renegotiatethese contracts later to account for innovations, but renegotiation is costly andthus may not occur frequently enough to provide appropriate incentives forentrepreneurial activity. Carlton and Fischel suggested that one of theadvantages of insider trading is that an agent revises his compensation packagewithout renegotiating his contract. By trading on the new information, the agentself-tailors his compensation to account for the information he produces,increasing his incentive to develop valuable innovations. Because insidertrading provides the agent with more certainty of reward than othercompensation schemes, it also provides more incentives.

9. Evaluating the Compensation Thesis

In evaluating compensation-based justifications for deregulating inside trading,it is crucial to determine whether the corporation or the manager owns theproperty right to the information in question. Some of those who favorderegulating insider trading deny that the property rights of firms to informationproduced by their agents include the right to prevent the manager from tradingon the basis of that information. In contrast, those who favor regulation contendthat when an agent produces information the property right to that informationbelongs to the principal. Where the property right to agent-producedinformation should be assigned is a question deferred to Section 20 infra. Thissection focuses on the contention by those who favor regulating insider tradingthat it is an inefficient form of compensation.

Manne (1966b, p.117-19) rejected contractual and bonus forms ofcompensation as inadequate incentives for entrepreneurial inventiveness on theground that they fail to accurately measure the value of the innovation to thefirm. Some contend, however, that insider trading is any more accurate. Theyassert, for example, that even assuming the change in stock price accuratelymeasures the value of the innovation, the insider's compensation is limited bythe number of shares he can purchase. This, in turn, is limited by his wealth. Assuch, the insider's trading returns are based, not on the value of his contribution,but on his wealth.

Another objection to the compensation argument is the difficulty ofrestricting trading to those who produced the information. Where informationis concerned, production costs normally exceed distribution costs. As such,many firm agents may trade on the information without having contributed to itsproduction.

A related objection is the difficulty of limiting trading to instances in whichthe insider actually produced valuable information. In particular, why shouldinsiders be permitted to trade on bad news? Allowing managers to inside tradingreduces the penalties associated with a project's failure because tradingmanagers can profit whether the project succeeds or fails. If the project fails, themanager can sell his shares before that information becomes public and thusavoid an otherwise certain loss. The manager can go beyond mere lossavoidance into actual profitmaking by short selling the firm's stock.

Easterbrook (1981) focused on the contingent nature of insider trading as aground for rejecting compensation-based arguments. Because the agents tradingreturns cannot be measured in advance, neither can the true cost of his reward.As a result, selection of the most cost-effective compensation package is mademore difficult. Moreover, the agent himself may prefer a less uncertaincompensation package. If an agent is risk averse, he will prefer the certainty of$100,000 salary to a salary of $50,000 and a ten percent chance of a bonus of$500,000 from insider trading. Thus, the shareholders and the agent would gainby exchanging a guaranteed bonus for the agents promise not to trade on insideinformation. See also Levmore (1982).

As with the market efficiency argument, little empirical evidence supports orcounters the compensation argument. The only useful empirical evidence isGivoly and Palmon's (1985) finding that while insiders do earn abnormal returnsfrom trading in their firm's securities, these abnormal returns are based on theinsiders' superior assessment of their firm's status and not on exploitation ofinside information. If so, the compensation argument rests on fundamentallyflawed assumptions.

10. Public Choice

Some critics of the insider trading prohibition contend that the prohibition canbe explained by a public choice-based model of regulation in which rules aresold by regulators and bought by the beneficiaries of the regulation. Thissection focuses on slightly different, but wholly compatible, stories aboutinsider trading told by Dooley (1980) and Haddock and Macey (1987). Oneexplains why the SEC wanted to sell insider trading regulation, while the otherexplains to whom it has been sold.

11. The Sellers Story

Dooley (1980) explained the federal insider trading prohibition as the culminationof two distinct trends in the securities laws. First, as do all government agencies,the SEC desired to enlarge its jurisdiction and enhance its prestige.Administrators can maximize their salaries, power, and reputation by maximizingthe size of their agency's budget. A vigorous enforcement program directed ata highly visible and unpopular law violation is surely an effective means ofattracting political support for larger budgets. Given the substantial mediaattention directed towards insider trading prosecutions, and the public taste forprohibiting insider trading, it provided a very attractive subject for such aprogram.

Second, during the prohibition's formative years, there was a major effort tofederalize corporation law. In order to maintain its budgetary priority overcompeting agencies, the SEC wanted to play a major role in federalizing matterspreviously within the state domain. Regulating insider trading was an ideal targetfor federalization. Rapid expansion of the federal insider trading prohibitionpurportedly demonstrated the superiority of federal securities law over statecorporate law. Because the states had shown little interest in insider trading foryears, federal regulation demonstrated the modernity, flexibility, andinnovativeness of the securities laws. The SEC's prominent role in attackinginsider trading thus placed it in the vanguard of the movement to federalizecorporate law and ensured that the SEC would have a leading role in any systemof federal corporations law.

