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Should Insider Trading Be Legalized?

Stock market trading screen. New research examines insider trading.The SEC is targeting insider trading more aggressively than ever (and is in the middle of prosecuting the biggest insider trading case in history, that of Galleon Group founder Raj Rajaratnam and 20 other individuals), yet some economists have recently offered new arguments in favor of the practice.

But Professor of Business Law Robert Prentice says that any claim that insider trading benefits rather than harms the market is severely misguided.

“Businesses often abuse the freedom they are given,” Prentice says. “Increasingly, we’re going to have a regulatory world. The key is to have intelligent regulation, with research to figure out what works and what doesn’t.”

The aim for intelligent regulation is at the heart of a recent paper, “Insider Trading as a Signaling Device,” coauthored by Prentice and Assistant Professor of Business Law Dain Donelson. The paper, published in the spring 2010 issue of the American Business Law Journal, recently won the Outstanding Article award from the Academy of Legal Studies in Business.

The paper challenges two new arguments supporting insider trading from George Mason University School of Law Dean Emeritus Henry Manne and Yale Law School Professor Jonathan Macey.

“Manne argues for blanket legalization of insider trading, arguing that it would improve internal corporate efficiency by signaling top managers regarding the efficacy of their corporate plans,” Prentice and Donelson write. “And Professor Macey and others propose that insider trading should be allowed for only the limited purpose of encouraging underlings to signal the capital markets regarding ongoing corporate fraud or other wrongdoing.”

In addition to the gut instinct most people intuitively feel that insider trading is simply unfair, Prentice and Donelson say the proposals touting the supposed benefits of insider trading don’t hold up.

In response to the idea that insider trading would improve corporate efficiency and the flow of information between subordinates and managers, Prentice and Donelson counter that:

  • Corporate decision-makers often already possess inside information
    Insider trading may not move the stock price (thus sending no signal)
    Insider trading sends only an imprecise signal (stock price movements of individual companies are frequently affected by factors that are difficult to analyze).
    As to insider trading as a whistleblowing tool, the researchers contend it would create more disadvantages than advantages and would fail to create a strong signal of misconduct that could be identified over other causes of a movement in stock price.

Finally, Prentice and Donelson point out that the business community itself does not typically protest insider trading laws, and some firms voluntarily adopt standards more restrictive than those required by law. Additionally, while 20 years ago the United States was isolated in its regulatory stringency, most other developed economies, from South Korea to France, have now followed the U.S. example.


#1 "In addition to the gut

"In addition to the gut instinct most people intuitively feel that insider trading is simply unfair" indeed it is. but we just have to be vigilant before taking any actions.

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