What is Really Unethical About

Insider Trading? JenniferMoore

ABSTRACT. Insider trading is illegal, and is widely believed a very shady business indeed.: For many, insider
to be unethical. It has received widespread attention in the trading has become the primary symbol of a wide-
media and has become, for some, the very symbol of ethical spread ethical rot on Wall Street and in the business
decay in business. For a practice that has come to epitomize community as a whole. 2
unethical business behavior, however, insider trading has For a practice that has come to epitomize un-
received surprisingly little ethical analysis. This article ethical business behavior, insider trading has re-
critically examines the principal ethical arguments against ceived surprisingly little ethical analysis. The best
insider trading: the claim that the practice is unfair, the
ethical assessments of insider trading have come
claim that it involves a "misappropriation" of information
and the claim that it harms ordinary investors and the from legal scholars who argue againsf the practice.
market as a whole. The author concludes that each of these But their arguments rest on notions such as fairness
arguments has some serious deficiencies;no one of them by or ownership of information that require much
itself provides a sufficient reason for outlawing insider more examination than they are usually given.3
trading. This does not mean, however, that there are no Proponents of insider trading are quick to dismiss
reasons for prohibiting the practice. The author argues that these arguments as superficial, but offer very little
the real reason for outlawing insider trading is that it ethical insight of their own. Arguing almost solely
undermines the fiduciary relationship that lies at the heart of on grounds of economic efficiency, they generally
American business. gloss over the ethical arguments or dismiss them
entirely. 4 Ironically, their refusal to address the
ethical arguments on their merits merely strengthens
"Insider trading," as the term is usually used, means the impression that insider trading is unethical.
the buying or selling of securities on the basis of Readers are left with the sense that while it might
material, non-public information. It is popularly reduce efficiency, the prohibition against insider
believed to be unethical, and many, though not all, trading rests on firm ethical grounds. But can we
forms of it are illegal. Insider trading makes for assume this? Not, I think, without a good deal more
exciting headlines, and stories of the unscrupulous- examination.
ness and unbridled greed of the traders abound. As it This paper is divided into two parts. In the first
is reported in the media - complete with details of part, I examine critically the principal ethical argu-
clandestine meetings, numbered Swiss bank accounts ments against insider trading. T h e arguments fall
and thousands of dollars of profits carried away in into three main classes: arguments based on fairness,
plastic bags - insider trading has all the trappings of arguments based on property rights in information,
and arguments based on harm to ordinary investors
or the market as a whole. Each of these arguments, I
Jennifer Moore is an Assistant Professor in the Department of
Philosophy and the Department of Business Administration at
contend, has some serious deficiencies. No one of
the University of Delaware. She teaches and does research in the them by itself provides a sufficient reason for out-
areas of business ethics and business law. She is the author of lawing insider trading. This does not mean, however,
several articles in business ethics and co-editor of the anthology, that there are no reasons for prohibiting the practice.
Business Ethics: Readings and Cases in Corporate Once we have cleared away the inadequate argu-
Morality, published by McGraw-HilL ments, other, more cogent reasons for outlawing

Journal of Business Ethics 9: 171-182, 1990.

© 1990 KluwerAcademic Publishers. Printed in theNetherlands.
172 Jennifer Moore

insider trading come to light. In the second part of strict notion of fairness, it has its proponents, 8 and
the paper, I set out what I take to be the real reasons hints of this view appear in some of the judicial
for laws against insider trading. opinions? One proponent of the equal information
The term "insider trading" needs some prelimi- argument is Saul Levmore, who claims that'"fairness
nary clarification. Both the SEC and the courts have is achieved when insiders and outsiders are in equal
strongly resisted pressure to define the notion clearly. positions. That is, a system is fair if we would not
In 1961, the SEC stated that corporate insiders - expect one group to envy the position of the other."
such as officers or directors - in possession of As thus defined, Levmore claims, fairness "reflects
material, non-public information were required to the 'golden rule' of impersonal behavior - treating
disclose that information or to refrain from trading. 5 others as we would ourselves.""~ If Levmore is
But this "disclose or refrain" rule has since been correct, then not just insider trading, but all transac-
extended to persons other than corporate insiders. tions in which there is a disparity of information are
People who get information from insiders ("tippees") unfair, and thus unethical. But this claim seems
and those who become "temporary insiders" in the overly broad. An example will help to illustrate some
course of some work they perform for the company, of the problems with it.
can acquire the duty of insiders in some cases. 6 Suppose I am touring Vermont and come across
Financial printers and newspaper columnists, not an antique blanket chest in the barn of a farmer, a
"insiders" in the technical sense, have also been chest I know will bring $2 500 back in the city. I
found guilty of insider trading. 7 Increasingly, the offer to buy it for $75, and the farmer agrees. If he
term "insider" has come to refer to the kind of had known how much I could get for it back home,
information a person possesses rather than to the he probably would have asked a higher price - but I
status of the person who trades on that information. failed to disclose this information. I have profited
My use of the term will reflect this ambiguity. In this from an informational advantage. Have I been
paper, an "insider trader" is someone who trades in unethical? My suspicion is that most people would
material, non-public information - not necessarily a say I have not. While knowing how much I could
corporate insider. sell the chest for in the city is in the interest of the
farmer, I am not morally obligated to reveal it. I am
not morally obligated to tell those who deal with me
I. Ethical arguments against insider trading everything that it would be in their interest to know.
U.S. common law supports this intuition. Legally,
Fairness people are obligated not to lie or to misrepresent a
product they are selling or buying. But they are not
Probably the most common reason given for think- required to reveal everything it is in the other party's
ing that insider trading is unethical is that it is interest to know) l One might argue that this is
"unfair." For proponents of the fairness argument, simply an area in which the law falls short of ethical
the key feature of insider trading is the disparity of standards. But there is substantial ethical support for
information between the two parties to the transac- the law on these matters as well. There does seem to
tion. Trading should take place on a "level playing be a real difference between lying or misrepresenta-
field," they argue, and disparities in information tilt tion on the one hand, and simple failure to disclose
the field toward one player and away from the other. information on the other, even though the line
There are two versions of the fairness argument: the between the two is sometimes hard to draw) z Lying
first argues that insider trading is unfair because the and misrepresentation are forms of deception, and
two parties do not have equal information; the deception is a subde form of coercion. When I
second argues that insider trading is unfair because successfully deceive someone, I cause him to do
the two parties do not have equal access to informa- something that does not represent his true will -
tion. Let us look at the two versions one at a time. something he did not intend to do and would not
According to the equal information argument, have done if he had known the truth. Simply not
insider trading is unfair because one party to the revealing information (usually) does not involve this
transaction lacks information the other party has, kind of coercion.
and is thus at a disadvantage. Although this is a very In general, it is only when I owe a duty to the
 What is Really Unethical About Insider Trading? 173

