Economics Update (January-March 1998)

Debate Continues Over
the Harm of Insider Trading

I nsider trading has generated some of the most sensational scandals in the popular business press. In one of the most publicized cases, in the late 1980s, Michael Milken and Ivan Boesky were sentenced to stiff prison terms and payment of enormous damage assessments and punitive penalties.

But among economists and legal scholars, insider trading — trading of a firm's stock or derivatives assets by its officers, directors and other key employees on the basis of information not available to the public — remains controversial. In fact, many academic and legal studies question whether insider trading is even harmful, much less worthy of legal action. In an article in the Atlanta Fed's Economic Review (Fourth Quarter 1997), Jie Hu and Thomas H. Noe explore the sources of the insider trading controversy.

The authors point out that even though the Securities and Exchange Commission (SEC) was established in 1934, prosecution of insider trading was not very common until the second half of this century. Since 1961 insider trading regulations have become more restrictive through case interpretations, leading to regulatory amendments and new legislation.

But despite the SEC's efforts to curb it, evidence shows that insider trading is active and that its profits are high relative to average market returns. These higher profits for insiders may indicate that current rules are not serving their intended purpose.

Hu and Noe explain that the divergent opinions over whether insider trading is harmful stem primarily from disagreement over which effects of insider trading have the most significant impacts on economic well-being. The extensive legal and economic literature suggests that designing effective policy on insider trading requires a detailed assessment of the structure of the economy, some sensitivity to cultural attitudes toward the appropriateness of such trading activity and careful consideration of the enforcement costs associated with regulating trade.

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