Insider Trading – Is It As Bad As You Think?

When most of us hear the words “Insider Trading”, we feel a little chill down our spines.  It is a bad thing of course, isn’t it?  Recent insider trading scandals like the case with hedge fund manager Raj Rajaratnam of the Galleon Group reverberate through our minds.  It is something that should be punished criminally, and eliminated from the markets if at all possible.  But anyone especially interested in this phenomenon should really stop and ask again that age old question that has plagued market regulators – is insider trading truly a bad thing? 

For that matter, do we even know what insider trading really is?  In the 1980’s and 1990’s, many famous insider trading cases appeared headlining the news.  This spate of illegal insider trading renewed interest in increasing regulation of these types of trades, and the question of how to define insider trading moved to the forefront.  Previously, legal insider trading had been mostly defined as trades by top executives or beneficiaries of corporations or their family members.  But couldn’t others outside this group obtain information that could move the stock price, and illegally benefit? And how exactly would those cases be defined as illegal? Michael Milken was one of the most famous illegal inside traders in the late 1980s, but it was not always clear that what he was doing was illegal. And how could regulation possibly define all the ways that one could obtain this inside information illegally?  Congress is famous for massively long bills, but the ways to trade on inside information are almost infinite.  So in 2000 a much more practical bill called Regulation FD was passed, broadly defining illegal insider trading as “anyone who trades on material, nonpublic information”.

Ok, so now we know what insider trading is.  However, before I go further, it is important to make a more clear distinction between legal and illegal insider trading.  Insider trading is actually legal for corporate insiders and is an active part of the marketplace, but is done in a controlled, regulated fashion.  Legal insider trading is not only accepted, but is considered desirable in the markets, because it improves the chance that the stock price more fully reflects current information regarding that stock, meaning that the current stock price is more accurate (this is called in the finance literature the “price discovery” process).  Who knows better than corporate insiders if their product is selling like hotcakes and orders are increasing, or if sales are slowing down and their warehouses are filling with costly inventory?  So these insider trades send a great signal to the marketplace on which direction the stock price is likely to move in the near future, and what the current fair price of the stock should be.  And because of improvements in insider trading laws (the biggest recently being Sarbanes Oxley in 2002), insiders cannot gain much profit before revealing their information to the general public. 

Now let’s consider illegal insider trading, which is usually assumed to be harmful to investors and the marketplace.  In fact, since current laws would be expected to only allow insider trading that is not detrimental to investors, it is easier to see why these illegal insider trades might cause problems. And in contrast to legal insider trading, illegal insider trading might be assumed to make the stock price less accurate (harming the “price discovery” process).  Thus in a market with heavy illegal insider trading, the average investor would constantly be buying at an abnormally high price, and selling at an abnormally low price, with these illegal inside traders profiting off of the difference.  This behavior would discourage average investors from trading in markets like this, causing further harm to stock price accuracy, as there would be less traders doing research on stock prices, etc.  However, there is a small contingent that believes that even illegal insider trades are beneficial to the marketplace. Nobel prize winning economist Milton Friedman argued that all insider trades should be allowed for trading, even the ones currently considered illegal, as this would open the markets up to the free and unhindered flow of information from insiders to the marketplace.  Stock prices would move up or down based on this increase of insider trades, more accurately pricing the stock than what happens in our current regulated environment.  While this sounds good in theory, evidence of market manipulation prior to the 1930s when insider trading was less regulated may conflict with this opinion.  Many Libertarian think tanks argue that the market would adjust to attempted manipulation while still allowing better stock pricing, but the debate rages on.  Actually, an excellent guide to understanding the distinction between the benefits and detriments of insider trading appears in the 1987 Oliver Stone classic film “Wall Street”, in which Michael Douglas portrays a corporate raider heavily using illegal inside information.   While most of the movie focuses clearly on this undesirable illegal insider trading, there is one famous scene (often called the “Greed is good” speech) in which Douglas’ character Gordon Gekko skewers the management and insiders of Teldar Paper for not personally buying into the stock, subtly suggesting that the poor performance of the firm was because “management has no stake in the company” and was thus uninterested in actually improving firm performance.

