The Rittenhouse Review

A Philadelphia Journal of Politics, Finance, Ethics, and Culture

Monday, March 17, 2003  

And We're the George Mason Law School!
We'll Hire Anyone!

Out to prove yet again that its editorial-page editors will print anything, absolutely anything, provided it serves the interests of the paper's most doctrinaire and/or affluent readers, today's edition of The Wall Street Journal features "The Case for Insider Trading," by Henry G. Manne, dean and professor emeritus at the George Mason University School of Law.

Insider trading refers generally, and reductively, to the purchase or sale of securities while knowingly in possession of material, non-public information. Current law on the subject is based on the premise that officers of publicly traded corporations, together with those acquainted or doing business with such individuals, should not be permitted to profit from their direct and specific knowledge of information about their companies' prospects that is not available to the trading public.

As reasonable as that premise sounds, there is a fringe element in the fields of economics and law that finds the legal basis of insider trading laws to be a horrific assault on the free market and free enterprise. Manne is quite at home among the extremists who hold this view. He writes today:

Insider-trading regulation had its primordial introduction in the muck of New Deal securities regulation, which was itself justified on the trumped-up theory that full disclosure was the best way to deal with corporate fraud and deception….

Prior to 1968, insider trading was very common, well-known, and generally accepted when it was thought about at all. When the time came, the corporate world was neither able nor inclined to mount a defense of the practice, while those who demanded its regulation were strident and successful in its demonization. The business community was as hoodwinked by these frightening arguments as was the public generally.

To present his case, Manne adds, in a clever twist of the tongue, "Since [1968], however, insider trading has been strongly, if by no means universally, defended in scholarly journals." [Ed.: Emphasis added.] Well, of course, Dean Manne. After all, many things have been strongly defended -- and wrongly defended -- in scholarly journals over the past several centuries. It is the nature of the beast. It is one of the reasons scholarly journals exist.

Manne argues, first, "that insider trading does little or no direct harm to any individual trading in the market, even when an insider is on the other side of the trades"[;] second, "that it always (fraud aside) [Ed.: That's quite a parenthetical!] helps move the price of a corporation's shares to its 'correct' level; and third, "that it is an efficient and highly desirable form of incentive compensation, especially for corporations dependent on innovation and new developments."

Giving short shrift to those he calls "critics of insider trading," Manne characterizes arguments in favor of current and possibly more restrictive insider trading laws as relying on two aggregate-harm theories. The first, he says, is the "market confidence" argument: "If investors in the stock market know that insider trading is common, they will refuse to invest in such an 'unfair' market. Thus investment and liquidity will be seriously diminished[.]" The second, according to Manne, is the "adverse selection" theory, which holds that specialists and market makers will broaden the bid-ask spreads in their books to cover for losses that stem from dealing with insiders.

Although it is clear at this point in the essay that Manne already has gone haywire, he then trots out a new, even more bizarre, "justification" [Ed.: Manne's word.] for insider trading:

Management and the shareholders of large, publicly-held corporations have a strong common interest in the accurate pricing of the company's shares. If pricing is not reliable, investors will demand a higher return in order to be compensated for assuming this added risk. Thus, all other things being equal, the shares of a company with reliable pricing of its shares will sell for more than otherwise identical shares.

Lack of confidence in the reliability of a share's price, reflected in a higher risk premium, will have several negative effects. The company will have to pay more for new capital, boards of directors and the managers themselves will have less reliable feedback on managerial performance, managers' professional reputations will suffer, and the managers will be at greater risk of displacement either through a takeover or action of their own board of directors….

No other device can approach knowledgeable trading by insiders for efficiently and accurately pricing endogenous developments in a company. Insiders, driven by self-interest and competition among themselves will trade until the correct price is reached. This will be true even when the new information involves trading on bad news. You do not need whistleblowers if you have insider trading.

And what a glorious day it would be if insider trading ran untrammeled through world financial markets:

If such trading is allowed, there are no delays or uncertainties about what has to be disclosed. There are no issues about when information must be published, or in what form. There is no need to regulate investment bankers, auditors, or stock analysts. The evaluation of new information will be done efficiently through a pure market process. Investors receive "virtual" full disclosure in the form of immediate and correct price adjustments.

Meanwhile, back here on Earth, I'm nearly speechless. I can only ask why such as Manne are called "conservatives." They are radical anarchists of a most dangerous sort. We should be glad the Journal is one of few mainstream publications that willingly and eagerly plays host to such absurdities.

[Post-publication addendum: See also Manne is Still Singing the Same Tune, at Letters to the Rittenhouse Review, March 17, 2003; and Anything Goes!, at Letters to the Rittenhouse Review, March 22, 2003.]

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