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International Journal of Social Economics 28,10/11/12 1046

Insider trading in financial markets: legality, ethics, efficiency

Phillip Anthony OHara
Curtin University, Perth, Australia
Keywords Insider dealing, Stock markets, Ethics, Legal matters, Efficiency Abstract Scrutinises legal, ethical and efficiency standards for and against insider trading. The main arguments supporting insider trading are that it promotes economic efficiency and enterprise. The primary argument against insider trading is that it can be a breach of fiduciary duty; the other arguments of asymmetrical information, in-principle unequal access to information, and misappropriation seem relatively difficult to accept. On balance, it seems that insider trading may possibly be organised in firms so long as policies are transparent, shareholders accept the practice and certain measures are taken to reduce the incidence of free riders. However, the current state of knowledge on the subject makes it very difficult to come to unequivocal conclusions about whether aspects of it should be illegal or not. Much more theoretical and empirical work is needed on the ethical and social foundations of capitalism, insider trading in general, potential conflict of interest between innovators and shareholders, free riders, possible lack of confidence in the market, and in what ways illegality changes the behaviour of agents.

Common law has historically required full disclosure of relevant inside information by an agent (e.g. manager) to a principal (e.g. shareholder). In the USA during the 1930s a legal war extended this requirement to public disclosure of important corporate inside information. A spate of legal and court actions in the 1960s through to the 1990s has extended this further to prevent both corporate insiders and outsiders from trading on inside information. Many business people have had their good name ruined as they are publicly humiliated on a charge of ``insider trading. But is the holy war against such practices a just war? The purpose of this paper is to find out. This article commences with a general view of the institutional and legal aspects of insider trading, including the workings of insider trading and the main legal theories, regulations and cases. Then we proceed to examine the arguments supporting the practice, especially the philosophy of ownership and enterprise, followed by the more specific points that it helps to instil innovation and efficiency into the stock market and the corporate system. From there we examine the main ethical arguments against insider trading, which seek to critique the notion that insider trading promotes a suitable ownership philosophy, innovation and efficiency. The main arguments against insider trading include asymmetrical information, in-principle access to information,
International Journal of Social Economics, Vol. 28 No. 10/11/12, 2001, pp. 1046-1062. # MCB University Press, 0306-8293

This paper was presented at the Association for Social Economics (ASE) meetings as part of the ASSA, Boston, 7 January 2000. Many thanks go to Edward OBoyle and R.A. OHara for extensive comments on previous versions of the paper; George Kadmos for stimulating discussions and research assistance, and participants of the ASE meetings for comments.

misappropriation and fiduciary duty. We subject these four arguments to critical scrutiny and find fiduciary duty to be the strongest; but it still has problems. Then in the last main section the whole debate about insider trading is critically assessed from the view of the current state of knowledge on the subject and the need to examine it from a more general vantage point. A conclusion follows. Legal and institutional aspects of insider trading Insider trading refers to the practice of ``insiders trading on shares of a company for which they have privileged ``material information not available to the ``public, and for which they seek to gain pecuniary or other benefits. ``Insiders refer to any person or group that is able to gain such privileged information about a company. Insiders can include directors, managers or employees of a company. Or they can refer to persons who gain privileged information indirectly from such managers or directors in a more intimate capacity, such as friends, family members, or close but external business associates. Or they can refer to persons who have a contractual or supply linkage to such a company, such as those who print annual reports or stockbrokers who may inadvertently gain an information advantage. Thus ``inside information can be gained from a multitude of sources from which such private information can be exploited for financial or other gain. Insider trading has been with capitalism for as long as share markets have been in operation (Herzel and Katz, 1987). Capitalism as we know it would perhaps be unrecognizable without the wheeling and dealing that is characteristic of such insider trading. Typically, insiders gain advantages through superior information about potential mergers, by buying shares in a company before the news of the merger becomes public, which usually results in the share price of this company increasing, after which the insider sells the shares and thus makes a quick profit. Another typical example is a director selling shares in his or her company before negative news about the company reaches the public domain, after which the price of such shares usually declines. A still further common example is a director of a mining company having private information about a major gold discovery and buying more shares in the firm, from which he or she may benefit after the information becomes public. More indirect insider trading also exists. For instance, a director of a company has lunch with her financial advisor and shares private information that the said companys annual reports have been consistently overstating profitability in recent years. The financial advisor then recommends to clients that they sell shares in the said company, and when the information becomes public those who sold such shares benefit. Another example is when a manager of a export-import company (with strong links to government) shares private information over dinner that, say, Taiwan is certain to announce a massive drop in tariffs in two months time, and that much could be gained by making an application to trade with Taiwan before the rush starts. A further example is

