The Ethics of Insider Trading

Author(s): Patricia H. Werhane

Source: Journal of Business Ethics, Vol. 8, No. 11 (Nov., 1989), pp. 841-845
Published by: Springer
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The Ethics of Insider Trading Patricia H. Werhane

ABSTRACT. Despite the fact that a number of economists sider Yet a number of economists and
trading.
and philosophers of late defend insider trading both as a
philosophers of late defend this kind of activity both
viable and useful practice in a free market and as not as a viable a as
practice in free market and
and useful
immoral, I shall question the value of insider trading both a that is not
immoral. In response to these
practice
from a moral and an economic of view. I shall
point argue defenses I want to
question the value of insider
that insider trading both in its present illegal form and as a amoral and an economic
trading both from point of
market mechanism undermines the efficient and
legalized view. I shall argue that insider trading both in its
proper functioning of a free market, thereby bringing into as a market me
its own raison d'etre. It does so and is present illegal form and legalized
question economically
chanism violates the privacy of concerned parties,
inefficient for the very reason that it is immoral. Thus this
cannot be either from an economic or a destroys competition, and undermines the efficient
practice justified
moral point of view. and proper functioning of a free market, thereby
into question its own raison d'etre. It does
bringing
so and therefore is inefficient for the
economically
Insider
trading
is the reverse of
speculation.
It is reward very reason that it is immoral.
without ? and injury done to That insider trading as an illegal activity interferes
risk, wealth generated
? an unfair . . . with the free market is pretty obvious. It is like a
others in information
by advantage [T]he
core
principle is clear: no one should profit from game where there are a number of players each of
not to
represents a constituency. In this sort of game
of information available whom
exploitation important
the public.1 there are two sets of rules ? one ostensive set and
another, implicit set, functioning for some of the
Insider in the stock market is characterized
trading In this some of the are
as the or of shares of stock on the basis players. analogy implicit rules
buying selling outlawed, the to them
known to the trader or to a few yet big players manage keep
of information only
of insider trading it is com operative and actually often in control of the game.
persons. In discussions But not all the players know all the rules being
monly assumed that the privileged information, if
or at least are most
known to others, would affect their actions in the played they ignorant of the
ones, ones that determine the wins
as well, in not be important big
market although theory this need and big losses. So not all the players realize what
the case. The present guidelines of the Securities and
rules actually manipulate the outcome. Moreover,
most forms of in
Exchange Commission prohibit some of the most
partly because important func
rules are some who do know
tioning illegal, players
the implicit rules and could participate do not. Thus
Patricia H. Werhane isWirtenberger Professor of Philosophy at
not everyone in a to do so
one position plays the trading
Loyola University of Chicago. She is of thefounding same
game the way. The game, then, like the mani
members of the Societyfor Business Ethics. Her publications
include Philosophical Issues in Art, Ethical Issues in pulated market that is the outcome, is unfair ?
unfair to some of the players and those they repre
Business, coeditedwith Tom Donaldson, Persons, Rights and
sent ? unfair not some of the
Corporations, Philosophical Issues in Human Rights, only because players
editedwith D. Ozar andA. R. Gini. She is currentlyworking on are not to the most
privy important rules, but also
a book onAdam Smith. because these "special" rules are illegal so that
they

Journal ofBusiness Ethics 8: 841-845,1989.

? 1989Kluwer Academic Publishers.Printed in theNetherlands.

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 842 Patricia H. Werhane

are a few of even the mation before it becomes are on

adopted only by privileged public, trading
not on certainties, since they are trad
players. probabilities,
But suppose that insider was decriminal before the takes are
trading ing activity actually place. They
ized or not prohibited by SEC one a and if they are wrong the market
regulations. Then, taking gamble,
insider would not be unfair itself will It is even
might argue, trading "punish" them. argued that
because anyone could engage in itwithout impunity. brokers who do not use inside information for their

Although one would be trading on privileged clients' are their clients.