12. The Buyers' Story

Haddock and Macey (1987) argue that the insider trading prohibition issupported and driven in large part by market professionals, a cohesive andpolitically powerful interest group, which the current legal regime effectivelyinsulates from insider trading liability. See also Macey (1991). Only insiders andquasi-insiders such as lawyers and investment bankers have a greater degree of

access to nonpublic information that might affect a firm's stock price than domarket professionals. By basing insider trading liability on breach of fiduciaryduty, and positing that the requisite fiduciary duty exists with respect to insidersand quasi-insiders but not with respect to market professionals, the prohibitionprotects the latter's ability to profit from new information about a firm.

Market professionals benefit in a variety of ways from the present ban.When an insider trades on an impersonal secondary market, the insider takesadvantage of the fact that the market maker's or specialist's bid-ask prices do notreflect the value of the inside information. Because market makers and specialistscannot distinguish insiders from non-insiders, they cannot protect themselvesfrom being taken advantage of in this way. When trading with insiders, themarket maker or specialist thus will always be on the wrong side of thetransaction. If insider trading is effectively prohibited, however, the marketprofessionals are no longer exposed to this risk.

Professional securities traders likewise profit from the fiduciary-duty basedinsider trading prohibition. Because professional investors are often activetraders, they are highly sensitive to the transaction costs of trading in securities.Prominent among these costs is the specialist's and market-maker's bid-askspread. If a ban on insider trading lowers the risks faced by specialists andmarket-makers, some portion of the resulting gains should be passed on toprofessional traders in the form of narrower bid-ask spreads.

Analysts and traders are further benefited by a prohibition on insider trading,because only insiders are likely to have systematic advantages over marketprofessionals in the competition to be the first to act on new information. Marketprofessionals specialize in acquiring and analyzing information. They profit bytrading with less well-informed investors or by selling information to them. Ifinsiders can freely trade on nonpublic information, however, some portion of theinformation's value will be impounded into the price before it is learned bymarket professionals, which will reduce their returns. Haddock & Macey (1987).

Circumstantial evidence for Haddock and Macey's thesis is provided by SECenforcement patterns. The frequency of insider trading prosecutions rosedramatically after the U.S. Supreme Courts decision in Chiarella v. U.S., 445 U.S.222 (1980), which held that insider trading is only unlawful if the trader violateda fiduciary duty owed to the party with whom he trades. Strikingly, however, inthe years immediately prior to Chiarella, enforcement proceedings often

targeted market professionals. After Chiarella, market professionals were rarelycharged. Dooley (1995, p.832-34).

C. The Argument for Regulation

Efficiency-based arguments for regulating insider trading (as opposed to thosegrounded on legislative intent, equity, or fairness) fall into three main categories:(1) insider trading harms investors and thus undermines investor confidence inthe securities markets; (2) insider trading harms the issuer of the affectedsecurities; and (3) insider trading amounts to theft of property belonging to thecorporation and therefore should be prohibited even in the absence of harm toinvestors or the firm. This section considers these arguments seriatim.

13. Does Insider Trading Injure Investors?

Insider trading is said to harm the investor in two principal ways. Some contendthat the investor's trades are made at the "wrong price." A more sophisticatedtheory posits that the investor is induced to make a bad purchase or sale.Neither argument proves convincing on close examination.

An investor who trades in a security contemporaneously with insidershaving access to material nonpublic information likely will allege injury in thathe sold at the wrong price; i.e., a price that does not reflect the undisclosedinformation. If a firm's stock currently sells at $10 per share, but after disclosureof the new information will sell at $15, a shareholder who sells at the current pricethus will claim a $5 loss. The investor's claim, however, is fundamentally flawed.It is purely fortuitous that an insider was on the other side of the transaction.The gain corresponding to shareholder's "loss" is reaped not just by insidetraders, but by all contemporaneous purchasers whether they had access to theundisclosed information or not. Bainbridge (1986, p.59).

To be sure, the investor might not have sold if he had had the sameinformation as the insider, but even so the rules governing insider trading arenot the source of his problem. The information asymmetry between insiders andpublic investors arises out of the federal securities laws' mandatory disclosurerules, which allow firms to keep some information confidential even if it ismaterial to investor decisionmaking. Unless immediate disclosure of materialinformation is to be required, a step the law has been unwilling to take, there willalways be winners and losers in this situation. Irrespective of whether insidersare permitted to inside trade or not, the investor will not have the same accessto information as the insider. It makes little sense to claim that the shareholderis injured when his shares are bought by an insider, but not when they arebought by an outsider without access to information. To the extent the sellingshareholder is injured, his injury thus is correctly attributed to the rules allowingcorporate nondisclosure of material information, not to insider trading.