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when a reporter of a financial newspaper gains private information that a certain manufacturing company is about to go into liquidation, and shares this information with friends (who subsequently benefit by selling shares in the company) before he makes it public in the newspaper. Insider trading has historically been endemic to the stock market. Indeed, the use of private information is common in all walks of social, economic and political life. Consider, for instance, the would-be-politician who gains private information that a certain member of parliament is about to vacate her seat, and who quickly seeks endorsement for the seat before the news becomes public, and as a result succeeds in being elected. Or consider the example of a father who shares private information with his daughter about a job opportunity in the fashion industry, and because she is quick on the scene is able to get the job. A further example is an independent gold miner who tells her son-in-law about a gold discovery, who then manages to stake out a lease for the site and make millions as a result. Should insider trading be illegal in the stock market? If it is illegal in the stock market, why not also make it illegal in other areas of social life? Up until the 1970s, insider trading was perfectly legal in almost every nation. Until then, the USA had been the main nation to legislate (indirectly) against the practice in the stock market. Under the influence of the financial wheeling and dealing of the Great Depression, the Securities and Exchange Act of 1934 outlawed ``fraud in the buying and selling of securities. Fraud is committed when an agent ``misrepresents the information she has at her disposal so as to persuade another individual (principal) to choose a course of action he would not have chosen had he been properly informed (Karni, 1992, p. 194). Insider trading is not even mentioned in this Act, but advocates of its illegality argue that the legislation indirectly includes it by trying to forbid the ``employment of manipulative and deceptive practices (Herzel and Katz, 1987, p. 16). The Act also seeks to ensure a ``fair and honest market, that is one that would reflect an evaluation of securities in the light of all available and pertinent data (Section 10b-5 of the Act; Bettis et al., 1998, p. 53). Section 10b-5 of the Act specifies that a person must disclose inside information or refrain from trading. Indirectly this Act outlawed insider trading by requiring that insiders redistribute profits gained through buying and selling shares within a six-month period (irrespective of whether it was the result of inside information; Section 16b of the Act). It also outlawed the use of private information to gain benefits (Section 10b of the Act), and imposed certain reporting requirements on insiders buying and selling securities in the firm (Section 16b). Little action was taken by the US Securities and Exchange Commission (SEC) against insider trading until the Texas Gulf Sulphur company case came before the courts during the mid-1960s. In late 1963 the company discovered an enormously rich ore of silver, copper and zinc in Canada and went to great lengths to keep it secret. However, many inside directors and employees heard about it and ``invested heavily in Texas Gulf Sulphur stock. The share price doubled before the public learned of the mineral discoveries. In 1965 the SEC

took out a civil suit against the traders and won the case that the directors and employees engaged in ``fraudulent behaviour. Congress increased penalties for insider trading in the 1980s through the Insider Trading Sanctions Act of 1984 (ITSA) and the Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA). ITSA increased penalties for insider trading violations, while ITSFEA increased penalties and expanded the scope for civil penalties for ``controlling persons who do not take adequate safeguards to prevent their employees and associates from engaging in insider trading (Udpa, 1996). ITSFEA requires agents such as investment advisors, brokerage dealers and accountancy firms to ``establish, maintain, and enforce written policies and procedures designed to prevent misuse of information; and liability in civil cases may take the form of penalties of $1m or three times the profit gained (or loss avoided) by the insider transaction (whichever is the greater) (Caccese, 1997)[1]. Maintaining ``Chinese walls between a firms information gathering and trading functions are usually effective defences in cases of legal suit. In addition, the Securities Enforcement Remedies and Penny Stock Reform Act was passed in 1990, which tightened reporting and established fines and responsibilities for those insiders who do not file their forms with the SEC on time[2]. US legislation led the way in relation to insider trading and only slowly has legislation been introduced in other nations[3]. The UK and Japan have generally followed the US example in the 1970s-1990s. The European Community oversees such legislation in member nations, although much of the legislation passed has not been adequately policed. Australia has legislation similar to the USA, and more recently legislation has been under way in parts of Asia. Most nations, however, do not outlaw or police insider trading practices. Much of the force of insider trading legislation has been influenced by the decisions of the courts, which have in some cases made apparently contradictory decisions. The US courts have based their decisions on the notion that those engaging in insider trading have wrongfully used such information. First, such information is said to be wrongfully used because insider traders break a fiduciary duty to look after the interests of shareholders, instead looking after their own interests as managers, entrepreneurs or workers in the company. Fiduciary duty argues that officers of a company have a duty to protect the interests of shareholders, and that inside use of company information breaks this bond of trust and service. Many of the cases of insider trading, such as SEC v. Texas Gulf Sulphur Co., were based on fiduciary duty. And second, many recent cases have been prosecuted for the practice of misappropriating information from a company. The misappropriation theory, has been applied since 1982 in cases such as OHagan v. US and US v. Carpenter[4]. Both fiduciary duty and misappropriation are said to involve: ``misusing material non-public information; breaching a duty arising from a relationship of trust and confidence; and using that information in a securities transaction.

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But whereas fiduciary duty involves corporate insiders having a ``duty to shareholders, misappropriation applies to stealing important proprietary information from a company (Ten, 1997, p. 1326). Misappropriation can apply to corporate insiders and outsiders, but was utilised in the courts mainly to charge corporate outsiders, since the fiduciary duty theory was used for corporate insiders. For instance, printers of corporate documents, journalists and dealers have been charged as corporate outsiders in this fashion. In terms of rate of return, some studies have shown in the USA that transactions based on insider trading obtain a rate of return that is on average three percentage points above the mean for all stocks (Chakraverty and McConnell, 1999, p. 193). Vincente (1999) argues that legislation has led insider traders to change their behaviour in order to evade legislation. Instead of taking advantage of critical information and making very large profits very close to the time of the events, they trade on inside, less significant but more numerous pieces of information, usually quite a long time before the critical event (e.g. the takeover, bankruptcy, etc.). Bettis et al. (1998) corroborate this finding through research that shows insiders consistently use their inside information to engage in four types of ``unfair advantage. If the private information is good news, they can gain by: buying more stock; or holding stock that was otherwise going to be sold. And if the information is bad news, they can benefit by: selling stock to ``ignorant traders; or refraining from buying stock that otherwise would have been bought. They suggest that changes be introduced requiring immediate disclosure of all value-relevant information; in short, a ``disclose rule rather than the current ``disclose or refrain from trade rule. The case for insider trading The case for insider trading is a philosophical, justice and efficiency view of the workings of capitalism and financial institutions. The philosophy emanates from the natural right of individuals to have a definitive sphere of unfettered activity, to acquire property, to trade, to buy and sell labour power, to become rich or poor. Ability, effort and luck must rule the distribution of resources, and individuals have natural rights to inquire into the possibilities for entrepreneurial profit and to accumulate wealth and capital. Freedom in the acquisition of property and in human association are natural rights which the state must not adversely affect unless they are directly hurting others. Violation of this right is unjust even if such a violation prevents greater wrong or promotes greater good (Brown, 1986, p. 89). Such a view of justice is similar to Nozicks entitlement view of justice. Nozicks theory is based on the notion of natural freedom, where individuals have certain negative rights, which are rights against other people interfering

