21 Pages Posted: 3 Nov 2012 Last revised: 1 Jul 2013
Date Written: November 1, 2012
Although insider trading is illegal and widely condemned, a stubborn minority still defends it as an efficient method of compensating executives and spurring innovation. However, their arguments depend on a crucial assumption that the scope of insider trading is constrained by the wealth of individual insiders. Accordingly, the abnormal profits realized by inside traders at the expense of outsiders are rarely or never so large as to cause outsiders to flee the affected stock. Similarly, the potential gains from insider trading are rarely if ever big enough to corrupt the managers’ conduct of the business. Thus insider trading generates benefits for stockholders that exceed their immediate losses from insider trading.
The theme of this note is that if insider trading were allowed, it would not be constrained by insiders’ wealth because insiders could obtain enough outside financing to fully exploit their informational advantage. In so doing they would inevitably muscle out public investors. Stock markets would drastically shrink if not disappear. The prospect of huge trading profits would tempt managers to alter many decisions and even to take steps damaging to the firm in ways that would be virtually impossible for corporate monitors to detect. The resulting damage to public shareholders would far exceed any benefits from insider trading. Individual companies cannot police insider trading. Accordingly, the case for legalizing insider trading is insupportable.
Keywords: legalized insider trading, insider trading, stock markets, insider information, public investors, Henry Manne, equity financing, corporate governance, securities
JEL Classification: G14, G30, K22
Suggested Citation: Suggested Citation
Dent, George W., Why Legalized Insider Trading Would Be a Disaster (November 1, 2012). Case Legal Studies Research Paper No. 2012-36. Available at SSRN: https://ssrn.com/abstract=2169975 or http://dx.doi.org/10.2139/ssrn.2169975