Informed Trading and Its Regulation.

• Author: Fox, Merritt B.

1. INTRODUCTION II. INFORMED TRADING'S EFFECT ON LIQUIDITY AND SHARE PRICE ACCURACY A. Market Participants and Their Reasons for Trading 1. Informed Traders a. Fundamental Value Information b. Announcement Information c. Information from Inside an Issuer d. Information from Inside a Non-issuer Source 2. Uninformed Traders 3. Noise and Anti-noise Traders 4. Professional Liquidity Suppliers B. Trading Venues and Orders C. Informed Trading and the Economics of Liquidity Provision 1. The Liquidity Supply Business 2. Transacting with Informed Versus Uninformed Traders 3. The Liquidity Impact of an Anticipated Level of Informed Trading 4. The Pattern of Transaction Prices in the Presence of Informed Trading 5. Adding in the Effects of Noise Traders and Anti-Noise Traders III. THE EVALUATIVE FRAMEWORK A. Goals B. Market Attributes that Impact These Goals 1. Price Accuracy 2. Liquidity a. More Efficient Allocation of Resources over Time b. More Efficient Allocation of Risk c. Greater Share Price Accuracy IV. THE SOCIAL IMPACT OF DIFFERENT KINDS OF INFORMED TRADING A. Fundamental Value Informed Trading. 1. Wealth Effects: The Ex-Post Perspective Through an Example a. Informed Traders b. Liquidity Suppliers c. Uninformed Traders 2. Wealth and Resource Allocation Effects: The Ex-ante Perspective a. Fundamental Value Informed Traders b. Liquidity Suppliers c. Anti-noise Traders d. Uninformed Traders: Actual Costs and Their Ultimate Incidence e. Uninformed Traders: Illusory Losses and Gains 3. Fairness Analysis 4. Efficiency Considerations a. Positive Effects on Price Accuracy i. Trading Profits Create Incentives to Produce New Information ii. Price Accuracy is Improved Over a Longer Span of Time iii. Consequences for the Extent of Positive Impact on Economic Welfare b. Comparison of Benefits with Costs B. Announcement Information 1. Wealth Transfers and Fairness 2. Efficiency Considerations . C. Inside Information: The Issuer as Source 1. Wealth Transfers: Their Incentive and Fairness Effects a. Ex-post Perspective b. Ex-ante Perspective i. Issuer Insiders ii. Liquidity Suppliers and Anti-noise Traders iii. Uninformed Traders iv. Fundamental Value Informed and Anti-noise Traders 2. Efficiency Effects: Claimed Social Benefits a. Price Accuracy Effects i. Delaying Versus Accelerating Issuer Disclosure ii. The Unimportance of Delay or Acceleration b. Managerial Compensation i. Distorted Incentives to Choose Risk Over Expected Return ii. Inefficient Allocation of Risk iii. Poorly Focused Reward for Performance and Distorted Internal Communications 3. Efficiency Considerations: Social Losses 4. Overall Policy Conclusions a. Should Issuers be able to Consent to Insiders Trading? b. Insider Trading on Small Bits of Nonpublic Information c. Trading by Tippees d. Trading by an Issuer Possessing Material Information or by Persons to Whom It Gives the Information D. Inside Information: A Non-Issuer Source 1. Socially Desirable Trades 2. Socially Undesirable Trades V. LEGAL REGULATION: DETERRING UNDESIRABLE INFORMED TRADING AND ENCOURAGING DESIRABLE INFORMED TRADING A. Informed Trading Prohibitions 1. Section 10(b) and Rule 10b-5: History of Development of the Current Law a. The Early History of the Development of the Doctrine b. Chiarella and Its Aftermath i. The Classical Theory of Insider Trading ii. The Misappropriation and Structural Access Theories iii. Tipper and Tippee Liability for Information Coming from within the Issuer iv. Tipper and Tippee Liability for Information Coming from within an Institution Other than the Issuer v. Informed Trading by an Issuer 2. Section 10(b) and Rule 10b-5: Evaluation a. Fundamental Value Informed Trading b. Announcement Information c. Inside Information: The Issuer as Source d. Inside Information: A Non-issuer Source B. The Way Forward Under Rule 10b-5 1. Problems with the Existing Law Concerning Trading by Outsiders Based on Information Originating from within the Issuer of the Traded Shares a. Personal Benefit in the Form of a Gift b. Personal Benefit in the Form of a Quid Pro Quo c. An Alternative Approach to Outsiders Trading on Information Originating from Within the Issue d. The Substance of the Alternative Approach: The Insider Tipper and the Direct Tippee i. Trades Based on Tips Made for Personal Benefit Reasons ii. Trades Based on the Unauthorized Selective Disclosure of Information for Reasons Other than Personal Benefit iii. Trades Based on Authorized Selective Disclosure e. The Substance of the Alternative Approach: The Indirect Tippee f. Implementation g. Trading by Outsiders on the Basis of Non-public Information Originating within Non-issuer Institutions C. Use of the Martin Act Regulation to Stop Informed Trading 1. Practices Not Prohibited by Rule 10b-5. 2. The Successful Martin Act Campaign Against "Insider Trading 2.0." 3. Evaluation a. Possible Uses by Outsiders of the Information They Generate about Issuers b. Using Generated Information to make a Public Announcement c. Combining Providing the Information to Select Traders Privately with Subsequently Announcing It Publicly D. The Broad Scale Legislative Approach to Informed Trading Prohibitions 1. EU Market Abuse Directive a. Fundamental Value, Announcement, and Issuer Insider Informed Trading b. Tippers and Tippees with Regard to Information from within the Issuer c. Trades Based on Information Originating from within a Non-issuer Institution d. Summary 2. Insider Trading Prohibition Act a. Fundamental Value, Announcement, and Issuer Insider Informed Trading b. Tippers and Tippees with Regard to Information from within the Issuer c. Trades based on information originating from within a non-issuer institution 3. An Alternative Approach E. Mandatory Affirmative Disclosure 1. The Relationship of Mandatory Affirmative Disclosure to Informed Trading 2. Regulation FD 3. European Continuous Disclosure Regime F. Return of Insider Profits G. Market Structure Rules 1. Stock Exchange Announcement Rules 2. Market Connection Regulation VI. CONCLUSION I. INTRODUCTION

