INSIDER TRADING: AN ETHICAL ANALYSIS

Robert W. McGee
Fayetteville State University

Yeomin Yoon
Seton Hall University

Abstract

Insider trading has received a great deal of bad press in recent decades. Nearly
every article in the popular press that has been written about it views the practice
in a negative light. However, the economics and legal literature are mixed on the
issue. This article examines the economics and legal literature and applies
several sets of ethical principles with the goal of determining when insider
trading constitutes unethical conduct and when it should be prohibited. The
conclusion is that the key to determining when the practice should be prohibited
should not depend upon a utilitarian analysis because utilitarian approaches
cannot provide clear guidance. A better approach would be to determine whether
a fiduciary duty has been breached or whether rights have been violated.

I – Introduction

Insider trading has acquired a bad name over the last few decades.
There is a widespread perception that it is inherently unethical (Hetherington,
1967; Scheppele, 1993; Schotland, 1967; Werhane, 1989, 1991). Many people
believe it should be illegal, which it is sometimes, in some jurisdictions. The
Organisation for Economic Cooperation and Development (OECD, 2003, 2004)
has issued guidelines to regulate it, and the European Union requires new
entrants for admission to have rules restricting the practice.
Many scholars, but not all, are opposed to the practice. The reasons for
their opposition are varied, and usually include some version of fairness
(Levmore, 1982; Mendelson, 1969; Schotland, 1967; Werhane, 1989, 1991).
Some scholars use the level playing field argument to justify their position
(Werhane, 1989, 1991). Others merely begin with the premise that insider
trading is always bad, and must therefore be made illegal, or at least more
heavily regulated.
However, not all scholars take this approach. A few of them do not
begin with the premise that insider trading is always evil or undesirable. Some
of them have even concluded that the practice can be beneficial at times (Carlton
& Fischel, 1983; Easterbrook, 1981; Macey, 1988; Machan, 1996; Manne,
1966a, 1966b; McGee, 1988; Morgan, 1987; Padilla, 2002; Peress, 2010) and
that regulating or prohibiting insider trading can cause unfairness to increase
(Tighe & Michener, 1994).

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This paper reviews that literature and applies several sets of ethical
principles to determine when insider trading is definitely unethical, when it is
definitely ethical, and when the ethical nature of the practice cannot be
determined with a high degree of certainty.

II - ETHICAL APPROACHES
II-A- Utilitarian Ethics
One of the interesting features of ethical scholarship is that different
ethicists sometimes reach different conclusions even when they apply generally
accepted ethical principles. One reason for this failure to agree is because
different ethical systems have different ethical principles, and sometimes it is
possible to reach different conclusions, depending on which set of ethical
principles one chooses to apply.
One of the most widespread ethical systems is utilitarianism. The vast
majority of economists are basically utilitarians, at least most of the time. Many
policy makers, politicians, bureaucrats and lawyers also use utilitarian ethical
principles when making decisions. The United States Constitution and the
constitutions of other countries are partially utilitarian based. The General
Welfare Clause that appears in many constitutions is one example of the
application of utilitarian ethics, but it may not be the only one, depending on
which constitution is being examined.
Because of this widespread use and acceptance of utilitarian ethical
principles, any analysis of insider trading that does not include a discussion of
the utilitarian approach would be incomplete. However, there are some inherent
flaws and structural deficiencies in utilitarian ethics that cannot be ignored if one
is to conduct a thorough analysis of insider trading or any other ethical issue
from a utilitarian perspective. The next few paragraphs examine some of the
main deficiencies and criticisms of utilitarian ethics that have been made by
scholars over the centuries.
Classical utilitarians like Jeremy Bentham (1988) and John Stuart Mill
(1993) took the position that an act or policy is good if the result is the greatest
good for the greatest number. This approach seems plausible, at least on the
surface, since to argue otherwise would be to take the position that an act or
policy is good if the result is not the greatest good for the greatest number.
One subtle flaw in this position, which any mathematician would be
quick to point out, is that it is impossible to maximize more than one variable at
the same time (Hardin, 1968; von Neumann & Morgenstern, 1947). In other
words, one may choose a policy that results in benefiting the most people, or one
may choose a policy that results in the greatest overall good, but if one tries to
do both at the same time, one variable will not be maximized. Thus, a good
utilitarian analysis must abandon at least one of these goals.
Another variation of utilitarian ethics is the positive-sum game
approach. This approach and terminology are especially popular among
economists. According to this approach, an act or policy is good if the result is a
positive-sum game. In other words, there are more winners than losers.

