“[Insider trading] is not, as some respected City gentlemen contend, a victimless crime.”
Insider dealing is defined as trading in organised securities markets by persons who are in possession of material non-public information. Empirical data suggests that it is a practice that plagues the financial markets. The practice of insider dealing has occupied a peculiar position in the catalogue of financial crime, in that for long periods of time, it was widely considered a legitimate business practice, especially in Europe. Over the last thirty years, however, the onus has shifted towards criminalising and/or sanctioning the practice. Insider dealing is now deemed illegal in all European Economic Area (EEA) countries and most other jurisdictions. The prohibition on insider trading has not been met with universal acceptance. In his seminal publications on the issue, Henry Manne positively reignited the debate on whether insider trading should be prohibited by trumpeting that such trading was not harmful, could facilitate entrepreneurial compensation and improve allocative efficiency within the financial markets. Manne’s argument injected vitality into the debate, but failed to recalibrate attitudes towards a general acceptance of the merits of insider trading.
The focus of this paper is a narrow one. This paper will look at one of Manne’s arguments in particular – the notion that insider trading causes no harm. The central thesis of this paper is to challenge Manne’s viewpoint by asserting that insider dealing does indeed cause a significant amount of harm. In order to illuminate this argument, this paper will examine the impact of insider trading on investors and market-makers. Furthermore, it will be shown that harm to one of these entities can have knock-on detrimental effects to other market participants. This paper will progress in three parts. Part I will introduce the harm argument with particular attention to the writings of Manne. Part II will then assess how insider trading causes harm to investors and other market participants. Part III will explore how insider trading can affect market-makers and other market constituents.
i. The Harm Argument
White collar crime such as insider dealing does not command the same attention than conventional crime, despite the huge monetary losses it causes as well as the social impact of losing faith in corporations. Hansen suggests that insider trading is considered harmless due to the nature of currency. The author suggests that currency is an abstraction – a figure on a spreadsheet as opposed to physical money stacked in a vault. Currency can be anonymous and colourless and does not need to reveal from where it originated. Furthermore, it is easier to identify the victims of crimes such as murder, rape and assault while the same cannot be said of insider trading. With insider trading it is much more difficult to delineate a direct link between the activities of the insider and the loss sustained by investors or society generally.
The seed of the ‘no harm’ argument was sown by legal expert Henry Manne. His publications rank as one of the ‘seminal events in the economic analysis of law’ and served to ignite an impassioned debate on the nature of insider trading. As an expert on insider trading, Manne opined that ‘The insiders gain is not made at the expense of anyone. The occasionally voiced objection to insider trading – that someone must be losing the specific money the insiders make – is not true in any relevant sense’. Particularly, Manne suggests that insider trading causes no significant economic harm to any group of investors. Levmore further defends the ‘no harm’ argument by insisting that investors suffer no extra harm from insider trading as they would have traded in any event based on their own independent investment decisions – they cannot therefore be considered ‘victims’. Some commentators advance further by concluding that the market seller may have received a lower price if there had been no insider, as there would be less demand for the seller’s shares. While Manne’s ideas were first published in 1966, the author remains unapologetic in his stance on the harm argument. His most recent work on insider trading is triumphant in insisting that ‘the idea that there is no direct harm… from the practice has held up very well’. However, the picture painted by Manne, of insider trading as a victimless crime, has struggled to find acceptance in the academic literature. Furthermore, the courts have been resolute in holding that insider trading is a harmful practice. In R v McQuoid the Court of Appeal in the United Kingdom, commenting on the finding of the trial judge held that ‘In passing sentence the judge observed that the offence committed by the appellant was not to be treated as a victimless crime. We agree.’
On closer inspection, it is not difficult to identify various constituencies that may be harmed by insider training. We now turn to take on the challenge posed by Manne when he commented ‘It is not enough simply to say that insider trading is unfair. If it is unfair, it must be unfair to somebody’. We will consider two ‘victims’ of insider trading – investors and market makers. As we shall explore, insider trading is harmful to these entities and this harm can have a knock-on effect on other market participants.
