Internalizing Outsider Trading

Abstract

The law takes a laissez faire approach toward the efforts of most investors in the securities markets to obtain an information advantage and trade based on this advantage. Indeed, the misappropriation theory of insider trading liability has the effect of assigning trading rights in the securities of a firm (the "traded firm") to the source of material, non-public information. When the source of the information is outside the traded firm?say, a stock analyst or an industry rival?trading on such information is clearly legal if the source consents. The outside trader, however, is often not well placed to decide whether such trading is socially beneficial, internalizing most of the benefits of such trading but not most of its costs. Coasean bargaining is not likely to solve the problem because the traded firm (whose shareholders' predominantly bear the costs of such trading) faces large transaction costs of identifying and bargaining with the undefined and potentially replenishing class of such outside traders. Our thesis is that it is more efficient to allow the traded firm to control whether particular types of informed trading takes place. Under our proposed regime, firms would have the right to impose ex ante restrictions against outsider trading on their stock on the basis of material, non-public information. Reassigning to the traded firm the right to control whether informed outsider trading occurs gives the initial trading decision to a party that internalizes much more of the costs of such trading and therefore is more likely to filter out socially inefficient trades. Reassigning the outsider trading right is also more likely to facilitate Coasean bargaining, because it is easier for potential outside traders to identify the traded firm than it is for the traded firm to identify the potential outside traders. Finally, reassigning the outsider trading right to the traded firm is more consistent with property-rights based notions of just deserts. The outside trader may have a Lockean ownership right in the deliberately acquired non-public information, but such ownership does not necessarily entitle her to trade on another firm's stock. The Lockean creators of the traded firm in initially issuing its stock should also have a right to put outside traders on notice that trading on the basis of non-public information is prohibited (or restricted in pre-specified ways).