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7072 Insider Trading: An Ethical Analysis

This approach also seems plausible on the surface, since any other
position would be less desirable. It would be an uphill battle to justify an act or
policy that results in a negative-sum game, wherein there are more losers than
winners.
However, if a certain policy benefits a small group very much, but only
at the expense of the vast majority, who lose only a little on a per capita basis,
the analysis becomes less clear. Protectionism is one example that might be
given. If some special interest group such as steel or textile producers go to the
legislature and convince them to pass some protectionist legislation that benefits
their group while causing the price of steel or clothing products to increase
slightly, it is difficult to determine whether the gains exceed the losses. If 30,000
jobs are saved in the textile industry as a result of some protectionist legislation,
both the textile industry and those 30,000 people who did not lose their jobs
benefit, but only at the added cost that consumers must pay for clothing items.
Is a protectionist piece of legislation ethical if saving 30,000 jobs
causes the price of a shirt to increase by $5? What if the number of jobs saved is
only 10,000, and the country that passes the protectionist trade bill has a
population of 300 million people, half of whom buy an average of three shirts a
year?
Economists have built models to estimate the gains and losses for
various protectionist trade policies. Some studies have determined that
protectionist trade policies result in deadweight losses, meaning that the total
losses exceed the total gains. One major problem inherent in any such analysis is
measurement. It is difficult, or even impossible, to measure all gains and losses.
Estimates must be made.
One inherent deficiency in any such analysis is the fact that not all
winners and losers can be identified. While it might be possible to identify the
winners as those who do not lose their jobs, and the losers as those who
consume the product that is being protected, there are many other groups and
individuals who are affected who are not as easy to identify.
If everyone has to pay $5 more for a shirt, that is $5 less they have to
spend on other products and services. All other industries are losers in a
protectionist scheme, since their sales are adversely affected. For every winner,
there are two losers. For example, if John has to pay $5 more for a shirt, Tim,
who sells books, makes one less book sale because John would have used that
$5 to purchase a book if he did not have to spend it on a shirt, so John and Tim
both lose, while only Jane, whose job was saved by the protectionist measure,
benefits. This kind of analysis is not new. Frederic Bastiat (1801-1850), a
French political economist, saw this relationship in the 1840s (Bastiat, 2007).
The point is that any utilitarian analysis must be incomplete because it
is impossible to identify all those who are affected by a particular act or policy.
That does not stop economists and others from trying, of course, but any
solution they arrive at must be discounted because they are working with
incomplete information.
Another inherent problem with any utilitarian analysis is that
interpersonal marginal utilities cannot be compared (Rothbard, 1970). It cannot

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be said that a dollar has less value to a millionaire than it does to a poor person.
If both use the dollar to buy a candy bar, they might have equal enjoyment from
consuming it. If it is the first candy bar the millionaire has eaten that day, he
might actually derive more benefit from eating it than would the poor man, who
has already had five candy bars that day. Also, because of the law of
diminishing marginal utility, the fifth candy bar consumed will be enjoyed less
than the fourth, etc. We cannot say that it will be enjoyer 14.3 percent less,
however, since utilities cannot be measured, they can only be ranked.
Another problem with any utilitarian analysis is that it ignores rights
violations (Frey, 1984; McGee, 1994; Rothbard, 1970). There are two ways to
look at this inherent deficiency. Some utilitarians would include rights violations
as a negative factor in the utilitarian calculus, and would conclude that a policy
or act may be ethical even if rights are violated, provided that good factors more
than outweigh the rights violations. Another group of utilitarians, including
Bentham (1988), would ignore rights violations entirely. Utilitarians would
agree with Shakespeare (2009) that “All’s well that ends well.”

II-B - Rights Theory

Rights theory can overcome some or all of the structural deficiencies
found in utilitarian ethics. According to rights theory, a policy or act is
automatically unethical if anyone’s rights are violated. The fact that the result
might be a positive-sum game is irrelevant.
Literature provides us with several examples to illustrate the point. In
The Brothers Karamazov, one of Dostoevsky’s (1952) characters asks whether
torturing and killing one small baby would be justified if the result would be
eternal happiness for everyone else either presently living or as yet unborn. A
utilitarian would be quick to justify the killing, since there are many winners and
only one loser. A believer in rights theory would disagree, arguing that the right
to life (as well as other rights) trumps the wishes of any majority.
Paulo Coelho (2007) provides a similar example in The Devil and Miss
Prym, where a small town that is in decline stands to receive enough gold to
solve their problems, provided they kill one old lady who is gravely ill and
almost at death’s door anyway.
A third example, attributed to Benjamin Franklin, cites the case of two
wolves and one sheep voting on what to have for lunch. The mere fact that the
two wolves stand to benefit by voting to have the sheep for lunch does not mean
that they have acquired the moral right to eat the sheep, regardless of the fact
that the process was arrived at democratically and that the majority benefit.
Ethical principles are not decided by majority rule for a rights theorist, whereas
they may be for a utilitarian.

