Insider trading refers to people such as managers of companies trading on information not available to the rest of the market, especially if such information was obtained from those in positions of fiduciary responsibility. The clamour for a relook at how insider trading regulation works has become rather shrill after the arrest of executives of the US-based hedge fund Galleon Group.
The cognoscenti, mainly academics, argue that much of the structure of capital markets is based on access to differential information. Many experts have suggested that current regulations seem to take a limited view of the various situations that might constitute insider trading and have sought greater clarity so that fund managers know when they have crossed the line. Regulators feel the line is drawn pretty clearly.
Insider trading has always lived uneasily with regulation. Regulators have viewed insider trading with great concern, believing that parties to market transactions should have equal information and that the basic incentive for people to invest in capital markets will be destroyed if investors feel that a few persons can fix the market to their advantage.
While this view is correct, readers will be surprised to know that other views on insider trading also prevail, especially among academics. It will be useful to discuss the underlying basis of these divergent views to understand whether there is indeed a need for regulators to cast in stone the boundaries of acceptable trading behaviour.
The school of opponents to regulation—those who actually believe that some insider trading is good for the markets—cite reams of academic evidence in their favour. Henry Mann, eminent lawyer and dean of George Mason School of Law, in his 1966 classic Investing in the Stock Market made the point that prohibition of insider trading actually prevented asset prices from adjusting quickly to the underlying economic reality. He believed that when insiders trade, asset prices move faster to their real value.
Other academics believe that even if an insider buys stock on good views, since that stock represents only a certain risk and return combination in the entire market, it is not the supply-demand of only that security but all others of a similar risk profile which affect its prices and, hence, insiders cannot easily affect prices.
Some other studies have shown that unless insiders are trading in very large quantities, it is unlikely that there will be material effects on price. Academics have also noted that an overly strict interpretation of insider trading means that when there is bad news in a company, insiders will simply not buy its stock and by non-trading they have implicitly used insider information, which is not shared with others. Not buying one’s own stock in anticipation of bad news is as much of an insider action as buying it in anticipation of good news.
It has also been argued that cases of misgovernance such as Enron would have been easier to spot if insiders had been able to trade more freely because some people would have surely reflected the inside knowledge they had.
Aswath Damodaran, the well-known valuation expert from New York University, says on his blog that there is a very weak correlation between insiders’ actions and stock price changes. He points out that Galleon has only had an average performance over the last few years despite evidently having access to various kinds of information.
Even courts have sometimes appeared ambivalent in their approach to this subject. US Supreme Court justice Louis Powell in Dirks v. SEC (the Securities and Exchange Commission) indicated that it is acceptable and common place for analysts to ferret out information from insiders. He also mentioned that by definition such information cannot be made simultaneously available to all public—the main feature that distinguishes inside from public information. The case further confirmed that simply asking for and trading on information which others do not have is not illegal and becomes so only if it breaches an explicit fiduciary duty to not use that information.
Both courts and academia have on occasion taken ambivalent stands on what constitutes improper trading. The above views, perhaps, constitute extreme positions and are unlikely to cut much ice with any regulator. Regulators have disagreed with these views.
It would appear that the regulators’ argument against insider trading is based on premises of fairness rather than evidence suggesting that it increases market efficiency or that it results in consistently higher returns to those indulging in it. Perceived fairness is a fundamental tenet of markets and we should agree that it needs to be regulated strongly.
An essential condition of strong regulation is the existence of clearly defined lines in the sand that cannot be transgressed. Such clarity of law is needed because modern capital markets are underpinned by some levels of information asymmetry. Some level of insider trading is actually a concomitant of markets and, hence, regulation needs to find ways to distinguish between what one might call acceptable and illegal sharing of insider information.
If we are able to do so, we will have set clearer markers for market participants to know what is right and wrong.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes every other Friday on issues related to governance. The views expressed here are personal. Write to him at firstname.lastname@example.org