A more sophisticated argument is that the price effects of insider tradinginduce shareholders to make poorly advised transactions. In light of theevidence and theory recounted above in Section 6, however, it is doubtfulwhether insider trading produces the sort of price effects necessary to induceshareholders to trade. While derivatively informed trading can affect price, itfunctions slowly and sporadically. Gilson and Kraakman (1984, p.631). Given theinefficiency of derivatively informed trading, price or volume changes resultingfrom insider trading will only rarely be of sufficient magnitude to induceinvestors to trade.

Assuming for the sake of argument that insider trading produces noticeableprice effects, however, and further assuming that some investors are misled bythose effects, the inducement argument is further flawed because manytransactions would have taken place regardless of the price changes resultingfrom insider trading. Investors who would have traded irrespective of thepresence of insiders in the market benefit from insider trading because theytransacted at a price closer to the "correct" price; i.e., the price that would prevailif the information were disclosed. Dooley (1980, p.35-36); Manne (1966b, p.114).In any case, it is hard to tell how the inducement argument plays out wheninvestors are examined as a class. For any given number who decide to sellbecause of a price rise, for example, another group of investors may decide todefer a planned sale in anticipation of further increases.

14. Does Insider Trading Undermine Investor Confidence?

In the absence of a credible investor injury story, it is difficult to see why insidertrading should undermine investor confidence in the integrity of the securitiesmarkets. Instead, any anger investors feel over insider trading appears to arisemainly from envy of the insider's greater access to information.

The loss of confidence argument is further undercut by the stock market'sperformance since the insider trading scandals of the mid-1980s. The enormouspublicity given those scandals put all investors on notice that insider trading isa common securities violation. At the same time, however, the years since thescandals have been one of the stock market's most robust periods. One can butconclude that insider trading does not seriously threaten the confidence ofinvestors in the securities markets.

Macey (1991, p. 44) contends that the experience of other countries confirmsthis conclusion. For example, Japan only recently began regulating insidertrading and its rules are not enforced. The same appears to be true of India.Hong Kong has repealed its insider trading prohibition. Both have vigorous andhighly liquid stock markets.

15. Does Insider Trading Injure Issuers?

Unlike tangible property, information can be used by more than one personwithout necessarily lowering its value. If a manager who has just negotiated amajor contract for his employer then trades in his employers stock, for example,there is no reason to believe that the managers conduct necessarily lowers thevalue of the contract to the employer. But while insider trading will not alwaysharm the employer, it may do so in some circumstances. Specifically, there arefour significant potential harms connected with insider trading that are worthconsidering: First, insider trading may delay the transmission of information orthe taking of corporate action. Second, it may impede corporate plans. Third, itgives managers an incentive to manipulate stock prices. Finally, it may injure thefirm's reputation.

16. Delay

Insider trading becomes a plausible source of injury to the firm if it createsincentives for managers to delay the transmission of information to superiors.Decisionmaking in any entity requires accurate, timely information. In large,hierarchical organizations, such as publicly traded corporations, informationmust pass through many levels before reaching senior managers. The morelevels, the greater the probability of distortion or delay intrinsic to the system.This inefficiency can be reduced by downward delegation of decisionmakingauthority but not eliminated. Even with only minimal delay in the upwardtransmission of information at every level, where the information must passthrough many levels before reaching a decisionmaker, the net delay may besubstantial.

If a manager discovers or obtains information (either beneficial or detrimentalto the firm), he may delay disclosure of that information to other managers so asto assure himself sufficient time to trade on the basis of that information beforethe corporation acts upon it. As noted, even if the period of delay by any onemanager is brief, the net delay produced by successive trading managers maybe substantial. See Haft (1982, p.1053-60). But see Macey (1991, p.36-37).Unnecessary delay of this sort harms the firm in several ways. The firm mustmonitor the manager's conduct to ensure timely carrying out of his duties. Itbecomes more likely that outsiders will become aware of the information throughsnooping or leaks. Easterbrook (1981). Some outsider may even independentlydiscover and utilize the information before the corporation acts upon it.

Although delay is a plausible source of harm to the issuer, its importance iseasily exaggerated. The available empirical evidence scarcely rises above theanecdotal level, but does suggest that measurable delay attributable to insidertrading is rare. Dooley (1980, p.34). Given the rapidity with which securitiestransactions can be conducted in modern secondary trading markets, moreover,a manager need at most delay corporate action long enough for a five minutetelephone conversation with his stockbroker. Even if the manager wished tocover his tracks by trading through an elaborate network of off-shore shellcorporations, very little delay is entailed once the network is up and running.

