Insider abstention.

• Author: Fried, Jesse M.
• Position: Essay

1. INTRODUCTION

   For more than thirty years, supporters and critics of insider trading regulation have agreed on one thing--that insiders can beat the market simply by using nonpublic information to decide when not to trade. This shared belief has influenced scholarship on both sides of the insider trading debate. It has led certain proregulation commentators to argue that insider abstention is as unfair as insider trading and that, ideally, both should be restricted. Opponents of insider trading regulation, on the other hand, have cited insiders' unfettered ability to abstain on nonpublic information to support one of their main claims--that any attempt to "level the playing field" between insiders and the public is bound to fail. This Essay explains why the conventional wisdom about insider abstention is wrong. It shows that when insiders cannot trade while in possession of nonpublic information, their ability to abstain based on such information does not enable them to outperform public shareholders. The Essay also explains why insider abstention is much less likely than insider trading to distort managers' incentives, and might even improve them. The Essay concludes by describing the implications of its findings for a number of issues in insider trading regulation.

   Insider trading continues to attract a considerable amount of attention from economists, (1) legal academics, (2) the media, (3) and government agencies (4) around the world. Although academics still debate the economic desirability of insider trading, the consensus among the American public, Congress, and the SEC is that insider trading is "unfair" and erodes investor confidence in the market. This consensus has given rise to a set of insider trading laws that attempts to preserve investor confidence in the market and level the playing field between insiders and public shareholders. (5)

   The primary mechanism for regulating insider trading is the duty to "disclose or abstain," which arises under Rule 10b-5 of the Securities Exchange Act of 1934. (6) Under the duty to disclose or abstain, a person in knowing possession (or "aware") of material nonpublic information must either disclose the information or abstain from trading when the other party to the transaction is entitled to know the information because of a fiduciary duty or other relationship of trust and confidence between them. (7)

   Although Rule 10b-5 prohibits insiders from trading while in possession of material nonpublic information, it does not prohibit them from using such information to abstain from trading. Thus, in certain cases Rule 10b-5 permits insiders to use material nonpublic information to their advantage. For example, a manager of ABC Corp. considering selling ABC shares on Monday afternoon learns, shortly before the planned sale, that there is undisclosed good news. That news, to be disclosed Tuesday, is likely to boost ABC's stock price. The manager abstains from selling the stock for $10 on Monday and instead sells on Wednesday, after the good news has boosted ABC's stock price to $12. A similarly situated public shareholder, ignorant of the impending good news announcement, sells his stock on Monday afternoon for only $10 per share, receiving $2 less per share than the manager.

   Because of this "abstention problem," many legal commentators--including both supporters and opponents of insider trading regulation--have concluded that even insiders unable to trade while aware of nonpublic information could still reap greater trading profits than public shareholders. This reasoning has led Henry Manne and other critics of insider trading regulation to argue that insiders' ability to abstain on nonpublic information makes regulating their use of nonpublic information essentially futile. (8) Those wishing to level the playing field between insiders and public shareholders share Manne's view that insider abstention gives insiders an advantage. For a number of these commentators, however, insider abstention is not an embarrassing gap that casts doubt on the entire enterprise of regulating insiders' use of private information, but rather is an undesirable loophole that can be closed, at least in certain circumstances. One commentator has discussed the possibility of either reading Rule 10b-5 expansively to ban insider abstention, or enacting a new statute targeted specifically at insider abstention. (9) In most cases it would be difficult to prove that an insider used nonpublic information to abstain from trading. Such evidence might be available, however, if the insider indicated, in writing or in conversation, an intent to buy or sell, and then subsequently did not trade after receiving nonpublic information indicating that the trade would be unfavorable. (10)

   The main purpose of this Essay is to show that the conventional view of insider abstention is incorrect. Using a simple model, I demonstrate that an insider unable to trade while in possession of nonpublic information cannot systematically earn higher trading profits than a similarly situated public shareholder by using nonpublic information to abstain from trading. As this Essay explains, insider abstention merely compensates the insider for his inability to trade while in possession of nonpublic information that indicates such a trade would be favorable. In fact, an insider prevented from both trading while in possession of nonpublic information and abstaining on such information would earn lower trading returns than a similarly situated public shareholder, all other things being equal.

   To be clear, I am not asserting that insiders are now prevented from trading while in possession of nonpublic information. Indeed, I have argued elsewhere that currently insiders are not always deterred from trading on "material" nonpublic information. (11) In addition, they are permitted to trade on various types of private information that are valuable but not considered legally "material." (12) Nor do I wish to argue here that insiders easily can be prevented from trading on nonpublic information. (13) Rather, my claim is that if insiders are unable to trade while aware of nonpublic information, their ability to abstain from trading on such information does not give them an advantage over public shareholders. In other words, parity between insiders and public shareholders can be achieved even if insiders remain completely free to engage in insider abstention. The Essay also briefly considers the effects of insider abstention on managers' incentives. While a complete study of these effects is beyond the scope of this Essay, a preliminary analysis suggests that insider abstention is much less likely than insider trading to distort managerial behavior, and might even improve managers' incentives.

   I then turn to examine two important policy implications of this analysis. The first implication relates to the longstanding "possession versus use" debate under Rule 10b-5. The SEC has ruled that a person trades in violation of Rule 10b-5 if he is in "knowing possession" (or "aware") of material nonpublic information when the trade is executed. Some commentators have argued that there should be no violation of Rule 10b-5 unless the insider "uses" the nonpublic information in deciding whether to trade. The analysis offered in this Essay shows that the SEC's "knowing possession" standard creates a more level playing field between insiders and outsiders than does the "use" standard. The second implication relates to the SEC's safe harbor from Rule 10b-5 liability for insiders executing trades according to prearranged trading plans. Using this Essay's findings, I explain why the SEC's safe harbor allows insiders to profit from material nonpublic information and how it could easily be modified to prohibit insiders from profiting from such information.

   Before proceeding, it is worth noting that there are various types of "insiders"--persons who receive nonpublic information bearing on the value of publicly traded securities: For example, there are "corporate insiders," the executives and directors of a firm who acquire nonpublic information about the firm through their positions in the corporation; "temporary insiders," the firm's lawyers, accountants, and bankers who acquire such information while providing services to the firm; and "tippees," persons who receive nonpublic information from other insiders. Although the examples and model in this Essay feature a corporate insider, the analysis of that insider's trading returns would apply to any person with nonpublic information about the value of a publicly traded firm's shares. Thus, any insider who is unable to trade while in possession of nonpublic information cannot expect to beat the market by abstaining on such information.

   The remainder of the Essay proceeds as follows. Part II describes the nature of insiders' informational advantage over public shareholders. It then explains how Rule 10b-5 reduces insiders' ability to exploit this advantage by prohibiting insiders from trading on material nonpublic information. Part III uses a simple model to examine the distributional effects of insiders' use of nonpublic information to abstain from trading, a use of inside information permitted by Rule 10b-5. The model demonstrates that an insider who is prevented from trading while in knowing possession of nonpublic information, but who is free to abstain from trading based on such information, cannot systematically beat the market. It also shows that an insider unable to trade or abstain while aware of nonpublic information will underperform the market. Part III ends by explaining why insider abstention is less likely than insider trading to distort managers' incentives. Part IV discusses the implications of the analysis in Part III for the longstanding "possession versus use" debate under Rule 10b-5 and the regulation of insider selling plans. Part V concludes.

2. INSIDERS' INFORMATIONAL...