   Informed trading--trading on information or analysis not yet reflected in a stock's price--drives much of the stock market. (1) Such information enables a more accurate appraisal of a stock's value than what its current price implies. The trader may have obtained this information from astute analysis of publicly available information, from public information that has just been disclosed and is not yet reflected in a stock's price, or from confidential information possessed by the issuer of the stock or by another entity, such as a potential acquirer.

   No issue in securities law has garnered more attention from law and economics scholars and the larger public alike than insider trading, in which a trader transacts based on nonpublic information obtained from inside an issuer or another entity. (2) The legal literature has thought far less about how the other forms of informed trading should be regulated and how current law in fact affects them already. The ambition of this article is to advance thinking on both fronts. To that end, we argue that both types of insider trading (by insiders within and without an issuer) are better regulated as part of the more general phenomenon of informed trading, and that securities regulation could better promote social welfare if it was designed with an awareness of what all types of informed trading have in common and how they differ. (3)

   The basics of microstructure economics reveal that informed trading leads to more accurate share prices, (4) which in turn increase the efficiency with which the economy allocates goods and services. (5) However, informed trading also reduces market liquidity, (6) which makes trading costlier and leads to a variety of inefficiencies. (7) There is thus a fundamental tradeoff in how informed trading affects the two principal social functions served by equity markets--providing accurate prices and facilitating liquidity. This Article takes this basic tradeoff and uses the tools of microstructure economics, modern finance theory, and the theory of the firm to try to identify which forms of informed trade are in fact socially desirable, which are socially undesirable, and how to best regulate the market as a result. More specifically, we argue that given this difficult tradeoff, two key factors are crucial to determining the social utility of a trading practice--the strength of any incentives it provides for the generation of new information by traders and what one could call the "counterfactual latency" of that trading practice--the period of time between when given information would come to be incorporated into a stock's price with and without the given trading practice. The time horizon of the information on which an informed trade is based--the latency before it would otherwise be reflected in price--crucially determines both the strategies of those trading on it and the social value of such trading. Disaggregating traders and trading strategies in this way provides powerful new insights into how we can use regulation to deter socially undesirable forms of informed trading and promote socially desirable ones.

   Essentially, the welfare case is strongest for promoting trading strategies where the prospect of profit generally induces robust information gathering activity and when the content of that information would not otherwise become reflected in public stock prices for a considerable period of time without that trading strategy. The case for permitting a strategy is weakest when the information-gathering incentives are weak and the information incorporated in price by the trading strategy would have rapidly become incorporated anyway.

   The emphasis we place on counterfactual latency leads us to ask some questions that seem to have been neglected previously. For instance, what is the typical latency between when an insider transacts based on material nonpublic information and when that...