Ethics of Insider Trading

“Insider trading” is one of those phrases that most adults have heard (at least on the nightly news), but that relatively few understand. (Perhaps the most famous case: Martha Stewart was originally charged with insider trading in the ImClone case.) I imagine few people even know what it really refers to. Well, it refers to situations in which corporate “insiders” (executives, directors, etc.) buy or sell their company’s stock on the basis of significant corporate information that is not available to the investing public more generally. (For more details, see the Wikipedia page on insider trading.)

But even if we don’t all know just what insider trading is, we all know insider trading is bad, and must be stopped. Right? But it’s hard to stop something that’s hard to define. In that regard, see this nice piece by Steve Maich, Editor of Canadian Business: “Chasing our tails while we chase insider trading.”

In case you hadn’t noticed, we are in the midst of a crackdown. Or rather, another crackdown. The crime du jour is an old favourite: insider trading….

There are obvious benefits to these shows of regulatory force. Seeing hedge fund managers and lawyers in handcuffs not only produces a nice dopamine rush, it’s also meant to demonstrate the integrity of the capital markets. But the costs are frequently overlooked. Like most crackdowns, this one seems likely to deepen cynicism, erode confidence and lob more grenades at shell-shocked markets….

Maich is undertandably cynical about these enforcement efforts:

Despite the periodic efforts of regulators to stamp it out, insider trading runs as rampant as ever, and that isn’t going to change. This is in part because it’s notoriously difficult to prove, but also because we have never definitely solved the fundamental puzzles at the heart of this supposed crime….

It’s worth adding that there is genuine disagreement over just why insider trading is unethical. (Some people even think it’s not unethical at all, because the executive who trades on “inside” information ends up indirectly bringing that information to the market, rendering the latter more efficient.) And if we’re not entirely sure why it’s unethical, it makes it that much harder to figure out in which cases it’s unethical.

The only scholarly article I’ve read on the ethics of insider trading is by Jennifer Moore, and is called “What Is Really Unethical About Insider Trading?”* Moore looks at a number of arguments against insider trading — arguments rooted in fairness, in property rights, and in the risk of harm to investors — and finds most of them lacking. Moore ends up arguing — plausibly, in my view — that the real reason insider trading is unethical is that it jeopardizes the fiduciary relationships that are central to business. If insider trading were permitted, that would put corporate insiders in a conflict of interest. Basically, the interests of corporate insiders would stop being well-aligned with the interests of the shareholders they are supposed to serve. And if the interests of corporate insiders aren’t aligned with the interests of shareholders, then people are much less likely to be willing to buy shares (i.e., to invest) in companies. And that wouldn’t be good for the firm, for its shareholders, or for society in general.

—–
*Jennifer Moore, “What Is Really Unethical About Insider Trading?” Journal of Business Ethics, Volume 9, Number 3, 171-182.

13 comments so far

  1. Sam on

    Chris, thanks as usual for your interesting and thoughtful blog. I have two big complaints about Moore’s well-known piece, 1) her “fiduciary argumnet” seems not to work so well in cases where the trader is an outsider (non-employee), as was Martha, 2) Moore’s dismissal of the “fairness argument” seems quite lame. As I recall, she brushes it aside with her plumber analogy, the point of which is supposed to be that insider trading is not unfair to outsiders, since they could have been insiders too (had they so chosen), which seems both false and a non sequitor. – Regards, Sam

    • Chris MacDonald on

      Sam:

      Thanks. I haven’t thought deeply about this, but I’m willing to at least attempt a quick, limited defence of Moore on those 2 points.

      1) Even if outsiders are not themselves fiduciaries, they (typically?) gain their information from people who are. So, their willingness to profit from insider trading may in effect induce actual insiders to act in ways contrary to their fiduciary obligations (i.e., by sharing insider info).