Delay (either in transmitting information or taking action) also often will bereadily detectible by the employer. Finally, and perhaps most importantly, insidertrading may create incentives to release information early just as often as itcreates incentives to delay transmission and disclosure of information.

17. Interference with Corporate Plans

Trading during the planning stage of an acquisition is the paradigm example ofhow insider trading may affect corporate plans. If the managers charged withoverseeing the acquisition buy shares in the target, the price of the targetsshare's may rise, making the takeover more expensive. Price and volume changescaused by their trading also might tip off others to the secret, interfering with thebidder's plans, as by alerting the target to the need for defensive measures.

The trouble with this argument, of course, is its dependence upon price andvolume effects. As the theory and empirical evidence recounted above in section6 suggest, price or volume changes resulting from insider trading may raise themarginal cost of corporate plans but will only rarely pose significant obstaclesto carrying corporate plans forward.

The risk of premature disclosure poses a more serious threat to corporateplans. The issuer often has just as much interest in when information becomespublic as it does in whether the information becomes public. Suppose Target,Inc., enters into merger negotiations with a potential acquirer. Target managerswho inside trade on the basis of that information will rarely need to delaycorporate action in order to effect their purchases. Having made their purchases,however, the managers now have an incentive to cause disclosure of Target'splans as soon as possible. Absent leaks or other forms of derivatively informedtrading, the merger will have no price effect until it is disclosed to the market, atwhich time there usually is a strong positive effect. Once the information isdisclosed, the trading managers will be able to reap substantial profits, but untildisclosure takes place, they bear a variety of firm-specific and market risks. Thedeal, the stock market, or both may collapse at any time. Early disclosure enablesthe managers to minimize those risks by selling out as soon as the price jumpsin response to the announcement.

If disclosure is made too early, a variety of adverse consequences may result.If disclosure triggers competing bids, the initial bidder may withdraw from thebidding or demand protection in the form of costly lock-ups and otherexclusivity provisions. Alternatively, if disclosure does not trigger competingbids, the initial bidder may conclude that it overbid and lower its offeraccordingly. In addition, early disclosure brings the deal to the attention ofregulators and plaintiffs' lawyers sooner than necessary.

An even worse case scenario is suggested by the classic insider tradingcase, SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394U.S. 976 (1969). In TGS, insiders who knew of a major ore discovery traded overan extended period of time. During that period the corporation was attemptingto buy up the mineral rights to the affected land. Had the news leakedprematurely, the issuer at least would have had to pay much higher fees for themineral rights, and may well have lost some land to competitors. Given themagnitude of the strike, which eventually resulted in a 300-plus percent increasein the firm's market value, the harm that would have resulted from prematuredisclosure was immense.

Although insider trading probably only rarely causes the firm to loseopportunities, it may create incentives for management to alter firm plans in lessdrastic ways to increase the likelihood and magnitude of trading profits. Forexample, trading managers can accelerate receipt of revenue, changedepreciation strategy, or alter dividend payments in an attempt to affect shareprices and insider returns. Brudney (1979). Alternatively, the insiders mightstructure corporate transactions to increase the opportunity for secret-keeping.Both types of decisions may adversely affect the firm and its shareholders.Moreover, as Levmore (1982, p.149) suggests, this incentive may result inallocative inefficiency by encouraging overinvestment in those industries oractivities that generate opportunities for insider trading.

Easterbrook (1981, p.332) identifies a related perverse incentive created byinsider trading. Managers may elect to follow policies that increase fluctuationsin the price of the firm's stock. "They may select riskier projects than theshareholders would prefer, because if the risks pay off they can capture aportion of the gains in insider tradings and, if the project flops, the shareholdersbear the loss." In contrast, Carlton and Fischel (1983, p.874-76) assert thatEasterbrook overstates the incentive to choose high-risk projects. Becausemanagers must work in teams, the ability of one or a few managers to selecthigh-risk projects is severely constrained through monitoring by colleagues.Cooperation by enough managers to pursue such projects to the firm's detrimentis unlikely because a lone whistle-blower is likely to gain more by exposingothers than he will by colluding with them. Further, Carlton and Fischel arguemanagers have strong incentives to maximize the value of their services to thefirm. Therefore they are unlikely to risk lowering that value for short-term gainby adopting policies detrimental to long-term firm profitability. Finally, Carltonand Fischel alternatively argue that even if insider trading creates incentives formanagement to choose high-risk projects, these incentives are not necessarilyharmful. Such incentives would act as a counterweight to the inherent riskaversion that otherwise encourages managers to select lower risk projects thanshareholders would prefer.