So back to the original question – is insider trading really bad?  Always remember when answering that question to define exactly what insider trading is first.  Under the current regulatory environment, most scholars believe legal insider trading to be a good thing for the creation of more efficient markets, while illegal insider trades are considered undesirable for establishing proper stock prices.   The dividing line between the two shifts periodically with economic conditions and political parties in office, but one thing is certain – insider trading will always be with us, whether legal or illegal, so we better get used to it and try to understand it more fully.

Tony Via is a 5th year Finance PhD student at the University of Alabama, and currently resides in Tuscaloosa, AL.  He is originally from Decherd, Tennessee, and worked as a mechanical engineer before returning to graduate school.  His research specializations are in Investments and Market Microstructure, and he has done consulting work in proprietary trading and market impact models.


UAB Follow Up

My previous post did generate some discussion, at least on twitter, and a question was raised regarding the issue of forming a private group to build the stadium. To paraphrase, would the venture be viewed as legitimate since it is operating outside of the athletic department?

This is a good question but before I answer it, let me explain perhaps in a bit more detail what I meant by the alternative solution. This would be a private venture which would form for the sole purpose of building, maintaining, and marketing the stadium as a venue for UAB football as well as any other off season events.

(This bit is a business refresher for anyone that doesn’t deal with corporate finance often.)

As with any company there would need to be capital. The two types of capital are debt (which is a claim for a set dollar amount) and equity (a claim on residual income after debt holders are paid). If the project were built by UAB itself then no equity is possible so it is a debt issue specifically a 30 year bond issue. With a group of investors instead of the university it would be possible to have partners form and give money for an equity stake in the venture. This equity position means that less debt would be required which makes getting the debt easier.

(End of the refresher)

So if there was a group of investors that wanted to make this happen, how could they establish that they are legitimate? The first thing would be to secure property near UAB campus. This is an “On Campus” stadium but for UAB that is a good part of Southside. I am not going to pretend to be up on real estate prices in Birmingham so I do not know what it would cost to get that property, especially since it is a good bit of land and located next to UAB and medical complex. Once property is secured there would need to be a commitment from UAB that if such a stadium were built in a certain time frame that they would stop playing games in the current venue, Legion Field, and switch to the new stadium. Given the contracting this could be easy to plan for and should be something that UAB could commit to since they are currently contracting to use a private facility.

How much money needs to be raised? Well when FAU built an on campus stadium they received $12MM from a builder which they combined with campus funding for a total of $25MM and used that to help secure an additional $44.6MM, in the form of a loan, of debt. Having so much capital before the loan was required because the loan was backed only by the revenue of the stadium so Regions would be unable to go after the school itself if FAU had defaulted. The stadium has been very successful so that is not a concern.

The UAB plan would be $60MM plus the cost of securing the land and administrative costs in establishing the venture and securing investors/lenders. Getting debt of 60% of the value of the project is clearly easier than getting debt of 100% of the project so the more of their own money investors put up, the faster the process and the lower the rate.

I do not know if legally the group could take money in advance for boxes, priority seating, naming rights and the like (to be held in escrow) which could perhaps assist in demonstrating the potential cash flow for lenders. Even without such though, by having investors with an equity stake the on campus stadium could be a reality in a short period of time.

To answer the question of legitimacy, stadiums, arenas, auditoriums, fields, etc. are often run by private organizations. It is not as common that they are built without it being done through some city or state government but that is in large part due to lower cost of borrowing in municipal bonds because of their tax exempt status. If muni bonds are required then the city, county or state could get involved but given the lending issues in the past in the area that may not be easy to swing. As the FAU example showed, muni bonds are not always used and so the project could be financed without them.

In short, I think that an investor group could be formed from business people in the Birmingham area to establish an on campus stadium.