The ban on insider dealing serves little purpose. Far better to encourage a breed of fully informed shareholders who can actually use their rights of ownership. Anthony Harris
Insider trading is blatantly unfair. One side of the deal knows more than the other; losses are incurred, potential profits missed. The reputation of the market suffers, and newcomers to financial investment - the Sids of this world - take fright; bad news for a shareholding democracy.
So insider dealing is banned, not only under UK and US law but by an EC decree as well. Quite right too.
Or perhaps not. After all, the legislation does not actually work; it has proved next to impossible to get the evidence for a successful prosecution in Britain. The only rules which do prove effective in constraining insider dealing and which do result in penalties - such as removing a company from the stock market - are not enshrined in law, and are operated by the stock exchange.
So the reassurance the law seems to offer is phoney. But even if it worked, whom would it protect? Nobody who makes a voluntary sale or purchase at a time of their own choosing: if investors later find they were misinformed, it was because information was suppressed, not because an insider got hold of it and acted accordingly. On the contrary, the outsider will get a better deal if an insider is active because the insider's buying or selling moves the price in the same direction as would an announcement.
The insider is part of the market's information system, the only advantage is that he or she got in first.
Unfair? Legend records that when the insider dealing law was first passed, a Hong Kong financier asked a British attache to explain it. What, he wanted to know, was this insider trading? 'It is dealing on the basis of information from inside the company,' the attache explained in the voice of a curate denouncing sin. 'Of course,' said the financier. 'No sane man would trade without such information. Otherwise he would be assuming that he is cleverer than the market, which would just be arrogance. But do you really need a law to enforce common sense?'
Even if this defence is thought sophistry, is it sensible to combat so-called unfair advantage with a law which aims to make everyone equally ignorant? The point is conceded by many defenders of the law but the main thrust of their defence is a call for more and earlier information from companies. The law, they claim, is designed to provide more, not less, information. Desirable, by all means, but irrelevant since the information problem is tackled not by the law but by the stock exchange authorities which determine what information should be made available.
The question remain: who loses on insider dealing? Investors, after all, choose what to buy or sell, and, as we have seen, this decision is not helped, even in theory, by a ban on insider trading. On the contrary, an effective ban could only increase the risk that securities would be mispriced. That is why insider dealing has often been described as a victimless crime. There is one important exception, however: the market-makers. These are dealers, who buy and sell according to investors' demands, and thus cannot choose their own timing - a unique class. Dealers not only miss profits when insiders buy, but suffer real out-of-pocket losses when they sell. Clearly they are victims, yet what market-makers passionately demand is not criminal sanctions, but full and timely information.
Some secrets need to be kept secret for good commercial reasons, even if they are price-sensitive. The technical hitches which bug nearly all new products, but which are usually resolved, are an example. Premature disclosure of such flaws would damage sales and confidence, and the long-term interests of shareholders. The stock exchange's Rule 9.4 recognises this justification for commercial secrecy, thus admitting that the interests of companies - which are really those of the whole economy - can conflict with those in the financial markets who want all relevant information out in the open as soon as possible.
This potential conflict was also recognised in a recent series of speeches by Labour's City spokesman, Alistair Darling. He contrasted alert portfolio management, essentially a short-term approach which reacts to the latest information, with responsible ownership, where investors adopt the role and attitudes of long-term owners.
In practice most shareholders are in for the long term. While in theory, small investors can respond to bad news simply by switching funds, in real life they seldom do so. For their part, pension funds, investment and unit trusts may claim to practise active management, but again, the larger funds have long realised that in reality they are locked in. They cannot dump their shares without provoking a minor panic, so they, too, are de facto long-term investors. Unhappily, it has taken them a long time to wake up to the implications of this unwilling commitment, and exercise their ownership rights and responsibilities.
This has led to some slow-motion disasters. In the '50s and '60s, I had a close-up view of the decline and fall of the British Motor Corporation. In the mid-'60s, a senior executive took to briefing a few journalists on each new disaster even before it occurred.
'If I can't get rid of the board,' he explained, 'the company is dead.' But although we regularly reported his leaks, the board survived, and the company did not. At much the same time, the formerly triumphant Volkswagen began to go wrong; it was still an efficient producer, but of cars which no longer sold. The big stakeholders, in German fashion, were banks, and they did act. In an overnight putsch, the old management was sacked, and a new one turned the company around.
Some big US pension funds recognised years ago that they can protect interests by tackling weak management head on. These fund managers lobby, and failing that, they vote. They are now the terror of underperforming boards. Some British funds have at last begun to do the same, but others continue to keep their distance. In theory, they say, they support interventionism but the insider trading law prevents companies from giving them the information they need to act in good time. So the main check on mismanagement is still the hostile takeover, a second-best solution from the economic point of view. Potential acquirers want to buy cheap, and wait for trouble to build up; only owners have the motivation to tackle trouble early.
But shareholders who want to act as responsible owners are hampered by limits on the information they can receive - as imposed by insider dealing legislation. Such an obstruction could be removed if the law were amended to recognise a new class - contractual long-term investors. They would undertake not to trade shares without adequate notice. Since a non-trader cannot, by definition, be an insider dealer, these long-term holders could insist on full information, and make full use of their ownership rights.
The law, in short, need not concern itself with the functioning of the securities market since this is best left to the market authorities. It should aim rather to make capitalism work better. In Britain, this means attacking the long-recognised failure of shareholder control as it is currently practised. We need not a shareholding democracy, but proper control through democratic shareholding. Control requires information so the conclusion is obvious. Efficient capitalism needs more insiders, not fewer.