advantage cheating
knowledge, others, too, could trade on their privi Finally, and
more
importandy, economists like

leged information. The market would function more Henry Manne argue that insider is beneficial
trading
efficiently since the best-informed and those most to outsiders. Whether it is more beneficial than its
able to gain information would be allowed to exer absence is a question Manne admits he cannot
cise their fiscal answer. But Manne
capabilities. The market itself would defends insider trading because,
the excesses of insider I use he argues, it reduces the factor of chance in trading
regulate alleged trading.
the term excesses because to this both for insiders and outsiders. When shares are
"alleged" according
line of reasoning, if the market is
functioning prop traded on information or
probabilities rather than on
or losses are created as a result rumor or whim, reflects more accurately
erly, whatever gains the market
of open competition are a natural outcome of that the actual economic status of that company or set of
are not excesses at all, and even
competition. They companies. Because of insider trading, stock prices

tually the market will adjust the so-called unfair go up or down according to real, factual informa

gains of speculators. tion. Outsiders benefit from this because stock prices
There are several other defenses of insider trading. more
closely represent the worth of their company
First, insider
information, e.g., information about a than shares not affected by insider Insider
trading.
new stock issue, layoffs, etc., then, the fairness of the
merger, acquisition, trading, actually improves
information known to a few, should be and market, to this argument, in
only according by reflecting
remain private. That information is the property of stock prices the fiscal realities of affected corpora
those engaged in the activity in question, and they tions all traders of the stocks.2
thereby benefitting
should have the right to regulate its dissemination. These for insider are persua
arguments trading
Second and conversely, even under ideal circum sive. Because outsiders are not harmed
allegedly
stances it is impossible either to disseminate infor from privileged information not available to them
mation to all interested parties equally and fairly, or and may indeed benefit from insider trading, and

alternately,
to
preserve absolute secrecy.
For exam because the market punishes rash speculators, insider
in a new stock or on a stock cannot be criticized as In fact, it
ple, issuing deciding trading exploitation.
a number of in the transaction from makes the market more efficient. as these
split, parties Strong
brokers to printers learn about that information in arguments are, however, there is something amiss
advance just because of their participation in
making with these claims. The error, I think, rests at least in
this activity a reality. And there are always share part with the faulty view of how free markets work,
holders and other interested parties who claim they a view which stems from a that
misinterpretation
did not receive of such an activity or did
information derives from a of Adam Smith and
misreading
not receive it at the same time as other shareholders a of Smith's notions of self
specifically misreading
even when the information was disseminated to interest and the Invisible Hand.

everyone at the same time. Thus it is, at best, The is this. It is sometimes
misinterpretation
difficult to stop insider trading or to judge whether a assumed that an unregulated free market, driven by
certain kind of knowledge is "inside" or competition and self interest, will function auto
privileged.
This is not a good reason to defend insider trading as nomously. The idea is that the free market works

economically
or
morally desirable, but it illustrates like the law of gravity ? autonomously
something
the difficulties of defining and controlling the phe and anonymously in what Iwould call a no-blooded
nomenon. fashion. The interrelationships created by free mar
Third, those who become to inside infor ket activities based on self-interested are
privy competition
mation, even if they take advantage of that infor similar to the between the
gravitational relationships

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 The Ethics of InsiderTrading 843