Carlton and Fischel are correct that shareholders may prefer higher-riskprojects. Because shareholders hold residual claims, they will prefer that the firminvest in projects with a significant upside potential. This is true even if suchventures pose a substantial risk because shareholders earn no return until allprior claims are paid. However, shareholders would not approve high-riskprojects where the increased risk is not matched by a commensurate increase inpotential return. Allowing insider trading may encourage management to selectnegative net present value investments, not only because shareholders bear thefull risk of failure, but also because failure presents management with anopportunity for profit through short-selling. As a result, shareholders mightprefer other incentive schemes.

18. Manipulation

Manipulation of stock prices, as a form of fraud, harms both society andindividuals by decreasing the accuracy of pricing by the market. Some of thosewho favor regulation of insider trading argue that if managers are permitted totrade on inside information they have a strong interest in keeping the stockpricing stable or in moving it in the correct direction while they are trading.Therefore, they have a strong incentive to use manipulative practices. See, e.g.,Schotland (1967, p.1449-50).

Manne (1970, p.575) acknowledged that manipulation is harmful and thatmanipulation of stock prices would cease if insider trading could be effectivelyeliminated because nobody would then benefit from it. Manne's principalresponse to the manipulation argument is not that it is wrong, but that the costsof producing perfect compliance with a prohibition against insider trading areunacceptably high. Like most arguments in this debate, the thrust of themanipulation rationale depends on whose estimate of the costs is correct.

19. Injury to Reputation

Suppose that insider trading was shown to harm not the issuer, but the issuer'sshareholders. It has been said that insider trading by corporate managers may"cast a cloud on the corporation's name, injure stockholder relations andundermine public regard for the corporation's securities." Diamond v.Oreamuno, 248 N.E.2d 910, 912 (N.Y. 1969); cf. Macey (1984, p.42-43) (discussingthreat of reputational injury posed for the Wall Street Journal when one of itsreporters traded on confidential information). But see Freeman v. Decio, 584 F.2d186, 194 (7th Cir. 1978) (arguing that injury to reputation is "speculative").Reputational injury of this sort translates into direct financial injury, by raisingthe firm's cost of capital, if investors demand a premium (by paying less) whenbuying stock in a firm whose managers inside trade.

Because shareholder injury is a critical underlying premise of the reputationalinjury story, however, this argument would appear to collapse at the startinggate. As we have seen, it is very hard to create a plausible shareholder injurystory.

As such, the reputational injury story must turn to more generalized notionsof fairness. At this stage in the analysis, virtually all commentators make one oftwo moves. One group tries to find sources of unfairness unrelated to thequestion of shareholder injury, while the other simply asserts that insider tradingis not unfair absent a credible story of investor injury. The former move fails. AsBainbridge (1986, p.56-61) argues, insider trading is not unfair to investors in anymeaningful sense of the term. See also Easterbrook (1981, p.323-30); Macey(1991, p.23-31).

Some contend that the latter move also fails precisely because most peopledo not examine the problem dispassionately. Even though insider trading is notactually unfair, the reputational injury story may remain viable if most investorsbelieve it to be unfair. This perception of unfairness most likely proceeds fromresentment of the insider's informational advantage, which suggests that it maybe based on envy as much as on fairness norms. As an advertising slogan onceput it, however, image is everything. If one's definition of efficiency takes intoaccount seemingly irrational preferences, perhaps a prohibition of insider tradingcan be justified as a means of avoiding this sort of reputational injury. Whetherefficiency should include such preferences is a question beyond the scope ofthis essay.

Assuming the validity of the reputational injury story, arguendo, thereputational impact of insider trading probably is minimal in most cases. Theprincipal problem is the difficulty investors have in distinguishing those firmsin which insider trading is frequent from those in which it is infrequent. If theyare unable to do so, individual firms are unlikely to suffer a serious reputationalinjury in the absence of a truly major scandal.

20. Insider Trading as Theft: A Property Rights Analysis

There is an emerging consensus that the federal insider trading prohibition ismost easily justified as a means of protecting property rights in information. See,e.g., U.S. v. Chestman, 947 F.2d 551, 576-78 (2d Cir. 1991) (Winter, J., concurring),cert. denied, 112 S. Ct. 1759 (1992); Bainbridge (1993, p. 21-23); Dooley (1995,p.820-23); Easterbrook (1981); Macey (1984). For an argument that the propertyrights approach has explanatory as well as justificatory power, see Bainbridge(1995, p.1256-57). In contrast, for a vociferous critique of the law and economicsliterature on insider trading generally and the property rights approach inparticular, see Karmel (1993).

