Corporate & Securities Law

Professor Brad DeLong on Professor Henderson and Insider Trading

I was hesitant to get involved in the Henderson issue because though I certainly have personal opinions on tax policy I don’t profess particular expertise.  I was glad to briefly wish our departing colleague well and highlight some of his interesting and well-written scholarship at a time when the blogosphere became unhealthily obsessed with a few offhand blog remarks.  Like a dog with a bone, Professor DeLong just can’t let it go.  I hesitate to keep this going, but a failure to reply means Prof. DeLong gets the last word and that is a result I cannot abide.  Prof. DeLong quotes my brief description of Prof. Henderson’s piece on 10b-5 plans to measure the costs of insider trading as he writes:

I genuinely do not understand why Henderson has his job.

Let me explain that last at greater length.

J.W. Verret wrote:

Todd Henderson will be missed: I am saddened that our co-blogger Todd Henderson is putting up his blogging hat.  He leaves us with an academic reputation that is unsurpassed, unfortunately I can?t say that the reputation of everyone involved has held up very well in light of the very personal nature of attacks…. I do think, however, that this is a good opportunity to focus the world on the wide range of scholarly work from Professor Henderson…. Here are a few papers of his on ssrn worth reading (this certainly won?t be the last time we link to his work at TOTM):

In “Insider Trading and CEO Pay,” Prof. Henderson examines the effectiveness of insider trading as a compensation device using a study of 10b5-1 trading plans.  His findings are in line with Henry Manne?s original thesis from nearly 40 years ago that insider trading didn?t diminish firm market value on net and may serve a useful purpose as an executive compensation device to motivate managers to maximize the value of the firm…

To which my first reaction is simply: Huh?!

And my second reaction is: No! No! No! Ten-thousand times no! That is simply wrong.

….

Insider trading makes executives’ portfolios’ long not the company but long the volatility of the company. And shareholders don’t want executives making decisions that make the value of companies they own more volatile: stock market investments are risky enough as it is without giving executives reasons to boost the volatility pot.

This claim that freedom to engage in insider trading aligns executives’ interests with those of shareholders is so basically wrong, so obviously erroneous, so simply stupid that–well, words fail me.

I suppose Prof. DeLong and I agree on something.  Prof. DeLong’s words do seem to fail him quite thoroughly.  There is a long and storied debate about the costs and benefits of insider trading.  See Henry Manne, Harold Demsetz, Dennis Carlton and Daniel Fischel, Steve Bainbridge, David Haddock, Jonathan Macey, etc., etc.  Prof. Delong fails to reference that literature or the arguments presented therein and considered in more detail in the link to Prof. Henderson’s paper.  One vein of the discussion over insider trading concerns whether it can serve as an efficient compensation device and under what circumstances that might hold true.

If I were Prof. DeLong, and I wanted to offer a thoughtful critique Prof. Henderson’s view, I might focus on differences between using insider trading as a compensation device at the entrepreneurial stage of a firms development and the complications in incentives that might be theorized for larger and more established conglomerates.  I might also focus on the study of 10b-5 plans that Henderson uses in the ssrn piece and find some way to critique his sample or argue that some omitted variable has biased the results.  I might consider how firms nearing the zone of insolvency could complicate the question.  I don’t necessarily accept these arguments, but to me they represent how a scholar on his side of the debate would address the issue.

I would certainly have to address Prof. Henderson’s strong argument that a variety of other economic forces, like share prices, would constrain executives against abusing insider information to merely increase volatility rather than maximize returns.  I would also have to consider the arguments of many who critique insider trading regulation that firms should be permitted to adopt amendments to their charter, which would require a vote of a majority of shareholders, to permit insider trading at their firms.

If I were Prof. DeLong, in addition to reviewing the economic literature, I would also have to think about the law for a moment.  Even if the laws specifically referencing insider trading were rescinded, 10b-5 of the Securities Exchange Act would still prohibit the type of manipulative activity Prof. DeLong describes.  State corporate law fiduciary duties would similarly constrain the type of manipulative activity he describes.  So manipulative insider trading would still be prohibited even if non-manipulative trading on inside information were allowed.  Wow, now that we consider it, Prof. DeLong’s ill-supported and overbroad assertions are tough to swallow.

Whatever I did, if I were Prof. DeLong I hope I could come up with something better than “No! No! No! Ten-thousand times no! That is simply wrong.”  In fact, if you’re interested in a more open minded debate over the insider trading issue, see my recent article Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, where I actually criticize the government’s immunity, as a controlling shareholder in bailed-out firms, from insider trading laws and other corporate laws.  The fact that Prof. Delong doesn’t like Prof. Henderson’s views on tax policy, his blogging style, or the conclusions of his heavily cited and well-written scholarship certainly doesn’t justify or excuse hasty conclusions or scurrilous accusations like “I genuinely do not understand why Henderson has his job.”

The debate over the efficiency of insider trading is certainly counter-intuitive and controversial.  When Henry Manne first originated this discussion with his famous book in 1966, Professor Louis Loss, the leading securities law scholar of the time, shrugged it aside and casually ignoring the economics of the questions (as corporate scholars of the time were apt to do), replying “I don’t need a book to tell me whether insider trading is wrong.  I know its wrong.”  That brand of thought was lazy thinking then, and it’s even worse now that the debates over insider trading have undergone nearly 50 years of evolution.

Full post as published by Truth on the Market on October 02, 2010 (boomark / email).