coercively in their affairs and the right to property acquisition and accumulation (McGee, 1988). Respect for ``human rights are primary, and cannot be negated through ``the greater good; these rights are inalienable. This view of the world is non-teleological and promotes a view of justice without reference to its consequences; protection of individual rights to property and association are rights whatever happens. Such rights can never be justifiably violated. These foundational rights provide a basis for supporting the actions of the entrepreneur who seeks to be alert to any unexploited gains from trade, discovery, alertness or action. It also provides the basis for a minimalist state which is the outcome of the actions of individuals coming together to protect people from an unjust acquisition of property, abuse of life or body, and restraint of action. Thus ``the proper scope of government is to protect life, liberty and property, and any act by government which goes beyond this scope results in injustice because it must necessarily use coercion to take from some to give to others (McGee, 1988, p. 36). Manne has been the central figure supporting insider trading from the perspective of promoting entrepreneurial functions within the economy, based on a Schumpeterian outlook. In Insider Trading and the Stock Market (Manne, 1966a) he set out the clearest and most vigorous case for insider trading. The entrepreneur is that radical individual who does things differently in economic life and challenges established commercial and industrial practices. The entrepreneur promotes discontinuous and spontaneous change in the system of economic organisation. Such change emanates from the introduction of a new good, a new method of production, the opening of a new market, conquest of a new source of supply, or the carrying out of a new organisation of industry (Schumpeter, 1911, p. 66). The entrepreneur, according to Schumpeter, supplies the primary ideas and creative element for development and change. The profit made by the entrepreneur is a surplus above costs emanating from upsetting established lines of business, creating a new market and carrying out new combinations. Thus, entrepreneurial activity is different from that of capitalists or shareholders, because the latter provides the money while the entrepreneur provides the ideas and knows how to put changes into practice. The surplus value emanating from the entrepreneur cannot last because other competitors will eventually erode it through copying the new good, method or market. Also, in Schumpeters system entrepreneurial surplus is temporary not only in the sense that it will soon be eroded by competitors, but that the activity of innovating is not self-generating; entrepreneurs tend to become part of established practices and hence lose their innovative role. Such agents are not classes in the sense of workers and capitalists. The temporary nature of entrepreneurial surplus is important because such a role must be adequately remunerated in order to provide an incentive for further innovation. This is especially true for ideas that are hard to link specifically to profit for an individual. Henry Manne argues that insider trading

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provides one of the few means for adequately compensating innovators of ideas that are hard to link to profit for the innovators themselves. Manne starts his defence of insider trading by differentiating between ``long-term shareholders, who are long-term holders of securities and tend to trade on the basis of changes in fundamental values, and ``short-swing speculators, who trade on recent changes in the price of securities. The argument goes that insider traders will tend to deal with speculators rather than long-term investors; and hence that legislation against insiders supports the speculative function. Insider trading reduces the speculative function of stock markets, it is argued, since insiders tend to trade on material information, and they will move into the market quickly in order to create a return. Entrepreneurial profit is a difficult thing in many cases to gain, especially for the innovator who works in a corporate environment. A salary is said to be inappropriate (by itself), so also is a bonus which tends to accommodate managerial improvements, and so also is a stock option which, again, is more managerial in incentive structure. The patent system can be a useful reward system in some instances. However, for innovations that take years to make a return, or which cannot be adequately rewarded due to institutional or other reasons, allowing them to deal with inside information is in many cases the only alternative. As Manne (1966b, p. 118) says:
For the man who has not founded his own business to exploit his idea historically the traditional course for an entrepreneur trading in the stock market on inside information provides a reward system, and is the only effective device available for the entrepreneur who is employed by a large corporation . . . Insider trading allows any individual who works for a publicly traded corporation to play the entrepreneurial role, a very important advantage. Individuals can, in effect, sell their own ideas without the necessity of having large amounts of capital available. The increase in stock price, though not perfect, will provide as accurate a gauge of the value of the innovation as can be found, and it will leave little room for argument about an individuals worth.