II-C – Virtue Ethics

Another popular approach to making ethical decisions is virtue ethics,
which basically holds that an act or policy is good if the result is human
flourishing (Crisp & Slote, 1997; Hursthouse, 2002; Russell, 2013). This
concept is not new. It can be traced back to Aristotle (2000).

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7074 Insider Trading: An Ethical Analysis

It is somewhat akin to utilitarianism, in that it tends to look at total

winners and losers. But it also has something in common with rights theory, in
that the violation of rights might be regarded as something that retards human
flourishing.
The next few pages apply these three ethical systems to an analysis of
insider trading in an attempt to determine whether, and under what
circumstances, insider trading might be considered ethical or unethical.

III – Insider Trading

If one applies utilitarian ethics to insider trading, the conclusion is that

insider trading is ethical if the gains exceed the losses, and unethical if the losses
exceed the gains. Stated differently, insider trading is ethical if the winners
exceed the losers, and unethical if the opposite is the case.
These two utilitarian approaches are not quite identical, however, since
there could be many losers who only lose a little, while a few winners gain a lot.
Before one can determine whether insider trading is ethical, it is necessary to
decide which subspecies of utilitarian ethics should be applied.
Even if one decides which utilitarian approach to use, there is still the
problem of measurement. It is impossible to compare interpersonal utilities
(Rothbard, 1970), and it is also impossible to precisely measure gains and
losses. That does not stop economists from trying, of course, and several studies
of gains and losses have been made over the years (Bhattacharya & Daouk,
2002; Finnerty, 1976; Givoli & Palmon, 1985; Herzel & Katz, 1987; Leland,
1992; Meulbroek, 1992; Peress, 2010).
The results are mixed, of course, as one might expect. Some studies
have concluded that insider trading results in deadweight losses, whereas other
studies have found net gains. At least one study has found that insider trading
can result in either welfare losses or welfare gains (Leland, 1992).
Henry Manne (1966a, 1966b) was the first person to analyze insider
trading in any depth. He concluded, a priori, that insider trading is ethical
because it causes markets to work more efficiently. It is a utilitarian argument.
One strain of utilitarian thought is that an act or policy is ethical if the result is
increased efficiency (Barnes & Stout, 1992; Cooter & Ulen, 1988; Engelen,
2005; Goetz, 1984; Harrison, 1995; Katz, 1998; Malloy, 1990; Mercuro &
Medema, 1997; Posner, 1983, 1998; Rozeff & Zaman, 1988). This view has not
been without its critics (Hoppe, 2007), but let’s take a look at Manne’s argument
before jumping to conclusions.
Manne’s basic argument is that inside traders cause a stock’s price to
move in the correct direction sooner than would be the case in the absence of
insider trading. For example, if a stock is overpriced and no one knows that it is
overpriced, it will continue to be overpriced, but if a few insiders know that it is
overpriced, they will sell, causing downward pressure on the price, which causes
the price to be pushed in the correct direction. Empirical studies have confirmed
Manne’s a priori conclusion (Aktas et al., 2008; Chakravarty & McConnell,
1997; Cornell & Siri, 1992; Meulbroek, 1992).