There are essentially two ways of creating property rights in information:allow the owner to enter into transactions without disclosing the information orprohibit others from using the information. In effect, the federal insider tradingprohibition vests a property right of the latter type in the party to whom theinsider trader owes a fiduciary duty to refrain from self-dealing in confidentialinformation. To be sure, at first blush, the insider trading prohibition admittedlydoes not look very much like most property rights. Enforcement of the insidertrading prohibition admittedly differs rather dramatically from enforcement of,say, trespassing laws. The existence of property rights in a variety ofintangibles, including information, however, is well-established. Trademarks,copyrights, and patents are but a few of the better known examples of thisphenomenon. In context, moreover, even the insider trading prohibition'senforcement mechanisms are not inconsistent with a property rights analysis.Where public policy argues for giving someone a property right, but the costsof enforcing such a right would be excessive, the state often uses its regulatorypowers as a substitute for creating private property rights. Insider trading posesjust such a situation. Private enforcement of the insider trading laws is rare andusually parasitic on public enforcement proceedings. Dooley (1980, p.15-17).Indeed, the very nature of insider trading arguably makes public regulationessential precisely because private enforcement is almost impossible. The insidertrading prohibition's regulatory nature thus need not preclude a propertyrights-based analysis.

The rationale for prohibiting insider trading is precisely the same as that forprohibiting patent infringement or theft of trade secrets: protecting the economicincentive to produce socially valuable information. (An alternative approach isto ask whether the parties, if they had bargained over the issue, would haveassigned the property right to the corporation or the inside trader. For ahypothetical bargain-based argument that the property right would be assignedto the corporation in the lawyer--corporate client context, see Bainbridge (1993,p. 27-34).)

As the theory goes, the readily appropriable nature of information makes itdifficult for the developer of a new idea to recoup the sunk costs incurred todevelop it. If an inventor develops a better mousetrap, for example, he cannotprofit on that invention without selling mousetraps and thereby making the newdesign available to potential competitors. Assuming both the inventor and hiscompetitors incur roughly equivalent marginal costs to produce and market thetrap, the competitors will be able to set a market price at which the inventor likelywill be unable to earn a return on his sunk costs. Ex post, the rational inventorshould ignore his sunk costs and go on producing the improved mousetrap. Exante, however, the inventor will anticipate that he will be unable to generatepositive returns on his up-front costs and therefore will be deterred fromdeveloping socially valuable information. Accordingly, society providesincentives for inventive activity by using the patent system to give inventorsa property right in new ideas. By preventing competitors from appropriating theidea, the patent allows the inventor to charge monopolistic prices for theimproved mousetrap, thereby recouping his sunk costs. Trademark, copyright,and trade secret law all are justified on similar grounds.

This argument does not provide as compelling a justification for the insidertrading prohibition as it does for the patent system. A property right ininformation should be created when necessary to prevent conduct by whichsomeone other than the developer of socially valuable information appropriatesits value before the developer can recoup his sunk costs. Insider trading,however, often does not affect an idea's value to the corporation and probablynever entirely eliminates its value. Legalizing insider trading thus would have amuch smaller impact on the corporation's incentive to develop new informationthan would, say, legalizing patent infringement.

The property rights approach nevertheless has considerable justificatorypower. Consider the prototypical insider trading transaction, in which an insidertrades in his employer's stock on the basis of information learned solely becauseof his position with the firm. There is no avoiding the necessity of assigning theproperty right to either the corporation or the inside trader. A rule allowinginsider trading assigns the property right to the insider, while a rule prohibitinginsider trading assigns it to the corporation.

From the corporation's perspective, we have seen that legalizing insidertrading would have a relatively small effect on the firm's incentives to developnew information. In some cases, however, insider trading will harm thecorporation's interests and thus adversely affect its incentives in this regard.This argues for assigning the property right to the corporation, rather than theinsider.

Those who rely on a property rights-based justification for regulating insidertrading also observe that creation of a property right with respect to a particularasset typically is not dependent upon there being a measurable loss of valueresulting from the asset's use by someone else. Indeed, creation of a propertyright is appropriate even if any loss in value is entirely subjective, both becausesubjective valuations are difficult to measure for purposes of awarding damagesand because the possible loss of subjective values presumably would affect thecorporation's incentives to cause its agents to develop new information. As withother property rights, the law therefore should simply assume (although theassumption will sometimes be wrong) that assigning the property right toagent-produced information to the firm maximizes the social incentives for theproduction of valuable new information.

