The origins of insider trading regulation

While we’re talking about Congress’ insider trading legislation of the 80’s, it would be interesting to think about how we got insider trading liability in the first place. I discuss this background in my article on the Supreme Court’s O’Hagan case, Federalism and Insider Trading, 6 Supreme Court Economic Review, 123 (1998). A couple of recent papers by Stanislav Dolgopolov shed more light.

Congress didn’t invent liability for insider trading – it was a 1961 gloss on Section 10(b) of the Securities Exchange Act of 1934 Act by the SEC in Cady, Roberts, later ratified by lower federal courts, and finally acceptd by the Supreme Court. The SEC based the liability on

the existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone, and second, the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing

The SEC didn’t say why these circumstances justified liability or amounted to "inherent unfairness." Henry Manne thoroughly denounced the whole “inherent unfairness” notion 40 years ago in his Insider Trading and The Stock Market.

The Supreme Court in O’Hagan later added the rationale that "investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law." This echoed the House Report on the Insider Trading and Securities Fraud Enforcement Act of 1988, asserting that "the small investor will be--and has been--reluctant to invest in the market if he feels it is rigged against him."

Of course, this can’t be true. As Joo notes in the article discussed in my last post, there is ample evidence that investors realize there is insider trading, and yet investors still do amply trade. A more sophisticated version of the argument that was made to the Court in O'Hagan is that insider trading reduces outsider trading by increasing its cost.  That's supposedly because market makers have to increase the spread between bid and ask prices in response to insider trading.

This argument never had much weight as a rationale for insider trading liability as I discuss in my article.  In any event it has been thoroughly undermined in a recent article by Dolgopolov, The Relationship between Insider Trading and the Bid-Ask Spread: A Critical Evaluation of the 'Adverse Selection' Model, published in 33 Capital University Law Review, 83 (2004).

In fact, in a more recent paper, Insider Trading, Chinese Walls, and Brokerage Commissions: The Origins of Modern Regulation of Information Flows in Securities Markets, Dolgopolov shows the ignominious origins of insider trading regulation as a way to maintain the brokerage cartel during the pre-1975 regime of fixed brokerage commissions -- a time when insider trading was used as a kind of non-price competition.  This idea was first proposed by Henry Manne.

Putting all this together with Joo presents a picture of insider trading regulation that rather sharply contrasts with the idea that this regulation is some kind of moral imperative.