sun: automatic interac with restrained self-interest restrained

planets and the impersonal, self-interest,
tions determined a number of factors including moral and in
by by reason, sentiments, sympathy,
the distance and competitive self-interest of each of Smith's case the reason, moral sentiments and sym
To operate otherwise,
the market components. The free market functions, pathies of British gentlemen.
then, despite the selfish of the that is, with unrestrained self-interest, where that
peculiarities players
as the circle the sun their best self-interest causes harm to others would "violate the
just planets despite
to do otherwise. Given that laws of justice"6 or be a "violation of fair play,"7
intentions picture of the
free market, so-called insider trading, driven by self to Smith. This interferes with free compe
according
interest but restrained by competitive forces, that is, tition just as government regulation would because
the invisible hand, is merely one me the character of competition, and thus the direction
gravitational
chanism ? a but not an oddity or an of the Invisible Hand, on the manner in
complication depends
aberration in the market. which actors or control their own self-inter
exploit
is a crude the ests. The Invisible Hand, then, that "masterminds"
This and
exaggerated picture of
market, but I think it accounts for talk about the the free market is not like an autonomous gravita
market as
it functioned in this yet tional force. It depends on the good will, decency,
if independent
forceful way, and it accounts for defenses of unres self-restraint, and fair play of those parties engaging
trained self-interested actions place. It
in the market in market activities.8 When self-interests get out of
allows one to defend insiderbecause of the hand, Smith contends, must be
trading they regulated by
positive market fall-out from this activity, and be laws of justice.9
cause the market will control the excesses Similarly, the current market, albeit not Smith's
allegedly
of self-interested economic activities. ideal of laissez-faire, is affected by how people
The difficulty with this analysis is not so much operate in the market It does not operate
place.
with the view of insider trading as a legitimate autonomously. Unrestrained activities of insider
of economic traders affect competition than Smithian
activity but rather with the picture differently
actors in a free market. Adam Smith himself, which are more or less
despite exchanges equal exchanges
his 17th century Newtonian did not between self-interested but restrained parties. The
background,
have such a mechanical view of a laissez-faire eco term "insider that some traders
trading" implies
and in the Wealth Nations know morethan others, that information affects
nomy. Again again of
Smith extols the virtues of unrestrained competition their decision-making and would similarly affect the
as to the of the producer and the trading behavior of others should they become privy
being advantage
consumer.3 A system of perfect he to that information. Because of this, the resulting
liberty argues,
creates a situation where market is different than one unaffected by insider
"[t]he whole of the advan
and disadvantages of the different in itself, is not a reason to
tages employ trading. This, good
ments of labour and stock ... be either insider trading. Henry Manne, for example,
perfecdy question
or to the role of insider trading in influencing
equal continually
tending equality."4 Yet for recognizes
Smith the greatest cause of inequalities of advantage the market and finds that, on balance, this is bene
is any restrictive policy or activity that deliberately ficial.
to certain kinds of businesses, Insider is not merely a
gives privileges trades, trading, however, compli
or The is that Smith sees cation in the free market mechanism. Insider trad
professions.5 point perfect
as the necessary it is or
liberty condition for competition, ing, whether legal illegal, affects negatively
but perfect competition occurs in the ideal of laissez-faire it
only both parties of any market, because
the exchange are on more or less on thwarts the very basis of the marker,
equal grounds, competition,
whether it be competition for labor, jobs, consumers, as "insider" rules affect the fairness of the trader
just
or is not to even if that activity is not even if one
capital. This imply that Smith favors illegal and
outcomes. not. But the in obtain inside information
equality of Clearly he does could, theory, oneself.
market is most efficient and most fair when there is This is because the same information, or
equal
between is not available to everyone. So com
competition equally matched parties. information,
Smith's thesis was that the Invisible which on the
Moreover, petition, depends availability of equal
Hand works because, and only when, operate all parties is precluded. Insider
people advantage by trading

