Insider trading is more common than most investors know and regulators admit. Back in 1974, a paper published in the Journal of Financial Economics showed shares of the average takeover target beat the market by 14% over seven months prior to the announcement. Last month, a study published in the Journal of Multinational Financial Management found abnormal returns of nearly 7% during the 50 trading days before deal announcements.
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At least shares also jumped an average of 13% on announcement day, according to the recent study. That shows some investors were surprised.
In the United States, it's a crime to trade based on information that can influence returns ("material") and that isn't available to ordinary investors ("non-public"). The offense is commonly called insider trading, although confusingly, "insiders" is a regulatory term for company executives, board members and key stakeholders, who are permitted to buy and sell shares so long as they report their transactions. The illegal form of insider trading needn't be committed by insiders; a secretary with a scoop will do. Likewise, the normally legal trades insiders make become illegal when they're based on privileged information.
If the prevalence of insider trading is an awkward truth, here's something more awkward: Even the rule-makers don't always know the rules.
For example, if a shrewd janitor notices that the typically quiet phones in his company's sales department are ringing wildly, is he a criminal for buying shares? Maybe not, but he knows something material about revenues before the rest of us. A less-hypothetical example: If Wall Street researchers, assigned to figure out whether Apple ( AAPL ) shares are worth buying, ask overseas suppliers of gadget innards how business has been, should clients who trade on their advice go to jail? So-called channel checks used to be the mark of a thorough analyst. In November, the Securities and Exchange Commission announced it's looking into the practice.
Whether David Sokol, the Berkshire Hathaway ( BRK.A ) lieutenant who bought shares in Lubrizol before pitching the chemical maker as a takeover candidate to Berkshire chief Warren Buffett, did anything wrong rests on whether he knew he could influence the takeover decision. That's why in a letter to investors, Buffett took care to explain that Sokol didn't know. In a recent poll of business leaders, more than two-thirds said Sokol behaved unethically but only one-quarter said he broke the law. That's fewer than said they didn't know.
Some 45 years ago a scholar named Henry G. Manne proposed a fix for this legal murk. Make insider trading legal, he proposed in a book. If that seems absurd, consider that insider trading was the norm before the 1960s in the U.S. and remains common today in other developed countries. Manne offered three economic arguments. First, no one is harmed by insider trading; those who sell the shares that insiders buy would have sold anyway. Second, insider trading aids in a process called price discovery by moving shares toward the price justified by all information, public or not. Third, Manne argued that insider trading rights can serve as an explicit form of executive compensation, akin to an options package.
Manne became dean of George Mason University School of Law in 1986, the year Ivan Boesky was arrested for insider trading, and served until 1996. Today he is Dean Emeritus. In 2005 he wrote an essay reexamining his position. Two out of three arguments held up well, he reckons. Some critics have argued that insider trading carries a cost hidden in the spreads market makers use when they take the other side of buy and sell orders, but there's little hard evidence for it. Events like Enron's collapse suggest that better price discovery could have alerted investors to trouble sooner. The compensation argument proved "perhaps less robust than I and other proponents had originally assumed," wrote Manne.
He also offered a fresh idea. Enforcement of the insider trading ban is "arbitrary, capricious, political and extremely inefficient," he wrote. But if insider trading must be illegal, how about setting up a virtual market where company insiders can make cash bets on important news?
Jack Hough is an associate editor at SmartMoney.com and author of "Your Next Great Stock."Try our powerful Select Stock Screener to discover investment opportunities that meet your criteria.
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