There are great advantages of insider trading over other forms of compensation for innovators. Salaries and pensions are said to be usually fairly secure and predictable. Stock options and bonus plans will provide some motivation, but not to take great risks. Insider trading rewards are the right type of compensation package for risk taking and propelling new ideas and practices, according to Manne, because they relate to material information about specific developments in the corporation, such as a new process, product, market, corporate structure or source of raw material. The real challenge is to organise the corporate and managerial structure so that this inside information is directed to innovators rather than to free riders. Of course, it is necessary to provide a suitable legal system to encourage such insider practices. Insider trading, according to McGee (1988, p. 38), acts as a method of disseminating information that makes the stock market more efficient. For instance, when insiders buy (sell) shares it provides information to other market participants to buy (sell) as well, and in the process the market price

moves towards fundamental values. The free flow of actions in the market thus provides information which others act upon and provides a substitute for substantive information that forms the basis of the insiders actions[5]. As Manne (1992, p. 418) says:
Stock market efficiency, in the sense of prices quickly and accurately reflecting all news that could affect the value of shares, is essential to all of the stock markets major functions: the efficient allocation of capital by corporations, and the efficient operation of the market for corporate control. If there were effective enforcement of laws against insider trading, all corrections of price would have to come from individuals who received the information more slowly than insiders and who generally could not evaluate new developments as expertly. Certainly the stock market would be less efficient than it is with no insider trading.

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Insider trading laws thus impinge on the freedom of business, dampen innovation, reduce micro and macro efficiency, and usually also represent a cost to shareholders. Insider trading reduces uncertainty by increasing the amount of information available, thus lowering the variance of abnormal returns upon release of annual reports[6]. As is often repeated in the literature, insider trading is really a ``victimless crime which helps to stimulate entrepreneurial activity and the efficiency of the market. The case against insider trading The four main ethical arguments against insider trading are that of: (1) asymmetry of information; (2) unequal in-principle access to information; (3) contravention of property rights in information; and (4) being counter to fiduciary duty[7]. The notion of insider trading being unfair includes a number of arguments. One is that insider trading is unfair because the two parties to a transaction in the stockmarket do not have equal information. According to this view, both parties to a transaction should have the same material information concerning the conditions underlying a transaction. Asymmetry of information is thus proposed to be unethical because the two parties do not come to the transaction as equals. This argument, however, seems problematical, from the view of historical notions of fairness under capitalism, because this view of fairness would argue against most transactions in markets. As Moore (1990) points out, US common law supports the notion that people are required not to misrepresent or lie about a product or transaction, or to engage in coercion, and certainly they need to reveal information relating to price and availability. But they are not required to reveal all information. There will always be traders who have superior information about the product or transaction due to superior technical skills, greater knowledge, more experience and more contacts. The asymmetrical distribution of knowledge per se cannot be used as a serious argument against insider trading from the point of view of historically prevalent and ethical institutions of business.

International Journal of Social Economics 28,10/11/12 1054

A second argument against insider trading is that the information is not accessible to the ordinary shareholder to ascertain the appropriateness of buying and selling securities in the marketplace. This argument is not against the asymmetrical distribution of information per se, but more concerned that, in principle, this information should be public in the sense that hard work on the part of potential or actual dealers in the market will be able to unearth it. This aspect of fairness concentrates on the information being ``in principle open to everybody given sufficient hard work and research into the market and the economy in general. Koslowski (1995, pp. 214-15) believes that the ``principle of equal justice in the legitimisation of norms (which) demands the equal right of access to information for all shareholders and speculators is the basis of US and German legislation against insider trading. This argument has been critiqued by Moore (1990) who says that, were insider trading made legal, the information they have would be traded in a market and that information would be available to anyone who wanted to buy it. In principle, then, the information would be accessible to anyone who had the money and interest to acquire it. She doubts that the knowledge of insiders is in principle different from the knowledge that, for instance, plumbers have over people who are not plumbers, especially given the complexity of the different situations that arise over plumbing in different contexts. Just as I could have decided to become a plumber, so too could I have decided to become a corporate insider with access to information outsiders do not have. Thus, ``in principle access to information is not absolute but relative, depending on the degree to which they are insiders or outsiders. Dennert (1991) agrees with this ``relative argument while Kay (1988) believes that outlawing insider trading simply redistributes power from insiders to market professionals, while ``ignorant traders remain as powerless as before. A third argument against insider trading is that it contravenes property rights in information. In a similar way that inventions and trade secrets are treated as property, proponents of this view argue that inside information is a type of property, and that dealing in this information is a violation of property rights. There is much confusion and ambiguity in the literature about this notion, especially about whether it relates to ``corporate insiders or outsiders (or both) stealing information; what the link is with fiduciary duty; and whether people are stealing from innovators or shareholders. The misappropriation theory of property rights can apply to corporate insiders and outsiders but was introduced into legal theory mainly to reduce the degree to which corporate outsiders benefit from inside information. It was proposed that such corporate ``outsiders who utilise inside information for instance, printers of annual reports, journalists and dealers are stealing such information from the said corporation (or, in some cases, from the company that ``outsiders have a direct association with). By and large, those who support corporate insiders utilising such information are also against corporate outsiders stealing it; although for them, they may contend that the ``outsiders are stealing it from the innovators.

