I have always believed in the Insider Trading laws that protect the market from distortions arising from investors acting on non-public information. Recent articles by Don Boudreaux, discusses Insider Trading, and perhaps it isn’t as bad as I once thought.

One of the problems that was with enforcement of the law. Finding evidence that insider trading actually happened is incredibly difficult. Investors (including employees, directors etc.) buy and sell for many reasons: could it just be coincidence that they sold they shares just as a statement on profitability was about to be announced? Correlation does not prove causation and prosecutors would have to discover a “smoking gun” that proved that a trader acted on non-public information. But just because a law is hard to enforce doesn’t mean it is not worth having. We need another reason.

A company’s share price is a signal to the market about the value of  that company’s assets. The goal for a market is for assets to be priced as accurately as possible.  So how does a market determine an accurate value? This is from information, ideally disseminated widely, so that thousands of investors can make a judgement call of the value of the company. Information is king.

Let’s now jump to the way directors’ performance incentives. Directors are accountable to shareholders for the value of the company (ie. share price) that they have stewardship over. It is the shareholders interest (and thus the directors’ interest too) to increase the share price. Remember this as I will come back to this later.

So let’s say you are an employee, who gets hold of company information that shows that the company isn’t exactly in good shape. What should you do? Should you go public with that information – no, not if you want to hold onto your job. What you can do it start selling (or shorting) the stock. This would immediately send a signal to the market that the value is not quite what is claimed by the current share price – in other words, the share price falls. So insider trading or acting in your “self interest” actually helps the market determine the value of the company.

Now back to the directors of the company. With Enron, for example, they misled investors and “cooked” the books to artificially inflate the company. If employees/directors who knew this was going on and shorted the stock, this would have sent the share price down. Shareholders will be on the phone calling the CEO to politely enquire what is going on. Given that directors are directly compensated for the share price, they will have the incentive to rectify the problem, before it gets out of hand. While this may not prevent fraud, it will help price a company with greater accuracy, thus giving the market better information to base their investment decisions.

But isn’t this unfair? Why should an insider, in such a privileged position, profit from such internal information? I do not have a entirely cogent argument to this other than: “Life is not fair.” People from all walks of life have advantages over others. The question is, is acting on this insider information better for the market and society in general. If insider trading creates a better indication of a company’s health, then investors can with greater confidence allocate capital to company’s they believe will offer the greatest returns. This increases the productive use of our scarce resources and providing a maximal return to all.

(Thanks to the articles from Don Boudreaux)

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