Decision Theory and the Case for a Disclosure-Based Insider Trading Regime

Abstract

Stock trading on the basis of material, nonpublic information (insider trading) is a “mixed bag” in that it can create both social harms and social benefits. Attempts to regulate such mixed bag business practices may err in two directions: They may wrongly permit or encourage socially undesirable instances of the practice at issue, or they may wrongly condemn or deter socially desirable instances. In either case, social welfare suffers (i.e., “error costs” result). Attempts to avoid error in one direction or another by heightening the liability inquiry will tend to increase the administrative costs (“decision costs”) of the regulatory regime. Decision theory therefore calls for regulating mixed bag practices under a regime that “minimizes the sum of error and decision costs.” Adjudged under the decision-theoretic criterion, the current regime for regulating insider trading in the United States fails; it is difficult to administer, and it deters many instances of socially desirable informed trading. The approach apparently favored by the enforcement agencies fares even worse. The laissez-faire, “contractarian” approach favored by many law and economics scholars would represent an improvement over both the legal status quo and the approach favored by the enforcement agencies, but that approach, too, may be suboptimal.This paper advocates an optional, disclosure-based regulatory regime. Under the regime, authorized informed trading would be permitted as long as the trader first disclosed to a centralized, searchable database her insider status, the fact that she was trading on the basis of material, nonpublic in-formation, and the nature of her trade. Such an approach would (1) enhance the market efficiency benefits of insider trading by facilitating “trade decoding,” while (2) reducing potential costs stemming from deliberate mismanagement, disclosure delays, and infringement of informational property rights. By “accentuating the positive” and “eliminating the negative” consequences of informed trading, the proposed approach would perform better than the legal status quo and the leading proposed regulatory alternatives at minimizing the sum of error and decision costs resulting from insider trading restrictions.