Manne (1966a, 1991) and McGee (1988) argue, for instance, that the person or corporation who invented the product, discovered the source of raw material, opened up the market, or promoted a form of corporate reorganisation should have property rights over the information. People who work for this individual or firm without acting in an entrepreneurial fashion, plus all corporate outsiders, are thus not entitled to trade in this information. The nonentrepreneurial corporate insider and the corporate outsider who engages in insider trading deprives the person or corporation of the sole use of the information, and thereby ``contravenes it by utilising it in a way that is not intended or allowed. Moore (1990, p. 175) suggests that the misappropriation theory can also be applied to corporate insiders, but that the information cannot be contravened in this way if the shareholders and the company allow insiders to use such information. In order to downplay the notion of misappropriation or violation of property rights, she suggests that either the shareholders could directly seek to allow insider trading, or a company could have a policy supporting it inhouse in certain conditions, and thereby notifying actual and potential shareholders of this fact. This is exactly the argument put forward by Manne (1966a) when he says that insider trading is critical in order to increase the package of benefits to entrepreneurs. Innovations that are hard for their originators to benefit from, in particular, can be compensated for in this fashion. All that is needed is the acceptance by the company or shareholders; preferably with precise regulations as to who can and who cannot have access to such information and under what conditions. A related, fourth argument against insider trading is that of fiduciary duty, which argues it is not the entrepreneur who has the right to the information, but the entrepreneurs, managers and workers who owe a fiduciary duty to shareholders. This theory posits the notion that insiders have a long-standing ethical duty to enhance the interests of shareholders. Moore (1990) makes this argument the critical (and only real) case against insider trading. Fiduciary duty ``is a duty of a person in a position of trust to act in the interests of another person without gaining any material benefit, except with the knowledge and consent of that other party (Boatright, 1997, p. 278). The ``mainstream view in business ethics related to ``shareholder democracy is that officers and directors of companies have a fiduciary duty to shareholders and no one else, and that the company should be run in the pursuit of maximising shareholder wealth. Thus insiders should not perform self-dealing, bribery, direct competition or the use of confidential information. The shareholders are the owners of the company, ultimately the ones who are taking the risks, and therefore their interests are fundamental to the survival and growth of the company as well as the whole corporate system. Who bears the financial risk of the company is the central question about which depends the very success of innovation and growth of the economy. Therefore, the principals are said to be the shareholders; while the managerial and entrepreneurial functions are performed by agents of shareholders, those who owe allegiance to the owners of the company.

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Supporters of insider trading, such as Manne (1966a), argue that insiders who trade in privileged information usually do so in a way that supports the interests of shareholders, and that therefore there is no conflict with fiduciary duty[8]. Moore (1990) questions this on four fronts. First, it is argued that insiders may trade in negative information that harms the company. Second, allowing insider trading would encourage rumours about new products or processes false information which would benefit neither the firm nor the shareholder. Third, inside free riders who have nothing directly to do with the creation of the information would be encouraged to benefit from it, in addition to the innovators. And lastly, allowing insider trading is thought to distract attention from the day-to-day running of the business in favour of important information that may significantly affect stock prices. These conflicts of interest or social costs are said to be strong arguments for making insider trading illegal. The ``crime is not ``victimless because shareholders are likely to lose in multiple ways; but there are general social costs as well. Moore argues that these four problems would be likely to promote a lack of confidence in a market that encourages insider trading. Most of the social costs of insider trading are said to emanate from such lack of confidence and subsequent instability; therefore it should be part of criminal law and not simply private litigation. The supposed existence of such social costs is the prime reason for the authorities in the USA requiring that insiders ``either refrain from trading or publicly disclose the information rather than just disclosing the information to (say) shareholders due to strict fiduciary duty. Many authors have based their critique of insider trading on ``crony capitalism, encouraged by trading on inside information, where the ordinary shareholders are less inclined to trade because they feel that the market is biased against them. This may lead to a thin market lack of depth in buyers and sellers and hence greater instability. Such lack of confidence is said to lead to a lack of participation in the stock market, and hence to an inefficient allocation of resources. As the market has a greater proportion of insiders active in the determination of price, this may lead to conflict between insiders in the form of fraud, misinformation and devious schemes to ``create information upon which they can have an advantage over other insiders. Supporters of inside trading argue that there is little evidence of this ``lack of confidence ever happening in mature capitalist economies as a direct result of insider trading (see Dennert, 1991). It is more likely in emerging economies, but this is probably due to the power of ``mafier capitalists and a relative lack of institutional support systems rather than inside trading as such. Specifically, supporters of insider trading downplay these four social costs emphasised by Moore: that insider trading creates bad news, false rumours, free riders and interest in major market changes. First, the question of trading on bad news. It could be argued that a higher ethic above fiduciary duty is open information being directed into the marketplace to promote a fully informed social market. But if there is ``bad news relating to a company, and if this bad news is reasonably accurate, then there seems a greater good to society by insiders

