Insider Trading and the Public Enforcement of Private Prohibitions: Some Complications in Enforcing Simple Rules for a Complex World

In an article forthcoming in the European Journal of Law & Economics, I argue that, even if we accept the argument made by Manne, Epstein and others that firms wishing to allow their employees to trade on the firm’s material non-public information should be permitted to do so (assuming firms properly disclose this fact to the market), nevertheless there is still a crucial role for government in regulating insider trading.

In particular, allowing employees to profit by insider trading is a form of employee compensation that, in contradistinction from conventional forms of equity compensation, results in unknowable and effectively unlimited costs to the company and its shareholders. Since providing employee compensation in this form causes the company to lose control of its compensation expense, even if insider trading were legal, virtually every company would rely on conventional forms of employee compensation and require its employees to agree to refrain from insider trading. But, pace Epstein and others, companies lack the means to detect insider trading by their employees, and even when they do catch employees engaging in insider trading, companies can impose only mild contractual sanctions, generally not exceeding disgorgement of profits and dismissal. As a result, although an efficient agreement between a company and an employee would prohibit the employee from insider trading, this prohibition cannot be effectively enforced by the company.

Government, with its usual law enforcement powers, is better able to detect insider trading and can impose more severe sanctions on violators, including criminal penalties. Government should thus enforce a ban on insider trading in those instances, which will be virtually all instances, in which a company contractually prohibits its employees from insider trading. The efficient solution is thus a hybrid system of private prohibition and public enforcement. Such a system is not unusual but the norm. Employers prohibit employees from embezzling their money and stealing their property, and employees are subject to contractual sanctions and dismissal for violating these prohibitions, but we still need statutes against theft to generate an optimal level of deterrence. This is all the more true when the employee misappropriates the employer’s information, for such misappropriations are much harder to detect than thefts of money or property and often involve much greater value.

The article is available here.

Robert T. Miller is a professor of law and the F. Arnold Daum Fellow in Corporate Law at the University of Iowa College of Law and a Fellow and Program Affiliated Scholar at the Classical Liberal Institute at New York University Law School.