Because the relative rarity of cases in which harm occurs to the corporationweakens the argument for assigning it the property right, however, the criticalissue may be whether one can justify assigning the property right to the insider.On close examination, the argument for assigning the property right to theinsider is considerably weaker than the argument for assigning it to thecorporation. As we have seen, some have argued that legalized insider tradingwould be an appropriate compensation scheme. In other words, society mightallow insiders to inside trade in order to give them greater incentives to developnew information. As we have also seen, however, this argument appears tofounder on grounds that insider trading is an inefficient compensation scheme.Even assuming that the change in stock price that results once the informationis released accurately measures the value of the innovation, the insider's tradingprofits are not correlated to the value of the information. This is so because histrading profits are limited not by the value of the information, but by the amountof shares the insider can purchase, which in turn depends mainly upon his exante wealth or access to credit.

A second objection to the compensation argument is the difficulty ofrestricting trading to those who produced the information. The costs ofproducing information normally are much greater than the costs of distributingit. Thus, many firm employees may trade on the information without havingcontributed to its production.

The third objection to insider trading as compensation is based on itscontingent nature. If insider trading were legalized, the corporation would treatthe right to inside trade as part of the manager's compensation package. Becausethe manager's trading returns cannot be measured ex ante, however, thecorporation cannot ensure that the manager's compensation is commensuratewith the value of her services.

The economic theory of property rights in information thus cannot justifyassigning the property right to insiders rather than to the corporation. Becausethere is no avoiding the necessity of assigning the property right to theinformation in question to one of the relevant parties, the argument for assigningit to the corporation therefore should prevail.

D. Open Questions

If the property rights justification for regulating insider trading is accepted,several questions remain open. Among these are: (1) Should the insider tradingprohibition apply to all confidential information relating to the firm, or only toinformation whose use by an insider poses some serious threat of injury to thecorporation? (2) Should the insider trading regulatory scheme consist of amandatory prohibition or a default rule? (3) In the United States, the regulatorypurview of the federal securities laws is normally regarded as being limited toissues of disclosure and fraud. Questions of theft and fiduciary duty are usuallyrelegated to state law. Why is insider trading an exception to that scheme? Weconsider these questions seriatim.

21. Scope of the Prohibition

In Diamond v. Oreamuno, 248 N.E.2d 910 (N.Y. 1969), the New York (state) Courtof Appeals concluded that a shareholder could properly bring a derivative actionagainst corporate officers who had traded in the corporations stock. The courtexplicitly relied on a property rights-based justification for its holding: "Theprimary concern, in a case such as this, is not to determine whether thecorporation has been damaged, but to decide, as between the corporation andthe defendants, who has a higher claim to the proceeds derived from exploitationof the information." Critics of Diamond have frequently pointed out that thecorporation could not have used the information at issue in that case for its ownprofit. The defendants had sold shares on the basis of inside information abouta substantial decline in the firm's earnings. Once released, the informationcaused the corporation's stock price to decline precipitously. The informationwas thus a historical accounting fact of no value to the corporation. The onlypossible use to which the corporation could have put this information was bytrading in its own stock, which it could not have done without violating theantifraud rules of the federal securities laws.

The Diamond case thus rests on an implicit assumption that, as between thefirm and its agents, all confidential information about the firm is an asset of thecorporation. Critics of Diamond contend that this assumption puts the cartbefore the horse: the proper question is to ask whether the insiders use of theinformation posed a substantial threat of harm to the corporation. Only if thatquestion is answered in the affirmative should the information be deemed anasset of the corporation. See, e.g., Freeman v. Decio, 584 F.2d 186, 192-94 (7th

Cir. 1978).

Proponents of a more expansive prohibition might respond to this argumentin two ways. First, they might reiterate that, as between the firm and its agents,there is no basis for assigning the property right to the agent. See supra section20. Second, they might focus on the secondary and tertiary costs of aprohibition that encompassed only information whose use posed a significantthreat of harm to the corporation. A regime premised on actual proof of injury tothe corporation would be expensive to enforce, would provide little certainty orpredictability for those who trade, and might provide agents with perverseincentives.

22. Mandatory or Default Rules

For law and economics supporters of the insider trading prohibition, aninteresting question is whether the corporate employer should be allowed toauthorize its agents to inside trade. Because most property rights are freelyalienable, treating confidential information as a species of property suggests thatthe information's owner is presumptively entitled to decide whether someonemay use it to inside trade. In other words, the insider trading prohibitionarguably should be treated as simply a special case of the laws against theft.

Another way of phrasing the question is to ask whether the prohibition ofinsider trading should be a default or a mandatory rule. Default rules in corporatelaw are analogous to alienable property rights. Just as shareholders generally areprotected by the doctrine of limited liability unless they give a personalguarantee of the corporation's debts, patentholders have exclusive rights to theirinventions unless they authorize another's use by granting a license. Continuingthe analogy, mandatory rules in corporate law are comparable to inalienableproperty rights. Just as corporate law proscribes vote buying, the law prohibitsone from selling one's vote in a presidential election.

