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Source link: http://archive.mises.org/1678/ethics-and-insider-trading/

Ethics and Insider Trading

March 9, 2004 by

New in the Study Guide:

Tibor R. Machan: “What is Morally Right With Insider Trading?” , Public Affairs Quarterly, Vol. 10 (April 1996), pp.135-142. Also, Chapter 7 of Tibor R. Machan & James E. Chesher, A Primer on Business Ethics (Rowman & Littlefield, 2003).

{ 6 comments }

RTR March 10, 2004 at 5:57 pm

“A knows the president of a firm who tells me that they are thinking of expanding one of their divisions or have struck oil in a new field, so A buys a block of stock in anticipation of the increase of value once the deal is done or the knowledge becomes public. A is not deceiving anyone, nor is A defrauding anyone.” P. 4

A most certainly is deceiving and defrauding the shareholders of the firm. And he has knowingly done so. The president of the firm has violated his fiduciary duties to the firm, the shareholders. A knows that the president has committed fraud and A has perpetuated the fraud by acting on that information, even if A were to merely have overheard the drunk loose lips of the president of the firm in a bar bathroom. Company secrets have not been kept secret and the shareholders have suffered at a minimum opportunity cost fraud. The price per share has marginally increased due to A’s buy order. If the company were to repurchase shares the shareholders have been robbed at a minimum by that marginal amount. The subjective value of those corporate secrets must also be added to the true damages. There are many instances where the damage could be multiplied many times over if this tipped off competitor companies, etc. etc.

“A is not taking anything from others that A wasn’t freely given. A is acting on special, ‘insider,’ information, that is all.” P.4

It’s no different than if A had purchased an automobile from the president of the firm that A knew the president had stolen from his neighbor. A perpetuates the fraud by completing the transaction. If divulging insider information is morally wrong than knowingly perpetuating and profiting off that information should also be morally wrong. This is NOT information that has been freely given to A.

This paper has mis-focused on debunking one’s supposed duty to divulge information instead of focusing on one’s duty to NOT divulge and to NOT deliberately profit through the course of another’s improprieties, as in knowingly buying a new stolen car at 50% the market price. Obviously, trade only occurs when both sides increase their benefit. Any trade on the shares of the firm in this example must involve an owner of those shares and a purchaser of those shares who previously was not an owner. A has fraudulently profited at the expense of the previous owner of the shares by buying them at a lower value than the previous owner would have received if that information had been public; and more importantly A has stolen information from the previous owner of the shares that rightfully belonged to the previous owner of the shares as it was the fiduciary duty of the president to not disclose that information to an outsider before it was disclosed to the owners (the true inside owners) let alone disclosing it to the public at large.

I agree with much of what the author wrote, however, the basis of the argument is based upon a very bad example. Unfortunately, almost every case of insider trading involves either someone violating his fiduciary duty or someone else acting upon that violation of fiduciary duty. I haven’t heard of anyone being prosecuted for flying over a burning oil field and then acting upon that information. And in more recent events, Martha Stewart at a minimum knew that her broker was violating his fiduciary duty to not share what his client Sam Waksal was doing and even if the government could not convict her upon acting upon another’s fiduciary violation she is at a minimum morally culpable if not legally so. Whether she should have also been legally culpable on that basis is another issue. But the answer given current law regarding broker obligations is obviously yes as fraud has been committed and Martha Stewart perpetuated that fraud. Ironically, Waksal should also be entitled to collect damages from Merril Lynch as he received a lower marginal price for selling his shares due to Martha’s selling done on a violation of the broker’s fiduciary duty.

Kevin Carson March 10, 2004 at 9:30 pm

RTR,

I agree, to an extent. But this fiduciary duty of corporate officers should be defined by the internal bylaws of a corporation, and enforced by the corporation itself.