      2) I don’t recall the details, but it seems to me that Moore’s fairness argument rests on the idea that it’s too difficult to determine what counts as “fair” access to information. We’re not even sure what would count as equal access — it surely can’t mean equal possession of information, because that’s impossible. And whether any given person “could have” had access is hard to determine. But maybe that’s just a weak procedural point, rather than an in-principle objection to the fairness argument. Also, she notes that it’s not always unethical to profit from unequal information…only when doing so involves a violation of trust.

      Chris.

      • Sam Bruton on

        Chris, thanks, and fair points both. Regarding your second point, I guess I’ll have to look at the article again – I don’t remember her making much of the procedural/epistemological point, but even if she does, I wouldn’t say it helps the argument much. Regarding the first, I’m not sure we’re disagreeing. I hedged initially by saying her argument works “not so well” in the outsiders case, precisely for the reason you mention. I would just say that it strikes me as odd to say that Martha did something wrong because Waksal had an obligation he violated, which is what your point 1 seems to amount to. Now, maybe that’s not so bad if we’re just worried about justifying laws against insider trading – sometimes the law places an obligation on one party because it has trouble otherwise regulating the behavior of another – but I was assuming the debate was on a moral level too – why was Martha’s action unethical?

      • Chris MacDonald on

        Sam:

        I don’t have strong views on this. But I think that one way to answer your final question might be to argue that it’s an offence related to things like suborning perjury — it involves inducing (even if just via the bonds of friendship) someone to do wrong.

        Chris.

  2. Matt Zwolinski on

    I don’t know this literature terribly well either, but Alan Strudler’s piece in the Oxford Handbook of Business Ethics struck me as giving a nice overview, though I recall not being entirely convinced by the reasons he gives against the fiduciary account.

  3. Kirk Emery on

    I disagree with Moore’s analysis of the problem of insider trading being that it breaches the director’s fiduciary duty to shareholders. Legally speaking, the fiduciary duty is owed to the corporation, not to the shareholders (in Canada, at least).

    As well, Sam got it right when he said that non-employees may not breach a fiduciary duty when engaging in insider trading, be that duty to the corporation or the shareholders. An accountant or lawyer working at a separate firm hired to do some M & A work may use insider information to make illegal gains. This doesn’t mean the corporate employee who provided it breached an obligation by doing so. The accountant or lawyer would have needed that information to do their jobs anyway. However, the accountant or lawyer who traded on insider information, or gave it to others for that purpose, would do so in breach of different obligations.

    A less ethical or legal problem with insider trading is that it just tastes bad. A society that values some degree of equality in material wealth and opportunity frowns on corporate fat cats having privileged access to market opportunities. Societies that value equality tolerate capitalism because everyone supposedly has equal access to its opportunities and rewards, all of which is overturned by insider trading.

  4. [...] But what really is wrong with the kind of insider trading that Cheng Yi Liang engaged in? The precise worry about insider trading is the subject of some debate, and I’ve blogged about that before. (See: Ethics of Insider Trading.) [...]

  5. [...] is accused of a form of insider trading, essentially a kind of betrayal that is unethical at best, and illegal at worst. Now, Sokol himself [...]

  6. [...] to be made here. Somewhere between benign information-gathering, on one hand, and criminal insider trading, on the other, is a category of ethically-suspect behaviour that involves asking corporate insiders [...]

  7. [...] to be made here. Somewhere between benign information-gathering, on one hand, and criminal insider trading, on the other, is a category of ethically-suspect behaviour that involves asking corporate insiders [...]

  8. [...] to be made here. Somewhere between benign information-gathering, on one hand, and criminal insider trading, on the other, is a category of ethically-suspect behaviour that involves asking corporate insiders [...]

  9. [...] who was culpable in a headline-making scandal. Martha Stewart’s name comes to mind, but her insider trading had nothing to do with her executive position. (And sure, Oprah Winfrey, CEO of Harpo Productions, [...]

  10. [...] engage in insider trading is also relatively benign. There are, after all, people who believe that insider trading isn’t unethical at all, and shouldn’t be illegal. They argue that insider trading just helps make public information [...]


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