other party that I am legally required reveal all party or (2) the other party had demanded or been
information that is in his interest. In such a situation, led to expect disclosure. We shall return to this point
the other party believes that I am looking out for his below.
interests, and I deceive him if I do not do so. Failure There is a second ethical reason for not requiring
to disclose is deceptive in this instance because of the all people with informational advantages to disclose
relationship of trust and dependence between the them to others: there may be relevant differences
parties. But this suggests that trading on inside between the parties to the transaction that make the
information is wrong, not because it violates a disparity of information "fair." Perhaps I invested
general notion of fairness, but because a breach of considerable time, effort and money in learning
fiduciary duty is involved. Cases of insider trading in about antiques. If this is true, I might deserve to reap
which no fiduciary duty of this kind is breached the benefits of these efforts. We frequently think it is
would not be unethical. fair for people to benefit from informational advan-
Significantly, the Supreme Court has taken pre- tages of their own making; this is an important
cisely this position: insider trading is wrong because, justification for patent law and the protection of
and when, it involves the violation of a fiduciary trade secrets. "Fairness" is often defined as "treating
duty to the other parties to the transaction) 3 The equals equally." But equals in what respect? Unless
Court has consistently refused to recognize the we know that the two parties to a transaction are
general duty to all investors that is argued for by equal in the relevant way, it is difficult to say that an
proponents of the fairness argument. This is particu- informational advantage held by one of them is
larly clear in Chiarella v. US, a decision overturning "unfair."
the conviction of a financial printer for trading on My point here is different from the frequently
inside information: heard claim that people should be allowed to profit
from informational advantages because this results in
At common law, misrepresentation made for the purpose a more efficient use of information. This latter
of inducing reliance upon the false statement is fraudu- claim, while important, does not really address the
lent. But one who fails to disclose material information fairness issue. What I am arguing is that the notion
prior to the consummation of a transaction commits of fairness offered by proponents of the equal infor-
fraud only when he is under a duty to do so. And the duty to mation argument is itself incomplete. We cannot
disclose arises when one party has information "that the make the notion of fairness work for us unless we
other party is entitled to know because of a fiduciary or
supply guiddines explaining who are to count as
other similar relation of trust and confidence between
"equals" in different contexts. If we try, we are likely
them."... The element required to make silence fraudu-
lent - a duty to disclose - is absent in this case. . . . to end up with results that seem intuitively unfair.
We cannot affirm petitioner's conviction without For these reasons, the "equal information" version
recognizing a general duty between all participants in of the fairness argument seems to me to fail. How-
market transactions to forgo actions based on material, ever, it could be argued that insider trading is unfair
nonpublic information. Formulation of such a broad because the insider has information that is not
duty, which departs radically from the established accessible to the ordinary investor. For proponents of
doctrine that duty arises from a specific relationship this second type of fairness argument, it is not the
between two parties.., should not be undertaken absent insider's information advantage that counts, but the
some explicit evidence of congressional intent.... ~¢ fact that this advantage is "unerodable," one that
cannot be overcome by the hard work and ingenuity
The court reiterated that "there is no general duty to of the ordinary investor. No matter how hard the
disclose before trading on material nonpublic infor- latter works, he is unable to acquire non-public
mation" in Dirks v. SEC. :s It is worth noting that if information, because this information is protected
this reasoning is correct, the legal and ethical status by law. 16
of insider trading depends on the understanding This type of fairness argument seems more prom-
between the fiduciary and the party he represents. ising, since it allows people to profit from informa-
Insider trading would not be a violation of fiduciary tional advantages of their own making, but not from
duty, and thus would not be unethical, unless (1) it advantages that are built into the system. Proponents
were clearly contrary to the interests of the other of this "equal access" argument would probably find
174 .Jennifer Moore

