Thursday, September 09, 2004

Insider Trading and Caveat Emptor

Stephen Bainbridge has a new piece at Tech Central Station with the title "Why Regulate Insider Trading?" Bainbridge, who blogs at and professes corporate and securities law at the UCLA School of Law, knows a lot more than most people about the subject of insider trading. Here's my simple view of it:

When a corporate officer or employee acts on "inside" information to profit from the sale or purchase of his company's stock, that person is engaging in a form of fraud. Why? Because, the information on which the officer or employee acts isn't his information. It belongs to the corporation and therefore to the corporation's shareholders.

An officer or employee who sells the corporation's stock knowing of bad news that's about to break is, in effect, profiting at the expense of other shareholders. The inside trader, by selling before other shareholders can sell, loses less than other shareholders; that is, he transfers his losses to others by acting on information that is rightly theirs.

The inside trader who sells short may actually profit from the losses of other shareholders.

An insider who buys his company's stock knowing of good news that is likely to drive up the price of that stock is profiting from the ignorance of other shareholders. If they had the same information, many of them would compete with the insider to bid up the price of the stock, thus reducing or even eliminating his ability to profit from inside knowledge.

What about the effects of insider trading on prospective shareholders? If a corporation has especially good or bad news, it ought to divulge that news to prospective shareholders. A prospective shareholder -- unlike a prospective used-car buyer -- has no way of knowing the current working condition of a corporation before he buys its shares. Nor can a prospective shareholder buy shares that come with a warranty against hidden defects. It is therefore a fraudulent act, to my way of thinking, if a corporation fails to divulge critical information about its affairs to prospective shareholders.

The right remedy for insider trading -- and for corporate failure to disclose critical information -- is to sue and prosecute for fraud. Knock off all the legalistic regulations -- just sue and prosecute. If the bastards aren't deterred, make them pay through the nose and with a stretch in the slammer.