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Thus, inside traders serve a useful purpose because they cause prices to
move in the correct direction faster than would otherwise be the case. Since the
vast majority stand to benefit by more efficient markets, their act, which might
or might not be based on greed (greed is irrelevant for a utilitarian), benefits
society. If that is the case, then it is those who would prohibit insider trading
who are acting unethically, not those who engage in insider trading (Ma & Sun,
1998).
One might raise an objection that whoever bought the shares the
insiders sold were harmed because they were not aware that the stock was
overpriced. Manne would be quick to point out that they would have sold their
shares anyway, anonymously through a broker, and the fact that they purchased
the shares from an insider rather than from some other anonymous seller is
irrelevant and does not make them any worse off than they would have been
anyway.
A few scholars have criticized Manne’s approach (Hetherington, 1967;
Schotland, 1967), but their criticisms do not hold up to analysis.
The argument has been made that investors will have less confidence in
the market where insider trading is present. If that is the case, then it would be
logical to assume that the market would work less efficiently, leading one to
conclude that insider trading constitutes unethical conduct. However, the studies
cited above concluded that insider trading results in increased efficiency, thus
refuting the view that the presence of insider trading causes the market to
function less efficiently.
Bainbridge (2000) has argued that, if insider trading causes the market
to function more efficiently, then investor confidence should increase rather than
decrease. Engelen and Van Liedekerke (2007) also make this point. They also
state that no empirical studies have ever found that investor confidence
decreases where insider trading is present. They cite a study by Young (1985),
which found that the number of small investors in the stock market increased
during the 1980s, a time when insider trading cases were frequently in the news.

III-A - Fiduciary Duty

It is generally conceded that someone who breaches a fiduciary duty is
acting unethically. The argument has been made that those who engage in
insider trading are breaching a fiduciary duty, and that is sometimes the case,
but it is not always the case. Some inside traders have a fiduciary duty not to
trade and not to disclose any information, but others do not.
Those individuals who are working on an acquisition or merger, or who
are discussing whether their company should declare bankruptcy, have a duty
not to trade in the stock and not to disclose anything about the discussions or
negotiations that are going on. Their duty is to their shareholders. This fiduciary
duty also applies to the attorneys who might be involved on both sides of the
negotiation, as well as the printer who is hired to print the merger prospectus
(Chiarella, 1980; Bainbridge, 2012), but it does not apply to a vast range of
other individuals who might have come across inside information.

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7076 Insider Trading: An Ethical Analysis

Some market analysts and brokers acquire inside information during

the normal course of their business, either by reading between the lines when
they interview corporate executives or by crunching the numbers to determine
that something is going on that has not been disclosed. Eavesdroppers on
elevators and girlfriends of insiders (Martha Stewart comes to mind) are also
within the class of inside traders who are protected. It should be pointed out that
Martha Stewart did not go to jail for insider trading. She went to jail because she
lied to federal authorities.

III-B - The Level Playing Field Argument

The level playing field argument has the underlying premise that
everyone should start at the same place and should have an equal chance, at least
initially. It is a fairness argument. It sounds plausible on its face. Who can argue
against fairness? However, the argument falls apart upon closer analysis.
In nature, some species are faster than others. Some individuals are
smarter than others, which results in some high school students being accepted
to Harvard University while others are rejected. Some people are born rich while
others are born poor. Ugly women stand a lesser chance of being asked to dance
than pretty women. People who work hard tend to get ahead faster than people
who are lazy. There is nothing inherently unethical about these differences.
They are just facts of nature.
The level playing field argument is better applied to sporting events
than to insider trading. It would be unfair to force one football team to run uphill
for an entire game while the other team can run downhill. It would be unfair for
one basketball team to have a larger hoop than the other team. But there is
nothing inherently unfair about having opportunities to earn large sums of
money merely because one person has better information than another person,
especially if that information has been obtained without violating anyone’s
rights or violating a fiduciary duty.
Another flaw in the level playing field argument is that it is neither
possible nor desirable to have a level playing field in economics (Macey, 1988;
McGee, 2008). Banana farmers in Honduras have an inherent advantage over
banana farmers in Alaska or Siberia, and that is how it should be. In order to
create a level playing field in the banana industry it would be necessary either to
subsidize Siberian banana farmers or place high tariffs on bananas imported
from Honduras so that Siberian banana farmers could compete. Subsidies and
penalties are invariably negative-sum games, since there is a deadweight loss.
Such schemes also violate both property and contract rights, since consumers are
not free to enter into contracts with the banana farmers of their choice, and since
tariffs are a form of forcible redistribution, akin to a tax on consumers for the
benefit of a special interest group of producers.
In order to have a level playing field in information, it would be
necessary to force those who possess nonpublic information to release it to the
general public. If that information were legitimately acquired, then any attempt
to force the owners of the information to give it away would necessarily
constitute a violation of their property rights, which is inherently unethical.

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Levmore (1982), who argued for absolute equality of information in the

marketplace, failed to address the property rights issue, which causes his
argument for absolute equality of information to fail.
Another aspect of this issue is that, if individuals are forced to give
nonpublic information to the general public before being able to trade on it, they
would have little incentive to gather such information, since they could not
profit from it. Thus, less information would be gathered, causing markets to
operate less efficiently. A number of scholars have pointed out that there is
nothing inherently wrong with using asymmetric information for profit (Lawson,
1988; Macey, 1988; Machan, 1996; Moore, 1990). It might even be argued that
the market could not function without asymmetric information.