my deal with the Vermont farmer unobjectionable, clusively that no fairness argument against insider
because information about antiques is not in prin- trading can be constructed. But they do suggest that
ciple unavailable to the farmer. The problem with a good deal more spadework is necessary to con-
the argument is that the notion of "equal access" is struct one. Proponents of the fairness argument need
not very clear. What does it mean for two people to to show how the informational advantages of insider
have equal access to information? traders over ordinary investors are different in kind
Suppose my pipes are leaking and I call a plumber from the informational advantages of plumbers over
to fix them. He charges me for the job, and benefits the rest of us - or, alternatively, why the informa-
by the informational advantage he has over me. Most tional advantages of plumbers are unfair. I have not
of us would not find this transaction unethical. True, yet seen such an argument, and I suspect that
I don't have "equal access" to the information needed designing one may require a significant overhaul of
to fix my pipes in any real sense, but I could have our traditional ideas about fairness. As it stands, the
had this information had I chosen to become a effectiveness of the fairness argument seems restricted
plumber. The disparity of information in this case is to situations in which the insider trader owes a duty
simply something that is built into the fact that to the person with whom he is trading - and as we
people choose to specialize in different areas. But will see below, even here it is not conclusive because
just as I could have chosen to become a plumber, I much depends on how that duty is defined.
could have chosen to become a corporate insider The most interesting thing about the fairness
with access to legally protected information. Access argument is not that it provides a compelling reason
to information seems to be a relative, not an abso- to outlaw insider trading, but that it leads to issues
lute, matter. As Judge Frank Easterbrook puts it: we cannot settle on the basis of an abstract concept
of fairness alone. The claim that parties to a transac-
People do not have or lack "access" in some absolute tion should have equal information, or equal access
sense. There are, instead, different costs of obtaining to information, inevitably raises questions about how
information. An outsider's costs are high; he might have informational advantages are (or should be) acquired,
to purchase the information from the firm. Managers and when people are entitled to use them for profit.
have lower costs (the amount of salary foregone);brokers Again, this understanding of the limits of the fairness
have relatively low costs (the value of the ume they spent argument is reflected in common law. If insider
investigating). . . . The different costs of access are simply trading is wrong primarily because it is unfair, then
a function of the division of labor. A manager (or a it should be wrong no matter who engages in it. It
physician) always knows more than a shareholder (or should make no difference whether I am a corporate
patient) in some respects, but unless there is something
insider, a financial printer, or a litde old lady who
unethical about the division of labor, the difference is not
u n f a i r . 17
heard a takeover rumor on the Hudson River Line.
But it does make a difference to the courts. I think
this is because the crucial questions concerning
One might argue that I have easier access to a insider trading are not about fairness, but about how
plumber's information than I do to an insider inside information is acquired and what entides
trader's, since there are lots of plumbers from whom people to make use of it. These are questions central
I can buy the information I seek. TM The fact that to our second class of arguments against insider
insiders have a strong incentive to keep their infor- trading, those based on the notion of property rights
mation to themselves is a serious objection to insider in information.
trading. B u t if insider trading were made legal,
insiders could profit not only from trading on their
information, but also on selling it to willing buyers.
Proponents of the practice argue that a brisk market
Property rights in information
in information would soon develop - indeed, it
might be argued that such a market already exists, As economists and legal scholars have recognized,
though in illegal and clandestine form. 19 information is a valuable thing, and it is possible to
The objections offered above do not show con- view it as a type of property. We already treat certain
 What is Really Unethical About Insider Trading? 175

types of information as property: trade secrets, uses inside information does not deprive the com-
inventions, and so on - and protect them by law. pa W of the use of the information. But he does
Proponents of the property rights argument claim deprive the company of the sole use of the informa-
that material, non-public information is also a kind tion, which is itself an asset. The insider trader
of property, and that insider trading is wrong "misappropriates," as the laws puts it, information
because it involves a violation of property rights. that belongs to the company and uses it in a way in
If inside information is a kind of property, whose which it was not intended - for personal profit. It is
property is it? How does information come to not surprising that this "misappropriation theory"
belong to one person rather than another? This is a has begun to take hold in the courts, and has become
very complex question, because information differs one of the predominant rationales in prosecuting
in many ways from other, more tangible sorts of insider trading cases. In U.S.v. Newman, a case
property. But one influential argument is that infor- involving investment bankers and securities traders,
mation belongs to the people who discover, originate for example, the court stated:
or "create" it. As Bill Shaw put it in a recent article,
"the originator of the information (the individual or In US v. Ckiarelta, ChiefJustice Burger... said that the
the corporation that spent hard-earned bucks pro- defendant "misappropriated" - stole to put it bluntly -
valuable nonpublic information entrusted to him in the
ducing it) owns and controls this asset just as it does
utmost confidence."That characterizationaptly describes
other proprietary goods." 2o Thus if a firm agrees to a
the conduct of the connivers in the instant case. . . . By
deal, invents a new product, or discovers new natural sullying the reputations of [their] employers as safe
resources, it has a property right in that information repositories of client confidences, appellee and his
and is entitled to exclusive use of it for its own cohorts defrauded those employers as surely as if they
profit. took their money.23
It is important to note that it is the firm itself
(and/or its shareholders), and not the individual The misappropriation theory also played a major
employees of the firm, who have property rights in role in the prosecution of R. Foster Winans, a Wall
the information. To be sure, it is always certain Street Journal reporter who traded on and leaked to
individuals in the firm who put together the deal, others the contents of his "Heard in the Street"
invent the product, or discover the resources. But column.24
they are able to do this only because they are backed This theory is quite persuasive, as far as it goes.
by the power and authority of the firm. The em- But it is not enough to show that insider trading is
ployees of the firm - managers, officers, directors - always unethical or that it should be illegal. If insider
are not entitled to the information any more than information is really the property of the firm that
they are entitled to corporate trade secrets or patents produces it, then using that property is wrong only
on products that they develop for the firm. 21 It is the when theft'tin prohibits it. If the firm does not prohibit
firm that makes it possible to create the information insider trading, it seems perfectly acceptable.2-~Most
and that makes the information valuable once it has companies do in fact forbid insider trading. But it is
been created. As Victor Brudney puts it, not clear whether they do so because they don't want
their employees using corporate property for profit
The insiders have acquired the information at the or simply because it is illegal. Proponents of insider
expense of the enterprise, and for the purpose of trading point out that most corporations did not
conducting the business for the collectivegood of all the prohibit insider trading until recendy, when it
stockholders, entirely apart from personal benefits from became a prime concern of enforcement agencies.2c'
trading in its [Link] is no reason for them to be If insider trading is primarily a problem of
entitled to trade for their own benefit on the basis of such property rights in information, it might be argued,
information. . . . 22 then it is immoral, and should be illegal, only when
the company withholds permission to trade on
If this analysis is correct, then it suggests that inside information. Under the property rights theory,
insider trading is wrong because it is a form of theft. insider trading becomes a matter of contract between
It is not exactly like theft, because the person who the company, its shareholders and its employees. If
176 Jennifer Moore

