Outsider Trading as an Incentive Device

Abstract:     
Outsiders often have and seek to trade on a firm's material, nonpublic information. For example, lawyers have traded on advance information about the filing of a lawsuit, a social activist has announced a plan to trade on advance information of a boycott, and a hedge fund operator has engaged in a controversial trading maneuver in a control contest. Trading on nonpublic information is generally permitted if the information was not misappropriated or accompanied by fraud, manipulation, or other misconduct. However, recent public focus on the above transactions signals possible regulation in certain outsider trading situations. More generally, Professors Ian Ayres and Stephen Choi propose giving firms broad rights to decide whether outsider trading in their stocks will be regulated. We argue against broad regulation on the basis that outsider trading can provide incentives for socially beneficial conduct. In particular, outsider trading provides an important way to capitalize on investments in information that are not otherwise protected by the intellectual property laws. Understanding these benefits is a crucial element in determining appropriate regulation limits.

JEL Classifications: G14, G18, G34, G38, K10, K21, K22, K41, L40

Accepted Paper Series