Insider trading can harm investors because investors, oblivious to the knowledge of the insider, will sell at the wrong price. The argument goes that an investor who trades contemporaneously with insiders who have access to non-public information suffer in that they sell below what they would have if privy to the insider information. The price achieved does not reflect the undisclosed information. For example, if stock currently sells at $10 per share, but after disclosure will sell at $15, a shareholder who sells at the current price will suffer a loss of $5. Manne refutes this argument suggesting that it is entirely by chance that the insider was on the other side of the transaction – the gain made by the insider could have been made by any purchaser whether they had access to the inside information or not. However, as we shall now explore, the ‘no harm argument’ has been attacked both in its approach and its content.
The rationale underpinning Manne’s argument has been the subject of trenchant criticism. Klock, an eminent legal and economic scholar is fiercely critical of Manne’s approach. The author suggests that Manne’s argument is structured in ‘a single transaction and holds everything else constant in a nirvana-like fallacy’. This is what economists call a partial equilibrium model. However, Klock concludes that this model is wholly inappropriate. Prices in securities markets impact upon the price of physical capital, which in turn impacts upon aggregate investment and long-term output. Therefore the effects of insider dealing are properly understood under the general equilibrium model, a model which involves the study of all overlapping markets simultaneously. Manne’s error is not surprising. He claims that he has only ‘amateur expertise in economics’. Klock attempts one further criticism of Manne’s approach to his thesis. It will be recalled that Manne attacked the argument of his critics that insider trading can lead sellers to sell for a lower price than they would have if furnished with the insider information. Manne’s rebuttal of this argument rests upon a comparison of the stock price received by investors before the information is disclosed. However, this argument fails to appreciate that if insider dealing was permitted, investors would anticipate the presence of insiders and would adjust their behaviour accordingly. Therefore, Manne’s attack on his critics for looking at the outsider’s position ex post, as opposed to ex ante, is weakened as this is exactly what he does when considering the outsider’s investment decision.
Criticism of Manne’s ‘no harm’ argument does not stop at his flawed approach. Many commentators have successfully dissected and fractured the credibility of the content of his argument. McVea advances four powerful arguments to rebut Manne’s claims that investors suffer no harm. Firstly, there are times when it is appropriate to insist that someone surrender gains won by the dishonest treatment of another, even where the wronged party did not rely on the wrongdoer. Secondly, an investor can endure a loss, even if his investment shows a gain, as that gain is a lower one than that which would have been awarded if he was privy to the insider information. Berg suggests that such a loss is recognised in the Theft Act 1968 which includes a loss ‘by not getting what one might get’. Thirdly, the ‘no harm’ argument assumes that the long-term investor is selling for reasons other than profit, however, most investors are acutely interested in their share price and the profit that can be realised from them. Finally, an investor who thought they would be on the wrong side of a trade might refrain from trading or use a more inefficient method of trading e.g. institutional investors. Consequently, it is a reasonable presumption that investors would prefer to limit the amount of insider trading in the market. The net effect of these four arguments is that the assertion that investors are not impacted by insider trading is reduced to fragile foundations.
Finally, we turn to the notion of risk and how enhanced risk to investors may impact the markets. If insider trading was permitted this would dramatically increase the level of risk in the securities markets for institutional investors. Investors are properly perceived as market players seeking a proportionate return based on the level of systemic or market-related risk they agree to endure. In a market which facilitates insider trading, investors must ‘assume that every investment presents the same risk of insider trading as does the market as a whole’. Consequently, investors would compensate for the enhanced level of risk by demanding a discount in share price. Insider trading would therefore trigger a drop in share price. Moore suggests that such a drop, while impacting on the share price, would not result in any net loss to the investor. The author further suggests that reduced prices may even improve efficiency in the market and result in a ‘bigger piece of the pie for everyone’.
However, Moore’s argument is decidedly myopic. Moore herself acknowledges that the claims she is making are empirical claims that she is not equipped to determine as true or otherwise. Furthermore, her neat argument fails to recognise the negative impacts that enhanced investor risk can create on constituents other than investors. Firstly, while investors can protect themselves through discounted prices, insider trading can harm the issuer of securities as their cost of capital increases by the amount investors discount the price of their securities. If investors detect insider trading, they will lower their investment in securities, which will raise the cost of capital that firms will have to pay in order to entice investors back into the market. Furthermore, as the markets for physical capital and securities are interlinked under the general equilibrium model, there could potentially be a net decline in aggregate investment resulting in lower levels of gross national output over time.