the employment contract forbids an employee from Harm

using the company's information, then it is unethical
(and illegal) to do so. There are two principal harm-based arguments
A crucial factor here would be the shareholders' against insider trading. The first claims that the
agreement to allow insider information. Shareholders practice is harmful to ordinary investors who engage
may not wish to allow trading on inside information in trades with insiders; the second claims that insider
because they may wish the employees of the com- trading erodes investors' confidence in the market,
pa W to be devoted simply to advancing shareholder causing them to pull out of the market and harming
interests. We will return to this point below. But if the market as a whole. I will address the two argu-
shareholders did allow it, it would seem to be ments in turn.
permissible. Still others argue that shareholders Although proponents of insider trading often
would not need to "agree" in any way other than to refer to it as a "victimless crime," implying that no
be told this information when they were bwing the one is harmed by it, it is not difficult to think of
stock. If they did not want to hold stock in a examples of transactions with insiders in which
company whose employees were permitted to trade ordinary investors are made worse off. Suppose I
in inside information, they would not b W that stock. have placed an order with my broker to sdl my
Hence they could be said to have "agreed." shares in Megalith Co., currently trading at $50 a
Manne and other proponents of insider trading share, at $60 or above. An insider knows that
have suggested a number of reasons why "share- Behemoth Inc. is going to announce a tender offer
holders would voluntarily enter into contractual for Megalith shares in two days, and has begun to
arrangements with insiders giving them property buy large amounts of stock in anticipation of the
rights in valuable information. "27 Their principal gains. Because of his market activity, Megalith stock
argument is that permitting insider trading would rises to $65 a share and my order is triggered. If he
serve as an incentive to create more information - had refrained from trading, the price would have
put together more deals, invent more new products, risen steeply two days later, and I would have been
or make more discoveries. Such an incentive, they able to sell my shares for $80. Because the insider
argue, would create more profit for shareholders in traded, I failed to realize the gains that I otherwise
the long run. Assigning employees the right to trade would have made.
on inside information could take the place of more But there are other examples of transactions in
traditional (and expensive) elements in the employee's which ordinary investors benefit from insider trad-
compensation package. Rather than giving out end ing. Suppose I tell my broker to sell my shares in
of the year bonuses, for example, firms could allow Acme Corp., currently trading at $45, if the price
employees to put together their own bonuses by drops to $40 or lower. An insider knows of an
cashing in on inside information, thus saving the enormous class action suit to be brought against
company money. In addition, proponents argue, Acme in two days. He sells his shares, lowering the
insider trading would improve the efficiency of the price to $38 and triggering my sale. When the suit is
market. We will return to these claims below. made public two clays later, the share price plunges
If inside information really is a form of corporate to $~5. If the insider had abstained from trading, I
property, firms may assign employees the right to would have lost far more than I did. Here, the
trade on it if they choose to do so. The only reason insider has protected me from loss.
for not permitting firms to allow employees to trade Not all investors buy or sell through such "trig-
on their information would be that doing so causes ger" orders. Many of them make their decisions by
harm to other investors or to society at large. watching the movement of the stock. The rise in
Although our society values property rights very share price might have indicated to an owner of
highly, they are not absolute. We do not hesitate to Megalith that a merger was imminent, and she
restrict property rights if their exercise causes signifi- might have held on to her shares for this reason.
cant harm to others. The permissibility of insider Similarly, the downward movement of Acme stock
trading, then, ultimately seems to depend on whether caused by the insider might have suggested to an
the practice is harmful. owner that it was time to sell. Proponents of insider
 What is Really Unethical About Insider Trading? 177

