ALREADY FACING UP to 20 years in prison following her conviction last Friday on four charges stemming from a 2001 sale of ImClone stock, Martha Stewart may still have to run another legal gauntlet as the Securities and Exchange Commission prepares a civil charge of insider trading.
But as supporters continue to defend the domestic diva, some economists are going a step farther and defending insider trading itself.
Insider trading, defined by the SEC as the use of "material, nonpublic information" in stock sales, was first outlawed in the United States in the wake of the stock market crash of 1929. The rule went unchallenged -- and unenforced -- for decades. But soon after the first insider-trading conviction in 1961, economist Henry Manne stunned the corporate law crowd by arguing that insider trading, though harmful to some investors, should be legal nonetheless.
First, Manne argued, insider trades would make a company's stock more quickly reflect the company's actual value, making the market more efficient. The canonical example is Texas Gulf Sulphur Co., whose managers gobbled up the company's stock in 1963 and `64 before announcing they had struck ore in Canada, inflating their share price with their own demand -- and enriching fellow stockholders -- well before the good news was released.
More importantly, Manne saw insider trading as a form of incentive compensation, a way to turn rule-bound managers into "corporate entrepreneurs" who would want to create more good news for their companies so they could trade on it.
Don Boudreaux, chairman of the economics department at George Mason University, takes Manne's argument a step farther, claiming that insider trading can actually fight corporate crime by serving as a silent form of whistleblowing. If insiders who knew about malfeasance were free to sell their company's stock short, Boudreaux claimed in a recent interview, the resulting decline in share value would serve as a distress signal to investors, and might eventually encourage a takeover.
But not everyone is convinced by such logic. Economist Andrew Metrick, of the University of Pennsylvania's Wharton School of Business, argues that the incentive to sell when one smells wrongdoing in the air is small compared to the incentive to produce fake information to temporarily pump up one's stock and then sell short. A study of the profits insiders actually reap, performed by Metrick and two Boston-area coauthors in 1999, shows that only 12 cents per $10,000 invested in domestic markets is lost to insider profits. If all insider trades were legalized, Metrick says, this quantity would shoot up, making average investors so afraid of getting burned by in-the-know sellers that firms would have trouble raising capital: a liquidity disaster.
Would the liquidity loss outweigh the potential gains outlined by Manne and Boudreaux? Some claim that without letting firms opt out of insider-trading enforcement, we'll never know for sure. But a few economists are taking an international approach. In the most comprehensive study so far, Utpal Bhattacharya and Hazem Daouk at Indiana University hounded officials from Armenia to Zambia to gather a complete survey of all 103 stock markets worldwide -- most of which adopted insider-trading laws sometime in the 1990s.
Strikingly, they found that while simply having laws on the books does nothing for liquidity, the first insider-trading prosecution coincided with a consistent drop in the cost of capital, often cutting it in half in emerging markets. Bhattacharya says this shows that when investors no longer fear they are trading with insiders, they demand lower returns and invest more. "If firms want to raise money," he says, "then they will have to assure the general public there is no insider trading."
(Curiously, another study by Bhattacharya showed that Mexican stocks don't react at all to official company news -- a sure sign, in his view, that the market has been corrupted by insider trading, which, according to Manne's logic, allows stock prices to reflect information before it is released.)
On the other hand, two recent studies suggest some overlooked upsides to insider trading. Hong Kong economist Guochang Zhang argues that insider trades could give shareholders an insight into their managers' true intentions. And according to Giovanna Nicodano and colleagues at the University of Turin, insider trading might even benefit risk-averse outsiders by distributing profits more equally between uninformed traders.
Whatever its economic effects, most legal scholars consider insider trading a form of fraud, because it is a blow to the transparency that makes markets work. But a thorny question remains: If a company were to advertise up-front that it allowed its insiders to trade on non-public information, why shouldn't investors have the chance to take a risk on it?
Leo Katz of Penn Law School, author of "Ill-Gotten Gains: Evasion, Blackmail, Fraud, and Kindred Puzzles of the Law" (1996), argues that as long as there's no coercion, deception, incompetence, or downside for third parties, people should be allowed to enter any contract they please. But just as a rapist shouldn't go free if his victims signed a release form, he said in an interview, insider trading may be a wrong that one cannot by definition consent to. Insider trading, he adds, may be one of those cases where we have "firm intuitions but no clear analytical grasp on what is wrong."
Besides, Katz says, even advance warnings about the possibility of insider trading would not necessarily take management off the hook for any legal claims. For example, he points out, one company's attempt to issue stock in 1964 accompanied by a prospectus declaring that "anyone considering purchase of this security must be prepared for immediate and total loss" was rejected by the SEC.