relaying this to the market through buying and selling behaviour. The second point about false rumours being propagated about a company to create a buying or selling opportunity has nothing to do with insider trading specifically and relates to ``fraudulent behaviour. The third point about free riders benefiting from the information has already been adequately covered by Manne (in theory if not in practice) when he suggests that the corporation devise an adequate system of making enterprising individuals privy to such inside information; although some leakage possibly quite a lot is bound to occur. The fourth point about insider trading distracting attention away from the day-to-day process of running a business in favour of activities that affect stock prices is a misnomer, if properly instituted, insider trading practices stimulate the activities of innovation and the discovery of new methods and processes. Assessment of insider trading What are we to make of the insider trading question? Should we argue, along with Manne and McCoy, that the practice promotes innovation and efficiency and hence major social benefits? Or should we argue with Moore and others that it breaches fiduciary duty and results in considerable social costs, in particular lack of confidence and instability? The easiest road would be to argue against the practice because the US and some other legal structures have built up an impressive edifice against it. Most of the articles in the literature support aspects of the legislation. However, if an honest attempt is made to assess the question it has to be said that the case for insider trading is also impressive. For instance, the major work on the practice (Manne, 1966a) is the most detailed account of it ever undertaken. No comparable study against it has been compiled. Also, the practice has been with capitalism for its entire history without seeming to lead to a lack of confidence or financial instability on the basis of the practice itself. The legislation against it has not reduced its incidence. Rather, it has led to more indirect insider trading by corporate outsiders, and more numerous transactions in smaller bundles further removed from the main events such as takeovers and bankruptcies. Only the big practices coinciding with big events are generally acted upon legally. The ``misappropriation court cases have failed to stem the tide of corporate outsiders undertaking the practice. And, strictly speaking, fiduciary duty should compel managers and the like to provide the information to shareholders rather than to ``declare (publicly) or refrain from trading as law dictates. The ``declare or refrain from trading regulation is misguided because insider ``trading can technically occur without trading, if the inside information leads to not buying or selling as the most profitable outcome. The main argument against insider trading seems to be the question of fiduciary duty. Under this principle, insider trading would not be outlawed altogether, and only those elements which breach fiduciary duty (in a significant case) would be prosecuted. Indeed, in this argument, there will be cases when insider trading is essential to protect the fiduciary duty of the board

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members to the shareholders or the company. For instance, if the managers know that the company is undergoing considerable financial turmoil then it could be argued that they have a duty to inform their shareholders first so that they can sell before the public is told. The ``public declaration of information clause in the Act seems, therefore, to be dependent upon the presumption of major social costs by such trading, except that clear evidence of this is lacking. Basing legislation against insider trading on fiduciary duty puts the onus on the courts to prove a clear conflict of fiduciary interest; and in other cases it requires insiders to trade on privileged information in order to adhere to fiduciary duty. Clearly this ethical notion is not a clear-cut case against insider trading per se, but supports it in some cases. The main argument of Manne (1966a, 1966b) is precisely this, that insider trading is in the interests both of the agent and the principle, or at least that it can be operationalised institutionally in this fashion. Recent literature has even cast doubt or revised the notion of fiduciary duty on the basis that the separation of ownership from control in the modern corporation may require a similar reworking of the notion of fiduciary duty (this literature started with the work of Dodd (1932)), or that other duties (such as to the environment) take precedence. As Dennert (1991) recognises, institutions like banks may have a fiduciary duty towards different clients, such as shareholders, business clients and customers: a structurally ingrained contradiction of duties. There are examples of other conflicting fiduciary duties, depending on whether shareholders buy, sell or refrain from trading. The notion of multiple agents and stakeholders rather than the simple idea of principle-agent places central emphasis on the complex and multifarious source of wealth generation in the corporation, and thus questions the simple idea of fiduciary duty (see Stiglitz, 1999, 1985). Indeed, Stiglitz argues that this notion of different stakeholders in the corporation or multiple principal agent theory is critical to the organisation of the social infrastructure of the corporation. While owners are critical to the corporation, it is important adequately to situate innovators, workers, managers, owners and the environment in the complex process of social wealth production. It is the failure adequately to include these groups in the corporation as a stakeholder (rather than insider trading) that leads to instability and institutional collapse, for instance in the case of the Russian experience with ``free markets. The simple fiduciary argument is thus a weak theoretical defence of insider trading in the financial system. What can be said about insider trading is that in this phase of evolution of the academic arguments for and against it neither is decisive. The foundationalist arguments for and against seem irreconcilable. The utilitarian argument of the costs and benefits are unclear empirically. Legality has changed the course and direction of insider trading marginally without much affecting the magnitude. Very little debate has been activated on insider trading in general in social, political economic and environmental practices in order to comprehend the wider questions that impinge on the subject beyond the stock market. Overall, what is striking is that the debate is at a relatively

low level of development, and the empirical material is indecisive. There is thus no clear-cut ``evidence of any sort that the practice should be outlawed, and if so in what form and from what basis. The material is still tentative and partial. Perhaps what is needed is not so much a tunnel-vision analysis of insider trading as a first priority but an ongoing general critical analysis of the institutional practices and theories underlying the dominant tendencies of modern capitalism. In this manner, the tendencies and dynamics of the system may shed some critical light on some of the more concrete aspects of its functioning. In this way, we may be able to comprehend and formulate policies about questions such as insider trading. But before this is possible much analysis and investigation is needed. Only then can we have a better idea as to whether insider trading should be legislated against, and if so how. Conclusion The conclusions of this paper are fairly clear: the current state of knowledge about insider trading does not provide a strong case against the practice beyond reasonable doubt. The arguments in favour of insider trading are well developed, and Manne has produced the only substantial study, supporting it on innovation, information-flows and efficiency grounds. He argues that innovators need additional remuneration, especially for advances which are slow at rewarding certain individuals. This can be done, so the argument goes, by adjusting the institutions of the corporation so that shareholders accept it and free riders are minimal. There may be problems with this perspective relating to conflict of interest between agents and principals, free riders and whether innovators or shareholders should be the principal recipient of rent. A considerable amount of further research is needed on these and other matters, however, before the question of legality can be seriously considered. Many of the ethical arguments against insider trading are problematical, as we have seen. The notion that traders should have equal information in the market is easily dismissed on the basis of the standard ethical and institutional workings of capitalism. The view that all traders should have ``in principle access to relevant information used in the market given sufficient hard work, contacts and research fails because information is relative rather than absolute. Becoming an insider or a professional trader is a skill like being a plumber, and outlawing insider trading effectively would give more power to professional traders than the average ``illinformed everyday trader. Similarly, there is no real evidence that having insider trading legalised has ever contributed to a significant degree of lack of confidence which has led to instability in the markets. The misappropriation theory was developed largely to prevent corporate outsiders from using the information for their own benefit, despite the fact that they usually do not have a fiduciary duty to corporate shareholders. Moore argues that misappropriation can be solved by an institutional agreement between shareholders and insiders; corporate outsiders, however, should not be protected in this way. A closely related theory, that of fiduciary duty, argues that agents inside the corporation have a duty to promote the interests of

