Insider Trading and Asymmetric Information

Some of us know more about some things than others, and we often exploit that advantage.

I know more about my driving habits than my auto insurance company. Borrowers know more about their repayment prospects than lenders. The seller of a car knows more about the condition of his car than the buyer. Members of a corporation's board of directors and officers know more about the profitability of the firm than shareholders.

These are just a few among thousands of examples of what economists call asymmetric information -- one side of a transaction knowing more than the other. Should actions taken, and advantages achieved, on the basis of asymmetric (insider) information be made illegal?

Here's a case in point. Martha Stewart, CEO of Martha Stewart Living Omnimedia Co., has been charged with obstructing an investigation into insider trading. She hasn't been charged with illegal insider trading, but she did sell 3,928 shares of stock in the biopharmaceutical company ImClone Systems, earning $228,000, the day before the FDA rejected approval of its anti-cancer drug Erbitux and its stock fell. The Justice Department alleges that she received an unlawful tip from her stockbroker.

U.S. Circuit Judge Richard Posner defines insider trading as: "the practice by which a manager or other insider uses material information not yet disclosed to other shareholders or the outside world to make profits by trading in the firm's stock." One might agree that an officer of a company has a fiduciary duty not to give outsiders confidential company information so they can profit (or avoid losses), but let's look at insider trading as a general phenomenon. What does it do or not do?

The instant the FDA rejected approval of Erbitux, the true asset value of ImClone Systems fell. While the insider might profit from selling on the heels of that knowledge, one thing for certain is that insider trading rapidly gets information to the equity market about ImClone's true value.

You might ask, "Is this fair?" Whether it's fair or not, it's the nature of markets that people benefit from specialized knowledge. I might know that there's oil on your land and you don't, and I buy it from you for a pittance and earn millions. Is that fair?

Take the Enron and WorldCom cases. Long before their collapse, there were insiders who knew about the accounting fraud and other management sharp practices that inflated the worth of the companies. Had just a few of Enron's and WorldCom's many insiders, who knew of these practices, sold their shares or gave out well-placed tips, shareholders would have learned much earlier about the true value of the companies and might have been better able to protect themselves.

What's referred to as "the market" is simply a collection of millions, perhaps billions, of independent decision-makers. No economist believes that markets are perfect, like heaven or a utopia. But the relevant comparisons are to the alternatives that we have on Earth. When there's market allocation, mistakes and shenanigans are detected and ruthlessly punished. After all, it wasn't the Securities and Exchange Commission, whose charter is to protect investors, who discovered Enron's and WorldCom's misdeeds, punished them by making their stock worthless and made heads roll. It was the market.

What happens when Congress cooks the books by concealing expenditures, uses sleight-of-hand with the Social Security account to boast of a balanced budget and tells us federal liabilities are $6 trillion when in fact they're really closer to $35 trillion? What happens when Congress exempts itself from any semblance of Generally Accepted Accounting Practices (GAAP), which it imposes on the business community? Absolutely nothing happens.

As for me, I'll take the profit-driven motives of market participants any day over the do-good-driven motives of government officials and their underlings.

Born in Philadelphia in 1936, Walter E. Williams holds a bachelor's degree in economics from California State University (1965) and a master's degree (1967) and doctorate (1972) in economics from the University of California at Los Angeles.

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