Abstract
This article presents a theoretical model of ethical behavior, insider trading, and insider non-trading. We argue that, with this framework, it is possible to identify the relative importance of different motives, namely “fear of punishment” and “ethical behavior,” for abiding by insider trading laws. Active insider trading behavior is a situation where a portfolio reallocation decision is modified as a result of material nonpublic information received about the stock; passive insider trading, in contrast, happens when a portfolio reallocation decision is canceled as a result of such information; lastly, pure ethical trading behavior is where a portfolio reallocation decision remains unchanged despite inside information received about the stock. Using a two-period model with a portfolio reallocation decision between periods, we find that the roles of law abidance and ethical behavior may only be distinguished in the presence of passive insider trading, while pure ethical trading is but a remote possibility. Appeals to ethics, used alone in an effort to increase compliance with insider trading laws, are therefore likely to be insufficient to fully deter such behavior. Lastly, we derive from our framework testable predictions as to the extent of passive insider trading, and the importance of ethics in curbing such behavior.
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