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shareholders, and that insider trading by managers or workers often breaks that duty. Manne critiques these ideas by postulating that the interests of shareholders and innovators coincide and the primary activity in the corporation is innovation. If the institutional arrangements of the corporation are organised so as to protect entrepreneurs and minimise free riders, it is argued, then the long-term viability of the corporation will generally be enhanced. In theory, at least, the role of the innovator seems to deal adequately with the issue of insider trading and supports the interests of shareholders. Nevertheless, those who argue against insider trading on the grounds of fiduciary duty have strong ground in relation to certain possible conflicts of interest. But the many theoretical and empirical questions impinging on insider trading have a long way to go before the principle of ``beyond reasonable doubt can be said to exist. Legislation in the USA has changed the nature and timing of the practice, without diminishing its incidence significantly. Therefore, it seems that those who have been charged and found guilty may have been acted upon unjustly, at least given the current state of knowledge on the subject. Much serious work needs to be done before a suitable assessment can be made about insider trading in the financial system. Also, much analysis is required about insider trading in other areas of social life in order to treat the phenomenon in a general fashion and understand it more comprehensively.
Notes 1. Boardman et al. (1998) found that insider trading reveals information to the market, and that more recent tighter legislation against it has reduced the incentive to engage in less profitable takeovers. The legislation has had more impact on negotiated takeovers than those based on bidding. 2. Seyhun and Bradley (1997) found that the effect of the anti-insider trading legislation has been to increase its incidence. For instance, they found that abnormal sellings one year before bankruptcy are more than three times greater in 1985-92 than in 1980-84, and more than ten times the abnormal amount in 1985-92 than in 1975-79. Insiders tend to sell shares in their company more than 30 days before the filing of bankruptcy, sometimes months or years before bankruptcy. This way they tend to evade the accusation that they are selling to avoid the negative effects of bankruptcy on their net wealth. 3. DeMarzo et al. (1998, p. 607) report that ``31 percent of SEC investigations come from exchange referrals, 41 percent come from public complaints (such as tips from employees or ex-spouses), and the remaining 28 percent come from various other sources including broker referrals and other SEC cases. Insider trading cases prosecuted by the SEC are civil cases. Hence only monetary penalties are involved. Alternatively, the SEC may pass a case to the Department of Justice for criminal prosecution. 4. The courts have sometimes rejected and sometimes accepted this theory. In the case of the United States v. Chiarella, the Supreme Court rejected the theory. Chiarella was a mark-up worker in a printing company who came across information relating to takeover bids and traded on that information. However, because the theory had never been used successfully in a lower court, and Chiarella was an ``outsider of the companies involved, the Supreme Court squashed his conviction. Some other courts have upheld the misappropriation theory on the basis of ``outsiders gaining inside information and sullying the reputation of the firms they work for rather than the companies involved directly in the inside information.

5. Lustgarten and Mande (1998, p. 325) conclude from their empirical study that ``when insiders trade, more information becomes available to market participants, increasing stock market efficiency . . . Results showed that increased insider buying is associated with smaller earnings forecast errors. The effects on forecast accuracy are stronger for large firms than for small firms . . . There was also evidence that the frequency with which analysts make forecasts is greater when insiders are trading. Our explanation for these results is that trading by insiders or disclosure of insider trading reveals information to financial analysts which lowers forecast errors and increases consensus. Other studies, however, do challenge these results. For instance, Chakraverty and McConnell (1999) conclude that we cannot ``argue that insider trading leads to more rapid price discovery than do trades by any other investor. 6. As Udpa (1996a, pp. 1086-7) concludes from his empirical study that: ``results suggest that insider trading lowers the magnitude of the earnings response coefficient . . . This suggests that insider trading prior to an earnings announcement, results in a greater amount of predisclosure information available to develop inferences about forthcoming earnings. This reduces the uncertainty that investors perceive is associated with the earnings of a firm. 7. A further argument against insider trading is that proposed by Koslowski (1995, p. 208), that it represents a form of ``agiotage. As he says: ``Agiotage designates the activity of making profit by raising a mere surcharge (agio) on a given good or service without adding value to it. The price differential between the shares bought and the shares sold is just the surcharge or agio levered by the agiotageur. The insider is an agiotageur who, although he or she buys at time t and sells at time t + 1, adds no value to the goods traded, i.e shares, since the information on which he or she bases the profit was already there at time t. However, since Koslowski fails to evaluate critically an argument already provided by Manne (1965) and others that the information provided by insiders to the market is critical in making the market more efficient, it is difficult to take his argument seriously. 8. Irving (1993) argues that insider trading is far less of a moral problem than the critical problem of directors keeping important information from shareholders. He argues that the ethical and legal emphasis should be on the withholding of information from shareholders rather than insider trading per se. With full information being made to shareholders, insider trading would be unlikely to be very common. However, without the legislative move on the information front, insider trading is bound to occur. He argues that the legislators are concentrating on the wrong source. References Bettis, J.C., Duncan, W.A. and Harmon, W.K. (1998), ``The effectivness of insider trading regulations, Journal of Applied Business Research, Vol. 14 No. 4, pp. 53-70. Boardman, A., Liu, Z.S., Sarnat, M. and Vertinsky, I. (1998), ``The effectiveness of tighter illegal insider trading regulation: the case of corporate takeovers, Applied Financial Economics, Vol. 8, pp. 519-31. Boatright, J.R. (1997), ``Fiduciary duty, inWerhane, P.H. and Freeman, R.E. (Eds), The Blackwell Encyclopedic Dictionary of Business Ethics, Blackwell, Oxford. Brown, A. (1986), Modern Political Philosophy: Theories of a Just Society, Penguin, Harmondsworth. Caccese, M.S. (1997), ``Insider trading laws and the role of securities analysts, Financial Analysts Journal, Vol. 53 No. 2, March-April, pp. 9-12. Chakraverty, S. and McConnell, J.J. (1999), ``Does insider trading really move stock prices?, Journal of Financial and Quantitative Analysis, Vol. 34 No. 2, pp. 191-209. DeMarzo, P.M., Fishman, M.J. and Hagerty, K.M. (1998), ``The optimal enforcement of insider trading regulations, Journal of Political Economy, Vol. 106 No. 3, pp. 602-32.