III-C - Applying Rights Theory

Applying rights theory would solve many of these problems, provided
that property rights were clearly defined. The problem with insider trading is
that property rights are not always clearly defined (Manne, 1985; Macey, 1988;
McGee, 2008).
Having a property right in information is much different than having a
property right in tangible property. If one owns a truck, there is clear title to the
truck. In a free society, individuals can do anything they want with their
property, provided that doing so does not violate the rights of anyone else. One
may drive a truck, but not into a group of pedestrians. One may rent or sell the
truck or drive it over a cliff, provided the owner of the property below the cliff
does not object.
Being in possession of inside information presents problems because
the same information can be owned by more than one individual. The person
who first acquires the information can sell it or give it away while still retaining
it. More than one person can use the information for profit. That is neither good
nor bad in and of itself, but it can complicate the issue.
Manne (1966a) has suggested that inside information can be another
kind of executive compensation. If an employer tells one if its vice presidents
that he or she can trade on that information, something of value is received, and
the corporation, in effect, transfers a property right in that information to
whoever receives it. Being able to trade on inside information can also have a
beneficial tax effect, since the gain may be deferred for years, and when finally
cashed in may result in capital gains, which are taxed at lower rates than
ordinary income. Thus, there are valid reasons for compensating executives by
allowing them to trade on inside information. Laws that prohibit such
transactions violate the rights of both the corporation and the executive.
Some scholars have taken the position that insider trading should not be
used as a form of executive compensation because it causes managers’ behavior
to change in undesirable ways, such as focusing on short-term profits or
engaging in unethical activities that cause stock prices to increase (Easterbrook,
1981; Moore, 1990; Scott, 1998). However, one might equally argue that stock
compensation plans have the same inherent dangers (Engelen, 2005).

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7078 Insider Trading: An Ethical Analysis

Problems can arise when a corporate executive trades on inside

information without the employer’s consent. Doing so might (or might not) be a
breach of fiduciary duty. Where such transactions are prohibited by the
corporation, it is a breach of the employment contract, which can be dealt with
just like any other breach of contract. Damages can be awarded, although it may
be difficult to calculate what the damages might be, especially if the corporation
benefits as a result of the insider trading. However, that should be a problem for
the parties involved, not the government.
If one applies virtue ethics to insider trading, the result depends on the
facts and circumstances. If the result if prohibiting insider trading is enhanced
human flourishing, the argument could be made that at least some forms of
insider trading should be prohibited. On the other hand, if insider trading has
some winners and no losers, which Manne suggests, then it should be permitted,
and anyone who prohibits it under such circumstances is acting unethically.
Rather than asking “Who is harmed by insider grading?” one might just
as easily ask, “Who is harmed by prohibitions on insider trading?” The obvious
victims of such prohibitions are the inside traders, of course, but there may also
be less obvious victims. If insider trading causes markets to operate more
efficiently, then the general public is harmed by prohibitions. In the case of
trading on inside information in connection with an acquisition or merger, the
corporation’s shareholders may also be harmed, since the deal they receive
would be less lucrative if insider trading were prohibited. In some cases, the
prohibition on insider trading may even thwart a takeover attempt, which almost
always harms shareholders (Bandow, 1988; Carlton & Fischel, 1983; Coffee, et
al., 1988; Jarell et al., 1988; Jensen, 1984; Johnson, 1986-1987; Manne, 1986;
Prychitko, 1987; Romano, 1987; Woodward, 1988).

IV – Concluding Comments

One problem with applying utilitarian ethics to the rule-making

process, in addition to those mentioned above, is that it is not always possible to
predict in advance whether a particular trade will be beneficial in the end.
Indeed, it is not always possible to determine whether a particular trade results
in a positive-sum game even after the fact.
That being the case, a flat prohibition on all insider trading is likely to
result in harm, since some inside trades are both beneficial and non-rights-
violating. In cases where rights are violated, the party whose rights are violated
can sue. Since justice can be done through the normal process and the use of
existing laws, it seems counterproductive to enact special laws to deal with
insider trading, since doing so places a chilling effect on what are often
legitimate transactions. If any laws need to be passed, they should be laws that
more clearly define the property rights in information, since this area is one that
is underdeveloped in the law.

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