Most of the corporate governance “reforms” we’ve seen proposed over the last couple of years are sold to the public as populist measures, using the “people’s capitalism” meme. Supposedly, the laws are just being pushed through to benefit all those working people whose 401k’s are going in the tank because of Kenny Boy. But in reality, most stock is still owned by a small minority of the population. And people like David Rockefeller don’t like THEIR stock going in the tank from the malfeasance of corporate CEO’s, either. Guess who the “reforms” are REALLY designed to help? They’re designed to help billionaires keep an eye on the hired help in corporate management, at taxpayer expense.

Monitoring the performance of corporate management is a transaction cost of investing, that should be borne entirely by investors.

RTR March 10, 2004 at 10:17 pm

Well for the most part I believe fiduciary duty is defined by internal corporate bylaws, or would be anyway if we didn’t have all the clutter of over-regulation by the government. However, I think a breaching of that contract, it is a contract freely entered into by the shareholders and the corporate officers, constitutes fraud and theft, and thus enters the realm of proper government function. The offender should be subject to civil damages incurred by the shareholders (as he would be now if he gave away a secret formula to a competitor company) and also punished criminally for violating the basis upon which free market transactions occur, private property, as private property that did not belong to the insider corporate officer has fraudulently or perhaps even negligently been given to another party.

It doesn’t really matter who the shareholder owners are. That’s all that needs to be done with government interference; protect private property and person. I’m arguing that “insider information” is really private property owned by the shareholders, not the corporate officers, and therefore trading it or based upon it, contrary to what I’ve seen in most of the free market literature regarding this subject, without the knowledge or consent of the shareholders is legally and morally wrong.

I agree with you that these “reforms” can be handled much better by the free market. Here the concept of market reputation takes care of that much better than government over the long term. There’s a natural disincentive to cheat by most as you will be at least surely punished by the market first. Stewart lost many many times more than she gained from her alleged sale of Imclone stock. Established quality reputation is a hard very valuable thing to build. Look what happened to the boxing and horse racing industries which were rife with charges of insider manipulation.

Unestablished ipo companies would be discounted compared to established reputable companies and this works perfectly well for used cars versus buying from dealerships with a good reputation. And it would work just as well with various companies that trade stock on an exchange. It’s a valuation of risk that is one of the great benefits markets bring as prices are set for junk bonds in comparison to triple A credit.

People don’t stop buying cars because shady salesmen exist and they wouldn’t stop investing either because shady corporate executives exist and will always exist in the future. So it’s much better to have the caveat emptor degree of risk priced in instead of naively believing that since we have laws against it all companies are at an equal remote chance of fraud risk. And the market does do this anyway and the littlest guy benefits immensely because (OF THE MARKET) all that information goes into the aggregate price of all buyers and sellers for a given company.

Arthur B. August 17, 2006 at 5:14 pm

There is no point in discussing weither insider trading is right or wrong, this is for the market itself to decide. There should be no law preventing insider trading, it should be in itself a part of the shareholding contract. Some company would include a no-insider-trading clause in there shareholding contract and some would not. The same goes for every kind of transparency regulation, such as Sarbannes-Oxley.
Imagine for exemple that Sarbannes-Oxley was in fact a private institution delivering a “compliency certificate”. Investors would have a choice between a company with a certified transparency and one that does not bear the costs associated with the regulation.

The Austrians saying that “insider trading is right” makes absolutely no sense and casts discredit. What matters is the market result of regulation competition.

Additionnaly, it is my opinion that very few investors would indeed invest in stocks not offering non-insider-trading guarantees.

John James February 23, 2011 at 3:55 pm

I don’t think the argument is that “insider trading is right”…but rather that it’s not immoral. As the author illustrates:

Sometimes such a practice can be conducted fraudulently, as when one who has obtained the information has a fiduciary duty to share it with clients but fails to exercise it, or in some other criminal fashion, as when the information is itself stolen.

These are not, however, features of insider trading as such, as understood in the context of the discussion of business ethics. Never mind that in the enforcement of government regulations it is in fact fraud that is cited that makes the conduct illegal that is referred to as insider trading.

wealth creation November 21, 2011 at 3:06 pm

Thank god some bloggers can write. Thank you for this writing…

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