Allow Insider Trading? Why Not Reduce Inside Information?

With the filing of the government's insider trading case against Galleon Management and diverse and sundry individuals, free market de-regulators have again piped up with time-worn arguments for legalizing insider trading. The essential premise of this thesis is that insider trading moves the market price of a company's stock toward the level at which it would trade if the inside information were publicly known. In this way, the information is "broadcast" through price movements in the stock, and buyers and sellers interact at "fairer" prices.

There are market problems with this proposition. Days or weeks can pass before the accumulated impact of the trades by knowledgeable players pushes prices to the level warranted by the undisclosed news. Along the way, a lot of trading at unfair prices could take place. Trades totaling hundreds of thousands or even millions of shares could be done at prices that favor insiders and disadvantage those left in the dark. Publicly announced news is widely known and produces almost instantaneous price movements. Public disclosure produces much fairer prices much faster, and everyone has the information needed to judge the fairness of the price.

In addition, insiders can have more than one reason for trading. A CEO may sell stock to cover a child's college expenses, or to build a vacation home. Sales don't necessarily mean something negative is happening at the company. Buying stock may indicate optimism about the company's future, or be a defensive measure against short sellers when the company's fortunes are known by the CEO to be dim. The mere fact of transactions, and the price movements they induce, may mislead instead of inform.

A little history is worth noting. Long before the SEC interpreted federal law to prohibit insider trading, state law prohibited it (see Strong v. Repide, 213 U.S. 419 (1909), a U.S. Supreme Court decision that interpreted state law to prohibit a corporate insider from taking advantage of nonpublic inside information in dealings with an uninformed shareholder). The state courts, before the SEC was created, were hesitant about applying this insider trading prohibition to anonymous trading on an exchange. However, it's likely that sooner or later an aggressive state official like, randomly speaking, the attorney general of New York, would convince state courts to enforce the prohibition in exchange-based trades, which today comprise the bulk of securities transactions. Realistically speaking, insider trading would probably be unlawful under state law if the SEC and U.S. Department of Justice ignored the issue.

Even the branch of federal insider trading law called "misappropriation" would probably be illegal under state law if it weren't part of federal law. Misappropriation refers, in essence, to trading by someone who isn't a corporate insider but has a fiduciary or contractual duty of confidentiality to refrain from trading on nonpublic information. The classic example of misappropriation comes up in the area of mergers and acquisitions. Let's say an activist shareholder decides to take a run at a company he believes to need the benefit of his activism. He hires an investment banker to provide advice and, potentially, financing for a takeover offer. The investment banker secretly buys the target company's stock through a foreign bank account in anticipation of the moment when the activist shareholder surfaces publicly (almost sure to be a market moving event). The banker's trades push up the price of the stock. The activist shareholder wants to prevent this kind of trading because it could increase the cost to the activist of purchasing stock, particularly in a potential takeover of the target company (since offers to purchase companies almost always come at a premium to the open market price of the stock). Activist shareholders typically expect and require their advisers and financiers to avoid trading in the stocks they target. If the federal government didn't enforce this obligation as misappropriation, state courts could easily enforce it as a breach of contract. Many millions and even billions of dollars are at stake, so activist shareholders and other potential acquirers of companies wouldn't let the problem rest. They'd enforce their contracts in state court if the SEC and DOJ weren't already on the beat.

Bashing the federal government for pursuing insider trading is misguided and an exercise in futility. But the Galleon case, with its many tentacles, reminds us that insider trading won't die as long as there is inside information. We know from recent experience how volatile the stock market can be. Inside information is about as close to a sure bet in stocks as is possible. That's why market players lust for it. Government enforcement provides some deterrence, but will never stamp it out entirely.

An intriguing and potentially more effective way to reduce insider trading is to speed up public disclosure of inside information. The less nonpublic information there is, the fewer the opportunities for insider trading and the fairer the day-to-day trading in the markets. Public companies today report their financial conditions quarterly and annually on SEC reports called 10-Q and 10-K. A few special events must be reported on SEC Form 8-K whenever they occur. But there is nothing like continuous disclosure. (Stock exchange rules do require listed companies to disclose all "material" developments, but the exchanges use these rules to require disclosure of developments only after funny trading is observed in the company's stock, and not to require immediate and continuous disclosure of all material developments.)

The quarterly and annual system of financial reporting was created in the 1930s and 1940s, when accountants used desk calculators (bulkier and heavier than many of today's laptops) to tally up companies' accounts. The sheer amount of time required to manually add, subtract, multiply and divide necessary to produce a company's financial statements made more frequent financial reporting difficult or impossible.

Today, electronic computing power abounds. Laptop computers can create hours of video. That's enough computing power to assemble a company's financial statements. Many companies calculate their operating results on a daily, weekly and/or monthly basis. Fast food and casual restaurant chains, and retailers are especially adept at this, since serving the fickle public is at the heart of their businesses and they need to monitor trends in product sales by the day. Since they use this information to manage their businesses, it must be pretty reliable. Why not put shareholders in the loop?

Companies generally make decisions about bad debts and other asset writedowns and writeoffs on a quarterly basis. But that's because the current system of reporting requires quarterly assessments. There's no intrinsic reason why these decisions cannot be made more frequently than once every three months. Debts go bad every day and recognition of uncollectability doesn't have to be delayed until the end of the quarter. Similarly, depreciation, depletion, and additions to or subtractions from reserve accounts are not intrinsically quarterly or annual determinations. They, too, can be made more often as relevant information permits.

Disclosure by public companies of at least some financial information could be made more frequently--monthly, weekly and even daily. Of course, the more frequent the disclosure, the more preliminary it's likely to be. But the current system of reporting already involves disclosure of preliminary information. The quarterly reports on Form 10-Q are preliminary as compared to the annual report on Form 10-K. A more continuous system of reporting would simply involve a greater degree of "preliminaryness." Just as investors have grown to understand the preliminary nature of quarterly reports, they can adjust to the preliminary nature of more frequent reporting.

Of course, financial reporting is a complex subject and any system of continuous reporting would have to be implemented over the course of enough time for both companies and investors to adjust. But there is nothing intrinsically impossible about it. Indeed, the SEC already requires continuous reporting of potential market moving information in another setting.

Shareholders controlling, individually or as part of a group, 5% or more of the outstanding shares of a public company are usually required to report their holdings on an SEC form called Schedule 13D. This schedule calls for the disclosure of a variety of information items, such as the identities of the shareholders in any group, any and all of their contracts, agreements, and understandings with respect to the stock, their plans, proposals and intentions with respect to the company (which most importantly include any intention of trying to take over the company), and their sources of financing. This is sensitive, market moving stuff, and 13D persons are required to promptly disclose in amendments to their filings any changes to these and other informational items. Promptly generally means no later than the next day--not quarterly, not annually.

Thus, the federal securities laws apply the concept of continuous reporting already, just not to public companies. 13D persons don't have to file financial statements, and public companies do, something that would make continuous reporting a much bigger undertaking for public companies. But lest we obsess over costs, and not benefits, consider a stock market with less insider trading, fewer missed analyst estimates, less stalking of companies by whisper numbers, fewer quarterly surprises for outsider shareholders, and fairer prices on a continuous basis. The current system of quarterly and annual reporting was the Glenn Miller era's response to the paucity of corporate reporting of even earlier times. We no longer use the manual typewriters and desk calculators of the 1930s and 1940s. There's no reason why we should keep using that era's financial reporting system.