trading argue that large trades by insiders move the for leaving the control of inside information up to
price of shares closer to their "real" value, that is, the individual corporations.
value that reflects all the relevant information about The second harm-based argument claims that
the stock. This makes the market more efficient and permitting insider trading would cause ordinary
'provides a valuable service to all investors. 28 investors to lose confidence in the market and cease
The truth about an ordinary investor's gains and to invest there, thus harming the market as a whole.
losses from trading with insiders seems to be not that As former SEC Chairman John Shad puts it, "if
insider trading is never harmful, but that it is not people get the impression that they're playing
systematically or consistently harmful. Insider trad- against a marked deck, they're simply not going to
ing is not a "victimless crime," as its proponents be willing to invest." 30 Since capital markets play a
claim, but it is often difficult to tell exactly who the crucial role in allocating resources in our economy,
victims are and to what extent they have been this objection is a very serious one.
victimized. The stipulation of the law to "disclose or The weakness of the argument is that it turns
abstain" from trading makes determining victims almost exclusively on the feelings or perceptions of
even more complex. While some investors are ordinary investors, and does not address the question
harmed by the insider's trade, to others the insider's of whether these perceptions are justified. If per-
actions make no difference at all; what harms them mitring insider trading really does harm ordinary
is simply not having complete information about the investors, then this "loss of confidence" argument
stock in question. Forbidding insider trading will not becomes a compelling reason for outlawing insider
prevent these harms. Investors who neither buy nor trading. But if, as many claim, the practice does not
sell, or who buy or sell for reasons independent of harm ordinary investors, then the sensible course of
share price, fall into this category. action is to educate the investors, not to outlaw
Permitting insider trading would undoubtedly insider trading. It is irrational to cater to the feelings
make the securities market riskier for ordinary of ordinary investors if those feelings are not justi-
investors. Even proponents of the practice seem to fied. We ought not to outlaw perfectly permissible
agree with this claim. But if insider trading were actions just because some people feel (unjustifiably)
permitted openly, they argue, investors would com- disadvantaged by them. More research is needed to
pensate for the extra riskiness by demanding a determine the actual impact of insider trading on the
discount in share price: ordinary investor.31

In modern finance theory, shareholders are seen as

investors seeking a return proportionate with that degree II. Is there anything wrong with insider
of systematic or market-related risk which they have trading?
chosen to incur. . . . [The individual investor] is "pro-
tected" by the price established by the market mecha- My contention has been that the principal ethical
nism, not by his personal bargaining power or position. arguments against insider trading do not, by them-
• . . To return to the gambling analogy, if I know you are selves, suffice to show that the practice is unethical
using percentage dice, I won't play without an appro- and should be illegal. The strongest arguments are
priate adjustment of the odds; the game is, after all, those that turn on the notion of a fiduciary duty to
voluntary.>
act in the interest of shareholders, or on the idea of
inside information as company "property." But in
If insider trading were permitted, in short, we could both arguments, the impermissibility of insider trad-
expect a general drop in share prices, but no net ing depends on a contractual understanding among
harm to investors would result. Moreover, improved the company, its shareholders and its employees. In
efficiency would result in a bigger pie for everyone. both cases, a modification of this understanding
These are empirical claims, and I am not equipped to could change the moral status of insider trading.
determine if they are true. If they are, however, they Does this mean that there is nothing wrong with
would defuse one of the most important objections insider trading? No. If insider trading is unethical, it
to insider trading, and provide a powerful argument is so in the context of the relationship among the firm,
178 Jennifer Moore

its shareholders and its employees. It is possible to inventions, creative deals, and efficient new manage-
change this context in a way that makes the practice ment practices, thus increasing the profits, strength,
permissible. But should the context be changed? I and overall competitiveness of the firm. Manne goes
will argue that it should not. Because it threatens the so far as to argue that permission to trade on insider
fiduciary relationship that is central to business information is the only appropriate way to compen-
management, I believe, permitting insider trading is sate entrepreneurial activity, and warns: "[I]f no way
in the interest neither of the firm, its shareholders, to reward the entrepreneur within a corporation
nor society at large. exists, he will tend to disappear from the corporate
Fiduciary relationships are relationships of trust scene."33 The entrepreneur makes an invaluable
and dependence in which one party acts in the contribution to the firm and its shareholders, and his
interest of another. They appear in many contexts, disappearance would no doubt cause serious harm.
but are absolutely essential to conducting business in If permitting insider trading is to work in the way
a complex society. Fiduciary relationships allow proponents suggest, however, there must be a direct
parties with different resources, skills and informa- and consistent link between the profits reaped by
tion to cooperate in productive activity. Shareholders insider traders and the performance that benefits the
who wish to invest in a business, for example, but firm. It is not at all clear that this is the case -
who cannot or do not wish to run it themselves, hire indeed, there is evidence that the opposite is true.
others to manage it for them. Managers, directors, There appear to be many ways to profit from inside
and to some extent, other employees, become fidu- information that do not benefit the firm at all. I
ciaries for the firms they manage and for the share- mention four possibilities below. Two of these (2
holders of those firms. and 3) are simply ways in which insider traders can
The fiduciary relationship is one of moral and profit without benefiting the firm, suggesting that
legal obligation. Fiduciaries, that is, are bound to act permitting insider trading is a poor incentive for
in the interests of those who depend on them even if performance and fails firmly to link the interests of
these interests do not coincide with their own. managers, directors and employees to those of the
Typically, however, fiduciary relationships are con- corporation as a whole. The others (1 and 4) are
structed as far as possible so that the interests of the actually harmful to the corporation, setting up
fiduciaries and the parties for whom they act do conflicts of interest and actively undermining the
coincide. Where the interests of the two parties fiduciary relationship. 34
compete or conflict, the fiduciary relationship is (1) Proponents of insider trading tend to speak as
threatened. In corporations, the attempt to discour- if all information were positive. "Information," in the
age divergences of interest is exemplified in rules proponents' lexicon, always concerns a creative new
against bribery, usurping corporate opportunities, deal, a new, efficient way of conducting business, or
and so forth. In the past few years, an entire disci- a new product. If this were true, allowing trades on
pline, "agency theory," has developed to deal with inside information might provide an incentive to
such questions. Agency theorists seek ways to align work ever harder for the good of the company. But
the interests of agents or fiduciaries with the inter- information can also concern bad news - a large
ests of those on behalf of whom they act. lawsuit, an unsafe or poor quality product, or lower-
Significantly, proponents of insider trading do not than-expected performance. Such negative informa-
dispute the importance of the fiduciary relationship. tion can be just as valuable to the insider trader as
Rather, they argue that permitting insider trading positive information. If the freedom to trade on
would increase the likelihood that employees will act positive information encourages acts that are bene-
in the interest of shareholders and their firms. 32 We ficial to the firm, then by the same reasoning the
have already touched on the main argument for this freedom to trade on negative information would
claim. Manne and others contend that assigning encourage harmful acts. At the very least, permitting
employees the right to trade on inside information employees to profit from harms to the company
would provide a powerful incentive for creative and decreases the incentive to avoid such harms. Permis-
entrepreneurial activity. It would encourage new sion to trade on negative inside information gives
 What is Really UnethicaIAbout Insider Trading? 179