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 844 Patricia H. Werhane

allows the insider to in and therefore are the X and Y*s

indulge greed (even though objects of Company
she may not) and that, by eschewing stock prices, secrecy. Second, insider on infor
trading privileged
works the very kind of market in which mation unfair to these traders. Even
against gives advantages
insider trading might be allowed to function. if outsiders benefit from insider are less
trading, they
If it is true, as Manne to benefit as much nor as soon as insider
argues, that insider trading likely
a more efficient stock market because traders for the very reason of their lack of proximity
produces
stock prices as a result of insider trading better to the can use information to
activity. Insider traders
the underlying economic conditions of those their advantage in the market, an
reflect advantage neither
companies involved in the trade, he would also have the management of X or Y nor other traders can
to argue that competition does not Even if the use of such information in the
always produce enjoy.
the best results in the marketplace. if market makes the market more efficient, this is
Conversely,
creates the most efficient market, in unfair since those without this infor
competition competition
sider trading cannot, because competition is "regu mation will not gain as much as those who have such
lated" by insiders. While it is not clear whether Even if insider does contribute to
knowledge. trading
outsiders benefit more from insider trading than market stabilization based on information, neverthe
without that activity, equal access to information less, one has also to justify the fact that insider
would allow (although not determine) every trader traders profit more on their than out
knowledge
to compete from an equal advantage. Thus pure siders, when their information becomes an
actuality
a the free market and in the Do
competition, supposed goal of simply by being "first" trading of the stock.
an aim of most persons who defend insider insider traders deserve this added profit because their
trading,
ismore creates a more
nearly obtained without insider trading. trading propitious market share
Insider
trading
has other ethical problems, Insider
knowledge
for outsiders? That is a difficult position
not to defend,
trading does protect the privacy of information because allowing insider trading also
it is supposed to protect. To illustrate, let us consider allows for the very Boeskyian that is damaging
greed
a case of a X and in any market.
friendly merger between Company
Company Y. Suppose this merger is in the Third, while X and Y on inside informa
planning trading
stages and is not to be made even to the tion may their share prices to the value most
public bring
shareholders for a number of months. There may closely their real price-earnings
reflecting ratio, this
be good or bad reasons for this secrecy, e.g., labor is not
always the case. Such
trading may reflect
undue optimism or about the
problems, price of shares of acquired company, pessimism possible
raiders, competi outcome of the merger, an event that has not yet
management changes, unfriendly
tion in certain markets, etc. law, management occurred. So the prices of X and Y may be over
By
and others privy to knowledge about the possible valued or undervalued on the basis of a
probability,
merger cannot trade shares of either company dur or, because insider traders seldom have all the facts,
on In these cases insider
ing the negotiating period. On the other hand, if that guesswork. trading deliber
information is "leaked" to a trader (or if she finds out ately
creates more risk in the market since the stock
some other then information that might or X and Y are for not alto
by means), prices manipulated
affect the merger is nowin the hands of persons not solid reasons. So market the end
gether efficiency,
part of the The of infor which insider is not guar
negotiation. alleged privacy allegedly justifies trading
mation, privacy insider anteed.
supposedly protected by
traders, is now in the hands of not disinterested What Henry
Manne's defenses of insider trading
this information a do show is what Adam Smith well that the
parties. While they may keep knew,
no to it in the first is neither nor
secret, they had right place. market independent self-regulatory.
Moreover, their possession of the information has What traders do in the market and how they behave
three possible negative effects. affects the direction and kind of restraint the market
First, they or their clients in fact may be interested will exert
on other traders. The character of the
to the merger, e.g., labor union leaders, stock market a
is product of those who operate within it,
parties
holders in competing etc., the very per asManne has demonstrated in his defense of insider
companies,
sons for whom the information makes a difference creates an
trading. Restrained self-interest approxi

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 The Ethics of InsiderTrading 845

mation of a and A. S. Skinner (Oxford University

self-regulatory market, because it is that Press, Oxford, 1976),
that allows self-interested individuals and companies I.x.c,II.v.8-12
4
to function as as Wealth Lxa. 1.
In the ofNations,
competitively possible. long 5
Wealth I.x.c.
run the market will operate more too, ofNations,
efficiently 6
IV.ix.51.
Wealth
because it precludes aberrations such as those exhi ofNations,
7
Adam Smith, The Theory ofMoral Sentiments, ?d. D. D.
bited by Ivan Boesky's and David Levine's behavior,
behavior that created market conditions favorable to Raphael and A. L. Macfie (Oxford University Press, Oxford,
1976),II.ii.2.1.
no one except themselves and their clients. 8 See Andrew
Skinner, A System of Social Science (Clarendon
Press, Oxford, 1979), especially pp. 237ff.
9
See, for example, TheWealth ofNations, II.ii.94, IV, v. 16.
Notes

1 Department ofPhilosophy,
Will, Your on Guiliani', Newsweek,
George 'Keep Eye
Loyola University ofChicago,
March 2,1987, p. 84. 820 N.
2 See Michigan Avenue,
Henry Manne, InsiderTrading and theStockMarket (The
Free Press, New York, 1966), especially Chapters X and XI. Chicago,
3 Adam USA.
Smith, The Wealth ofNations, ed. R. A. Campbell

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