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Dennert, J. (1991), ``Insider trading, Kyklos, Vol. 44, Fasc. 2, pp. 181-202. Dodd, E.M. (1932), ``For whom are corporate managers trustees?, Harvard Law Review, Vol. 45, pp. 1145-63. Herzel, L. and Katz, L. (1987), ``Insider trading: who loses?, Lloyds Bank Review, July, pp. 15-26. Irving, W.B. (1993), ``Insider trading: an ethical appraisal, in White, T.I., Business Ethics: A Philosophical Reader, Macmillan, New York, NY, pp. 379-98. Karni, E. (1992), ``Fraud, in Newman, P., Milgate, M. and Eatwell, J. (Eds), The New Palgrave Dictionary of Money and Finance, Vol. 2, Macmillan, London, pp. 194-5. Kay, J. (1988), ``Comment on King/Roell: insider trading, Economic Policy, Vol. 6, pp. 187-9. Koslowski, P. (1995), ``The ethics of banking: on the ethical economy of the credit and capital market, of speculation and insider trading in the German experience, in Argandona, A. (Ed.), The Ethical Dimension of Financial Institutions and Markets, Springer, Berlin, pp. 180-232. Lustgarten, S. and Mande, V. (1998), ``The effects of insider trading on financial analysts forecast accuracy and dispersion, Journal of Accounting and Public Policy, Vol. 17, pp. 311-27. Manne, H.G. (1966a), Insider Trading and the Stock Market, The Free Press, New York, NY. Manne, H.G. (1966b), ``In defense of insider trading, Harvard Business Review, Vol. 44 No. 6, pp. 113-22. Manne, H.G. (1992), ``Insider trading, in Newman, P., Milgate, M. and Eatwell, J. (Eds), The New Palgrave Dictionary of Money and Finance, Vol. 2, Macmillan, London, pp. 416-19. McGee, R.W. (1988), ``Insider trading: an economic and philosophical analysis, The Mid-Atlantic Journal of Business, Vol. 25 No. 1, November, pp. 35-48. Moore, J. (1990), ``What is really unethical about insider trading?, Journal of Business Ethics, Vol. 9, pp. 171-82. Schumpeter, J.A. (1911), The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle, Oxford University Press, London and Oxford. Seyhun, H.N. and Bradley, M. (1997), ``Corporate bankruptcy and insider trading, Journal of Business, Vol. 70 No. 2, pp. 189-216. Stiglitz, J. (1985), ``Credit markets and the control of capital, Journal of Money, Banking, and Credit, Vol. 17 No. 2, pp. 133-52. Stiglitz, J. (1999), ``Quis custodiet ipsos custodes?, Challenge, November-December, pp. 26-67. Ten, O. (1997), ``Insider trading and the dual role of information, Yale Law Journal, Vol. 106 No. 4, pp. 1325-30. Udpa, S.C. (1996), ``Insider trading and the information content of earnings, Journal of Business Finance and Accounting, Vol. 23 No. 8, pp. 1069-95. Vincente, C. (1999), ``The new improved game of insider trading, Fortune, Vol. 139 No. 11, 7 June, pp. 115-21. Further reading Cinar, E.M. (1999), ``The issue of insider trading in law and economics: lessons for emerging financial markets in the world, Journal of Business Ethics, Vol. 19 No. 4, Part 1, pp. 345-53. Kara, A. and Denning, K.C. (1998), ``A model and empirical test of the strong form efficiency of US capital markets: more evidence of insider trading profitability, Applied Financial Economics, Vol. 8, pp. 211-20. Nozick, R. (1974), Anarchy, State, and Utopia, Basic Books, New York, NY. Udpa, S.C. (1996), ``Accounting firm policies and procedures to prevent insider trading abuses, Ohio CPA Journal, December, pp. 29-31.