rise to inevitable conflicts of interest. Proponents of traders can reap large profits. Insider profits come
insider trading have not satisfactorily answered this from dramatic changes, from "news" - not from
objection. 35 steady, long-term performance. If the firm and its
(2) Proponents of insider trading also assume shareholders have a genuine interest in such per-
that the easiest way to profit on inside information is formance, then permitting insider trading creates a
to "create" it. But it is not at all clear that this is true. conflict of interest for insiders. The ability to trade
Putting together a deal, inventing a new product, on inside information is also likely to influence the
and other productive activities that add value to the types of information officers announce to the public,
firm usually require a significant investment of time and the timing of such announcements, making it
and energy. For the well-placed employee, it would less likely that the information and its timing is
be far easier to start a rumor that the company has a optimal for the firm. And the problems of false or
new product or is about to announce a deal than to negative information remain. 3G
sit down and produce either one - and it would be If the arguments given above are correct, permit-
just as profitable for the employee. If permitting ring insider trading does not increase the likelihood
insider trading provides an incentive for the produc- that insiders will act in the interest of the firm and
tive "creation" of information, it seems to provide its shareholders. In some cases, it actually causes
an even greater incentive for the non-productive conflicts of interest, undermining the fiduciary rela-
"invention" of information, or stock manipulation. tionship essential to managing the corporation. This
The invention of information is in the interest claim, in turn, gives corporations good reason to
neither of the firm nor of society at large. prohibit the practice. But insider trading remains
(3) Even if negative or false information did not primarily a private matter among corporations,
pose problems, the incentive argument for insider shareholders, and employees. It is appropriate to ask
trading overlooks the difficulties posed by "free why, given this fact about insider trading, the
riders" - those who do not actually contribute to the practice should be illegal. If it is primarily corporate
creation of the information, but who are neverthe- and shareholder interests that are threatened by
less aware of it and can profit by trading on it. It is a insider trading, why not let corporations themselves
commonplace of economic theory that if persons bear the burden of enforcement? Why involve the
can benefit from a good without paying for it, they SEC? There are two possible reasons for continuing
will generally do so. If there is no way to exclude to support laws against insider trading. The first is
those who do not "pay" from enjoying a benefit, no that even if they wish to prohibit insider trading,
one will have an incentive to pay for it, there will be individual corporations do not have the resources to
no incentive to produce it, and the good will not be do so effectively. The second is that society itself has
supplied. In the case of insider trading, an employee's a stake in the fiduciary relationship.
contribution to the creation of positive information Proponents of insider trading frequendy point out
constitutes the "payment." Unless those who do not that until 1961, when the SEC began to prosecute
contribute can be excluded from trading on it, there insider traders, few firms took steps to prevent the
will be no incentive to produce the desired informa- practice. 37 They argue that this fact indicates that
tion; it will not get created at all. insider trading is not truly harmful to corporations;
(4) Finally, allowing trading on inside informa- if it were, corporations would have prohibited it
tion would tend to deflect employees' attention from long ago. But there is another plausible reason for
the day-to-day business of running the company and corporations' failure to oudaw insider trading: they
focus it on major changes, positive or negative, that did not have the resources to do so, and did not wish
lead to large insider trading profits. This might not to waste resources in the attempt to achieve an
be true if one could profit by inside information impossible task. 38 There is strong evidence that the
about the day-to-day efficiency of the operation, a second explanation is the correct one. Preventing
continuous tradition of product quality, or a consis- insider trading requires continuous and extensive
tently lean operating budget. But these things do not monitoring of transactions and the ability to compel
generate the kind of information on which insider disclosure, and privately imposed penalties do not
180 Jennifer Moore