So phrased, the insider trading problem becomes a subset of one of thefiercest debates in the corporate law academy; namely, the extent to whichmandatory rules are appropriate in corporate law. A detailed analysis of thisdebate is beyond this essays scope. Accordingly, it perhaps suffices to observethat the question of whether the insider trading prohibition should be cast as analienable or an inalienable property right remains open. See generally Fischel(1984); Macey (1984); Ulen (1993).

23. How Should Insider Trading be Regulated?

Even among those who agree that insider trading should be regulated onproperty rights grounds, there is no agreement as to how insider trading shouldbe regulated. Bainbridge (1995, p.1262-66) contends that the federal Securitiesand Exchange Commission has a comparative advantage in prosecuting insidertrading questions, which justifies treating the prohibition as a matter of concernfor the federal securities laws. Macey (1991, p.40-41) agrees that insider tradingis difficult to detect and, moreover, that centralized monitoring of insider tradingby the SEC and the self-regulatory organizations within the securities industrymay be more efficient than private party efforts to detect insider trading. Henevertheless draws a distinction between SEC monitoring of insider trading anda federal prohibition of insider trading. Macey contends that the SEC shouldmonitor insider trading, but refer detected cases to the affected corporation forprivate prosecution. A third option, favored by some commentators, would beto leave insider trading to state corporate law, just as is done with every otherduty of loyalty violation, and, accordingly, divest the federal SEC of anyregulatory involvement. Although this debate has considerable theoreticalinterest, it is essentially mooted by the public choice arguments recounted insection 10 above. There is no constituency that would support repealing thefederal insider trading prohibition, while proposals to do so would meet strongopposition from the SEC and its securities industry constituencies that benefitfrom the current prohibition.

24. Some Suggestions for Further Empirical Research

Those who approach the insider trading proposition assuming that the propertyright to inside information belongs to managers in the absence of a compellingreason for assigning it to firms will necessarily draw different conclusions thanthose who start out with the opposite assumption. Unfortunately, in the absenceof decisive empirical evidence, the insider trading debate turns on who gets tochoose the null hypothesis--the proposition that the other side must refute--andon that issue there is unlikely to be agreement.

The problem is that serious empirical research on insider trading is obviouslyimpeded by the subject matters illegality. The two principal sources of raw datafor U.S. transactions are insider stock transaction reports filed under SecuritiesAct Section 16(a) and case files of actions brought under Securities ExchangeAct Rules 10b-5 and 14e-3. The first option is unattractive for two reasons: (1)only a small percentage of individuals with access to inside information areobliged to file under Section 16(a); and (2) it seems unlikely that insiders wouldknowingly report the most interesting transactions--those that violate Rules10b-5 or 14e-3.

The second option is unattractive because of the potential for selection bias.Many insider trading cases result from computer analysis of stock marketactivity. As such, empirical studies of SEC case files will be inherently biasedtowards cases in which insider trading conincident with noticeable price orvolume effects.

A third option is cross-cultural studies, focusing on stock markets operatingin countries where insider trading is either legal or not vigorously prosecuted.One must be careful, of course, to ensure that focusing on only one aspect ofcross-cultural comparisons does not invalidate the results.

Having said all of that, there remain several areas in which further empiricalresearch might be helpful. First, the data on the price and volume effects ofinsider trading remain confused. Further research on this issue seems warranted.A related area of research would focus on the incentive effects of insider tradingby corporate managers. Is there any empirical basis for the compensationargument?

Second, it would be helpful to gather better data on the effect of insidertrading on investor confidence. Here is one area in which cross-culturalcomparisons are both promising and yet fraught with danger. As Macey (1991,p. 44) observes, Japan only recently began regulating insider trading and itsrules are not enforced. Hong Kong has repealed its insider trading prohibition.Yet, both have vigorous and highly liquid stock markets. Query to what extentthe Japanese and Hong Kong experiences are relevant to an understanding ofU.S. capital markets. Assuming the validity of such comparisons, however,

studying the effects of insider trading regulation (or the lack thereof) on othermarkets would be instructive with respect to the panoply of questions relatingto investor confidence and injury.

Acknowledgments

Although any remaining errors are my sole responsibility, I wish to thank MituGulati and William Klein, both Professors of Law at UCLA, Lisa Meulbroek,Associate Professor at the Harvard Business School, and Thomas Ulen,Professor of Law and Economics at the University of Illinois, as well as the twoanonymous referees, for helpful comments on earlier drafts. I also wish to thankmy research assistant, Bradley Cebeci, for his excellent work in helping toassemble the bibliography.

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