Market-makers are defined as firms that stand ready to buy a particular stock on a regular and continuous basis at a publicly quoted price. They are specialists that provide liquidity on an organised exchange or an over-the-counter market. Market-makers are ‘prime targets of insider trading and always lose to insiders’. Insiders will only transact with market-makers if they anticipate that they will enjoy a higher profit than the brokerage fee they pay to market-makers. Insiders have an informational advantage over these market participants, and can buy when a firm’s shares are undervalued and sell when they are overvalued.
Market-makers anticipate the presence of insiders in the markets, and accordingly discount securities to take into account the higher risk involved. This discounting is an example of adverse selection: market-makers are unable to differentiate between insiders who possess material non-public information and uninformed traders who transact based on ‘noise’ and speculative bets. Manne himself, writing in 2005, conceded that the adverse selection argument threatened his ‘no harm’ argument, although his comments were restricted to short-term traders which represent the minority in the financial markets. This adverse selection means that the market-makers must charge a higher premium to all market participants to subsidise their losses to insiders. As market-makers continue to lose money to better informed insiders, they will increase the difference between the price they buy shares and sell them on in order to cover the increased cost of doing business. This is referred to as the bid-ask spread. Therefore, these increased costs can be seen as an indirect harm to market participants such as investors who use market-makers to effect investments. The prohibition of insider trading through regulation or criminal sanctions can actually reduce the bid-ask spread. As opined by Coffee ‘the more that the law successfully prohibits the use of non-public information, the more that the market maker can (and will be forced by competitive pressure to) narrow the bid-ask spread’. The policing of insider trading can therefore be properly interpreted as a mechanism for reducing the harm done to investors and other market participants impacted by the increased bid-ask spread.
The harm discussed thus far in relation to market-makers has involved harm to other market participants, not harm to the market-makers themselves. However, insider trading is capable of imposing a loss which may impact on market-makers. As already discussed, insider trading can impose a social loss: securities prices are discounted where there are higher transaction costs and this can dissuade some market investors from participating in the market or cause some to exit completely. This means that the customer base for market-makers contracts and leads to loss of potential revenues. Without a prohibition on insider dealing, the ‘trades can damage the dealer, perhaps fatally’. Furthermore, there is the possibility that higher bid-ask spreads can cause a ‘snowball’ effect throughout the markets. As the number of investors willing to trade decreases market-makers must widen the bid-ask spread even further in order to maintain their profits. This wider bid-ask spread will serve to further discourage outsiders from trading. Bhattatcharya and Spiegel urge further caution by insisting that contraction of the market may mean that market-makers will become unprofitable as the expected trades from outsiders does not cover the losses to insiders. This defeats Manne’s argument that the harm caused to market-makers ‘exists more in the theoretical world of finance literature than it does in the actual play of the market.’ Loss of revenue and customer base is a real and tangible harm and cannot be ignored.
Insider trading has been described variously as ‘immoral’, ‘unscrupulous’ and a ‘vicious practice’. It has fought stubbornly to remain in the gaze of academics and regulators. It is conceded that it is difficult to identify any directly harmful effects with insider trading. However, harm does not cease to be harm simply because it is not inflicted directly. Investors lose out in that they do not receive the gains that they could have. Market-makers may experience loss if investors refrain from exploiting the market. Investors may also become aware of higher risk in the markets and demand discounted prices which would result in a lower share price. Issuers of securities can also be affected as the cost to encourage investors into the market increases. Finally, as a result of the presence of insiders, market-makers will increase their transaction costs to cover losses which can be detrimental to investors. If investors refuse to trade then this can have dire economic consequences for the market-makers themselves. In conclusion, the harmful effects of insider trading that have been explored in this paper serve to uncover the proposition that insider trading is a ‘victimless crime’ as a fallacy.
List of Statutes and Cases
R v McQuoid  EWCA Crim 1301
Criminal Justice Act 1993, Part V, s. 52
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Manne H, ‘Insider Trading and the Law Professors’ (1970) 23 Vanderbilt Law Review 547
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Other Published Sources
The New York Institute of Finance, Stocks, Bonds, Options and Futures (New York 1987)
US Senate, Stock Exchange Practices, Hearings Before the Committee on Banking and Currency, 73rd Congress, 1st Session
Editorial, ‘Insider Trading is Not a Victimless Crime’ Sunday Telegraph, (London, December 28 1986)
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