WHY IS INSIDER TRADING ILLEGAL?

A recent item in the The Ethicist (New York Times Sunday Magazine, 1/22/06) resulted in a flurry of postings about why insider trading is wrong. See, e.g., Thom Lambert, Correcting “The Ethicist” on Insider Trading.

It has never been entirely clear why insider trading is illegal. The insider does not cause the outsider to trade at just the wrong time. The insider simply takes advantage of the fact that an outsider is always there to take the other side of the trade.

So the courts have resorted to theories based on the duty owed by the insider either to the corporation and its stockholders or to the source of the information not to use the information for personal gain. The problem is that if the corporation or the source gives permission to use the information, there would seem to be no reason for insider trading to be illegal. Yet no one has been so bold as to test the theory.

One might also argue under the fraud on the market theory that outsiders rely on the accuracy of the market. But that argument proves too much. It suggests that outsiders should be able to recover whenever insiders fail to correct the market.

There is another possibility. Most investors are well diversified. They do not care whether the market price is somewhat high or somewhat low when they trade as long as insiders do not use the opportunity to trade. As far as a diversified investor is concerned, you win some, and you lose some, but only the average matters. If insiders can trade at will when they know the price is wrong, the math no longer works, and there is no safety in numbers for outsiders.

So here is the theory: Insider trading is illegal because publicly traded companies and their directors, officers, and agents have effectively made a deal with outsiders (the market) not to take advantage of the situation when they know prices are wrong. Why? Because the most important reason for being a publicly traded company is not that you once raised a pile of money from an IPO, but rather that you might want to go back to the market for more, or pay your help with options, or just cash out some day. To sort of paraphrase Ed Koch and Ryan O'Neal: When you are publicly traded you never need to ask how you are doing.

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