Session 1 - Engelen c.s. - Insider trading

Question 1

Name the 3 different points of view regarding insider trading

Answer 1

1. Economic
2. Legal
3. Ethical

Question 2

Explain the economic point of view

Answer 2

From an economic point of view, inside information refers to ever situation in which some market participants are better informed than others about the relevant aspects of the valuation of a share of a certain company

Question 3

Explain the legal point of view

Answer 3

From a legal point of view, legal rules determine the threshold of admissible versus inadmissible use of asymmetric information

Question 4

Explain the ethical point of view

Answer 4

From an ethical point of view, acts which might be legally acceptable, might be unacceptable ethically

Question 5

What is special about insider trading from the 3 points of view

Answer 5

Not every case of insider trading from an economic point of view will be considered insider trading from a legal or ethical point of view

Question 6

Give the legal rules for insider trading from Europe

Answer 6

Europe directive, early 1990’s, updated with the Market Abuse Directive (2003), prohibits primary and secondary insiders to :

1. Use inside information in conducting a transaction
2. Disclose the inside information to a 3rd party
3. Recommend a transaction to a 3rd party

Question 7

Give the legal rules for insider trading from USA

Answer 7

US insider trading rules are governed by Securities Exchange Act (1934), plus US rulings. Insiders are only liable if they breach a fiduciary duty to the source of information

Question 8

Give 2 arguments in favour of insider trading

Answer 8

1. Market efficiency : Insider trading brings information into the open - the price of a stock will move closer to its fundamental value - market efficiency increases
2. Attract more creative managers

Question 9

Explain the utilitarian perspective of insider trading

Answer 9

Ethical acceptability is dependent on balancing the pros and cons of insider trading with respect to social utility. This mainly coincides with an economic analysis

Question 10

Give the pros based on the utilitarian perspective of insider trading

Answer 10

1. Contribution to market efficiency : prices become a more reliable criterion for the optimal allocation of scarce financial ressources at a fair price
2. An additional method for communicating information and an efficient replacement for public disclosure is created
3. Insider’s counterparts are better off than in a situation in which insiders do not use their privileged information
4. Banning insider trading could cause the stock markets to be less liquid
5. Small investors will benefit by the enhanced shareholder value creation because of equity-based compensation of management
6. Banning insider trading, market professionals will obtain benefits of the insider trading regulation, while imposing the cost on a large number of small investors

Question 11

Give an argument against insider trading based on the fairness perspective

Answer 11

Insider trading is unethical because it is simply unfair. It gives the outsiders an unfair comparative disadvantage that skews competition.

Question 12

Give the 2 version of the fairness argument

Answer 12

• Absolute equality version : focuses on the possession of information and pursues an absolute equality of markets participants. Every transaction in which there is asymmetric information becomes unethical
• Equal access view : Given that unequal possession is an advantage, which cannot be competed away since it depends upon a lawful privilege to which an outsider cannot acquire access, Brudney (1979) focuses on access to inside information

Question 13

What is the issue about this equal access view ?

Answer 13

It is unclear. Access to information is a function of the costs of obtaining informationThe resulting inequality of information is a result of the division of labor.

Question 14

Wherane (1991) rejects insider trading because it ignores 2 conditions necessary for fair competition. Give the 2

Answer 14

1. An efficient market where as much as possible complete information is available to everyone
2. The ideal of an equal comparative advantage between competitors

Question 15

Give an argument against insider trading based on the property rights perspective

Answer 15

Insider trading is wrong because it involves a violation of property rights and can be seen as a form of theft or misappropriation.

Question 16

Are property right violated? One has to determine

Answer 16

1. Who holds the property rights

2. What is the relationship between the trader and the owner

Question 17

Possession of a right means that a person controls at least 3-element bundle

Answer 17

1. The right to use a scare ressource
2. The right to exclude others from exercising this right of use without permission
3. The right to transfer control of the 3-element bundle

Question 18

Explain why property rights is a complex topic

Answer 18

Assigning property rights to those who created the information gives them the incentives to produce socially valuable information thus, social welfare is increased. The property right on inside information should be allocated to the party that values it most. The best legal rule is contractual

Question 19

Is there any issue between Insider trading and fiduciary relationships

Answer 19

Insider trading is not seen as threat to the fiduciary relation between shareholders and managers. Remuneration schemes, linking compensation to the creation of shareholders value, align the interest between shareholders and managers. Insider trading as a compensation scheme is not different than any other equity-based compensation schemes

Question 20

There are arguments against insider trading as a compensation scheme. Give 5 of them

Answer 20

1. Managers could trade on negative inside information
2. Managers would be focused on short-term stock price movements
3. Managers could create false information to induce stock price movements to capture profits
4. Managers would choose risky projects to increase volatility to increase profits
5. General meeting of shareholders would lose control over the amount of compensation of managers

Question 21

Zhang’s model (2001) suggests that insider trading is permitted so long as this brings benefit to shareholders. Give the 2 conditions necessary to operate properly

Answer 21

1. Insider is required to report his trading activity

2. Insider is prohibited from profiting by making short-term reversals of his trading position

Question 22

Explain the market morality perspective

Answer 22

Werhane (1989, 1991) tries to clarify the need for a basic market morality, carried by values like fairness in competition, or a form of self-interest that is restrained by reason as necessary conditions for a free market. Insider trading is connected to a “Boeskyian greed culture” that undermines market morality.