Legalize insider trading, part two

Posted: Jun 19, 2003 12:00 AM

Dean emeritus Henry Manne of George Mason University School of Law, last week in this column, explained the benefits of legalizing insider trading. He argued that insider trading makes the market more efficient, and enables quicker dissemination of good or bad news, thus allowing all investors -- big or small -- to react more quickly. More excerpts of my interview follow:

Professor Manne: The SEC is just disgraceful on this -- they insist that the traditional accounting forms will convey the kind of information you need for valuing stocks. That's just absurd. The Sarbanes-Oxley bill that was recently passed that regulates accounting makes about as much sense as Congress saying that we've got to perfect the system of astrology.

Larry Elder: Would you also not say that so many states have passed laws that stop corporate takeovers, and those laws also have hurt, because takeover artists are always looking for these kinds of accounting irregularities . . . ?

Manne: Absolutely. If there was ever any really evil special interest legislation, it's that state law that prevents takeovers. There's federal law that does that, and that has cost the American investors tens of trillions of dollars. . . . We have no idea how big it is, because it allows inefficiency to continue. The SEC regulation and the new Sarbanes-Oxley regulation of accounting encouraged the production of useless information, making it more difficult to get the valuable kind. And the only way you're really going to get it is by letting lots of people have access to information in a free market and a free-for-all -- let them use their information just like you let anyone use his private property in the market to benefit himself.

Elder: You say that use of insider trading by CEOs would be a desirable form of incentive compensation. Explain that.

Manne: I didn't limit that to CEOs, but one of the problems has long been how to compensate really entrepreneurial kinds of people in large bureaucratic companies. If you just give them salary, they won't have any incentive to go out and really take any risks or try anything new. But insider trading gives you all the correct incentives for that.

Ken (a caller): My disagreement is, if you have insider trading, at least in some cases, if the principals of the company know that the stock is about to tank because they didn't get a patent, they know that, their friends know that, they get rich selling the stock, but some poor guy who hasn't heard the information on the news yet, because it hasn't been released, buys the stock and it tanks the next day.

Manne: The law determines when these disclosures can be made. Now the poor guy out there who doesn't have the information -- he's in the market whether or not anything else has happened, his allowing insider trading doesn't speed up the time the actual disclosure will occur. . . . Do you think it's unfair that they make money? . . . I do know that in the competitive market, no one will continue to make abnormal returns without somebody coming in and competing away those profits. That's how the market works.

Elder: Ken's argument is, let's say there's a pharmaceutical company that applied for FDA approval. . . . The news media thinks they're going to get the approval, but the company gets the bad news: They don't get the approval, so they short-sell the stock.

Manne: Same thing. Short-sales will have the same impact on market price, and you want it to go down. You want that information into the capital markets just as fast as you possibly can get it there.

Elder: There are professionals who look at what the insiders in a company do, whether they buy . . . sell . . . short-sell, that's what they do for a living. They sit there and monitor the tape and when they see a bunch of people short-selling, they then react to that.

Manne: That's right. That's fortuitous. You can also say, well, they're not producing anything socially valuable . . . they're just leeches. The world is full of that kind of accident . . . people do make money by trading on their knowledge that insiders are trading.

Elder: And finally, worldwide, is insider trading pretty much banned at virtually every other stock exchange? I think I read that insider trading was legal in Japan. Am I wrong?

Manne: It's not legal on the books, but they have never had an enforcement action. Effectively, it's still legal there. And that's true in every country in the world that has these laws. I maintain that it's true in the U.S., but nobody can really notice it because you get these enormous headlines -- Martha Stewart and ImClone and problems like that -- and you think, oh, boy, the securities policemen are really doing they're job -- they're doing nothing. They're making headlines. They're not making enforcement of that law, because it's really impossible to do.

For more information, read Henry Manne's book, Insider Trading and the Stock Market.