seem sufficient to discourage insider trading. 39 The challenged in recent years, this has been primarily by
SEC is not hampered by these limitations. Moreover, people who argue that the fiduciary concept should
suggests Frank Easterbrook, if even a few companies be widened to include other "stakeholders" in the
allow insider trading, this could make it difficult for firm. 41 I have heard no one argue that the notion of
other companies to prohibit it. Firms that did not managers' fiduciary duties should be eliminated
permit insider trading would find themselves at a entirely, and that managers should begin working
competitive disadvantage, at the mercy of "free primarily for themselves.
riders" who announce to the public that they pro-
hibit insider trading but incur none of the enforce-
ment costs. 4° Oudawing the practice might be worth Ill. C o n c l u s i o n
doing simply because it enables corporations to do
what is in all of their interests anyway - prohibit I have argued that the real reason for prohibiting
trading on inside information. insider trading is that it erodes the fiduciary relation-
Finally, the claim that the fiduciary relationship is ship that lies at the heart of our business organiza-
purely a "private" matter is misleading. The erosion tions. The more frequently heard moral arguments
of fiduciary duty caused by permitting insider trad- based on fairness, property rights in information, and
ing has social costs as well as costs to the corporation harm to ordinary investors, are not compelling. Of
and its shareholders. We have already noted a few of these, the fairness arguments seem to me the least
these. Frequent incidents of stock manipulation persuasive. The claim that a trader must reveal
would cause a serious crisis in the market, reducing everything that it is in the interest of another party
both its stability and efficiency. An increase in the to know, seems to hold up only when the other is
circulation of false information would cause a someone to whom he owes a fiduciary duty. But this
general decline in the reliability of information and a is not really a "fairness" argument at all Similarly,
corresponding decrease in investor trust. This would the "misappropriation" theory is only persuasive if
make the market less, not more efficient (as propo- we can offer reasons for corporations not to assign
nents of the practice claim). Deflecting interests the right to trade on inside information to their
away from the task of day-to-day management and employees. I have found these in the fact that
toward the manipulation of information could also permitting insider trading threatens the fiduciary
have serious negative social consequences. American relationship. I do believe that lifting the ban against
business has already sustained much criticism for its insider trading would cause harms to shareholders,
failure to keep its mind on producing goods and corporations, and society at large. But again, these
services, and for its pursuit of "paper profits." harms stem primarily from the cracks in the fidu-
The notion of the fiduciary duty owed by man- ciary relationship caused by permitting insider trad-
agers and other employees to the firm and its ing, rather than from actual trades with insiders.
shareholders has a long and venerable history in our Violation of fiduciary duty, in short, is at the center
society. Nearly all of our important activities require of insider trading offenses, and it is with good reason
some sort of cooperation, trust, or reliance on others, that the Supreme Court has kept the fiduciary
and the ability of one person to act in the interest of relationship at the forefront of its deliberations on
another - as a fiduciary - is central to this coopera- insider trading.
tion. The role of managers as fiduciaries for firms
and shareholders is grounded in the property rights
of shareholders. They are the owners of the firm, and Notes
bear the residual risks, and hence have a right to
have it managed in their interest. The fiduciary I See, for example, Douglas Frantz, Levine & Co. (Avon
relationship also contributes to efficiency, since it Books, NY, 1987).
encourages those who are willing to take risks to 2 This is certainly true of former SEC chair John Shad, one
place their resources in the hands of those who have of the leaders of the crusade against insider trading, who
the expertise to maximize their usefulness. While recently donated millions of dollars to Harvard University to
this "shareholder theory" of the firm has often been establish a program in business ethics. Also see Felix Rohatyn
 What is Really Unethical About Insider Trading? 181

of the investment banking house Lazard Fr~res: " . . . [A] example to the one above, involving a violin expert who
cancer has been spreading in our industry . . . . Too much buys a Stradivarius (worth $50 000) in a second-hand instru-
money is coming together with too many young people who ment shop for only $100.
have little or no institutional memory, or sense of tradition, 12 It seems clear that sometimes failure to disclose can be a
and who are under enormous economic pressure to perform form of misrepresentation. Such could be the case, for
in the glare of Hollywood-like publicity. The combination example, when the seller makes a true statement about a
makes for speculative excesses at best, illegality at worst. product but fails to reveal a later change in circumstances
Insider trading is only one result." The New York Review of which makes the earlier statement false. Or if a buyer
Books, March 12, 1987. indicates that he has a false impression of the product, and
3 An important exception is Lawson, 'The Ethics of Insider the seller fails to correct the impression. A plausible argu-
Trading', 11 Harvard Journal of Law and Public Policy 727 ment against insider trading would be that failure to reveal
(1988). the information to the other party to the transaction allows a
Henry Manne, for example, whose book Insider Trading false impression of this kind to continue, and thus consti-
and the Stock Market stimulated the modern controversy over tutes a form of deception. It is not clear to me, however, that
insider trading, has nothing but contempt for ethical argu- insider trading is a situation of this kind.
ments. See Insider Trading and the Law Professors,23 Vanderbilt J3 An important question is whether trades involving the
Law Review 549 (1969): "Morals, someone once said, are a violation of another kind of fiduciary duty, constitute a
private luxury. Carried into the area of serious debate on violation of 10b-5. I address this second type of violation
public policy, moral arguments are frequently either a sham below.
or a refuge for the intellectually bankrupt." Or see Jonathan 14 Chiarella v. US, 445 U.S. 222, at 227-8; 232-233. Italics
[Link], Ethics, Economics and Insider Trading: Ayn Rand Meets mine.
the Theory of the Firm, 11 Harvard Journal of Law and Public 1~ 445 US at 233. Italics mine.
Policy 787 (1988): "[I]n my view the attempt to critique 16 The equal access argument is perhaps best stated by
insider trading using ethical philosophy - divorced from Victor Brudney in his influential article, 'Insiders, Outsiders
economic analysis - is something of a non-starter, because and Informational Advantages Under the Federal Securities
ethical theory does not have much to add to the work that Laws', 93 HarvardLaw Review 322.
has already been done by economists." 17 Easterbrook, Insider Trading, Secret Agents, Evidentiary
s In re Cad),,Roberts, 40 SEC 907 (1961). Privileges, and the Production of Information, 1981 Supreme
On tippees, see Dirks v. SEC, 463 US 646 (1983) at 659; on Court Review 350.
'temporary insiders', see Dirks v. SEC, 103 S. Ct. 3255 (1983) 18 Robert Frederick brought this point to my attention.
at 3261 n. 14, and SECv. Musella 578 F. Supp. 425. iv Manne, Insider Trading and the Stock Market (Free Press,
7 See Materia v. SEC, 725 F. 2d 197, involving a financial New York, 1966), p. 75.
printer and the Winans case, involving the author of the 20 Bill Shaw, 'Should Insider Trading Be Outside The Law',
Wall StreetJournal's 'Heard on the Street' column, Carpenterv. Business and Society Review 66, p. 34. See also Macey, 'From
US, 56 LW 4007; U.S.v. l/Vinans, 612 F. Supp. 827. It should Fairness to Contract: The New Direction of the Rules
be noted that the Supreme Court has not wholeheartedly Against Insider Trading', 13 Hofitra Law Review 9 (1984).
endorsed these further extensions of the rule against insider 21 Easterbrook points out the striking similarity between
trading. insider trading cases and cases involving trade secrets, and
8 See Kaplan, 'Wolfv. Weinstein: Another Chapter on Insider cites Perrin v. US, 444 US 37 (1979), in which the court held
Trading', 1963 Supreme Court Review 273. For numerous that it was a federal crime to sell confidential corporate
other references, see Brudney, 'Insiders, Outsiders and information.
Informational Advantages Under the Federal Securities 22 Brudney, 'Insiders, Outsiders, and Informational Advan-
Laws', 93 HarvardLaw Review 339, n. 63. tages', 344.
9 See Mitchell v. Texas Gulf Sulphur Co., 446 F. 2d. 90 23 U.S. v. Newman, 664 F. 2d 17.
(1968) at 101; SEC v. Great American Industries, 407 F. 2d. 453 24 U.S.v. Winans, 612 F. Supp. 827. The Supreme Court
(1968) at 462; Birdman v. Electro-Catheter Corp., 352 F. Supp. upheld Winans' conviction, but was evenly split on the
1271 (1973) at 1274. misappropriation theory. As a consequence, the Supreme
10 Saul Levmore, 'Securities and Secrets: Insider Trading Court has still not truly endorsed the theory, although
and the Law of Contracts', 68 VirginiaLaw Review 117. several lower court decisions have been based on it. Carpenter
11 See Anthony Kronman, 'Mistake, Disclosure, Informa- v. US, 56 LW 4007.
tion, and the Law of Contracts', 7 Journal of Legal Studies 1 25 Unless there is some other reason for forbidding it, such
(1978). The Restatement (Second) of Torts ~ 551(2)e (Tent. as that it harms others. See p. 176 first column below.
Draft No. 11, 1965) gives an example which is very similar -~0 Easterbrook, 'Insider Trading As An Agency Problem',
182 Jennifer Moore

Principals and Agents: The Structure of Business (Harvard glosses over it by claiming that bad news is not as likely as
University Press, Cambridge, MA, 1985). good news to be provide large gains for insider traders.
27 Carlton and Fischel, 'The Regulation of Insider Trading', Insider Trading and the Stock Market, p. 102.
35 Stanford Law Review 857. See also Manne, Insider Trading 36 There are ways to avoid many of these objections. For
and the Stock Market. example, Manne has suggested "isolating" non-contributors
2~ Manne, Insider Trading and the Stock Market; Carlton and so that they cannot trade on the information produced by
Fischel, 'The Regulation of Insider Trading'. others. Companies could also forbid trading on "negative"
29 Kenneth Scott, 'Insider Trading: Rule 10b-5, Disclosure information. The problem is that these piecemeal restric-
and Corporate Privacy', 9Journal ofLegal Studies 808. tions seem very costly - more costly than simply prohibiting
3o 'Disputes Arise Over Value of Laws on Insider Trading', insider trading as we do now. In addition, each restriction
The Wall StreetJournal, November 17, 1986, p. 28. brings us farther and farther away from what proponents of
31 One area that needs more attention is the impact of the practice actually want: unrestricted insider trading.
insider trading on the markets (and ordinary investors) of 37 Frank Easterbrook, 'Insider Trading as an Agency
countries that permit the practice. Proponents of insider Problem.'
trading are fond of pointing out that insider trading has been 38 Ibid.
legal in many overseas markets for years, without the dire 39 Penalties did not begin to become sufficient to discour-
effects predicted by opponents of the practice. Proponents age insider trading until the passage of the Insider Trading
reply that these markets are not as fair or efficient as U.S. Sanctions Act in 1984. Some argue that they are still not
markets, or that they do not play as important a role in the sufficient, and that that is a good reason for abandoning the
allocation of capital. effort entirely.
32 See Frank Easterbrook, 'Insider Trading as an Agency 40 Easterbrook, 'Insider Trading as an Agency Problem.'
Problem'. I speak here as if the interests of the firm and its 4~ See Freeman and Gilbert, CorporateStrategy and the Search
shareholders are identical, even though this is sometimes not for Ethics (Prentice-Hall, Englewood Cliffs, NJ, 1988).
the case.
33 Manne, Insider Trading and the Stock Market, p. 129. Department of Philosophy,
34 For a more detailed discussion of the ineffectiveness of College of Arts and Sciences,
permitting insider trading as an incentive, see Roy Schot- University of Delaware,
land, 'Unsafe at any Price: A Reply to Manne, Insider Trading
Newark, DE 19716,
and the Stock Market', 53 VirginiaLaw Review 1425.
35 Manne is aware of the "bad news" objection, but he
U.S.A.