Trading on inside information when there may be tippees

This is true first of those models, such as Fishman and Hagerty (1992) and Baiman and Verrecchia (1996), which follow Kyle (1985) in modeling the process of market trading. About models of this category it can be found that the equilibrium asset price would fully reveal the insiders’ information if their market orders are separably observable from those of noise or liquidity traders. The same can be said about Leland (1992) as well. In Manove (1989) and Bhattacharya and Nicodano (2001), the knowledge that the insiders are buying or selling is sufficient to reveal the insiders’ information. Baiman and Verrecchia (1996) recognize this to be a problem and interpret their model as portraying markets without regulations similar to the reporting requirement of §16(a) of the US Securities Exchange Act. There is one model, Ausubel (1990), to which the comment here does not apply, for the reason that inside information there has two dimensions, which cannot both be revealed by the asset price regardless of whether the insiders’ trades are observable. However, considering that firm value is one-dimensional, and that all that matters about the things privately known to the insiders is how the firm value might be affected, there is no loss of generality in treating inside information as a uni-variate denoting the effect on firm value.

See, e.g., Bainbridge (2000). In particular, this is the argument given repeatedly by the US Securities Exchange Commission in the prosecution of insider-trading cases, as noted in Karmel (1993).

This argument is laid out in Manne (1966a, chapter 8) and further elaborated in Manne (1966b). Its importance to advocates of deregulation is best seen from a comprehensive survey such as Bainbridge (2000). It should be mentioned that there is another deregulatory argument which appears to be equally important. It says that insider trading has the effect of increasing the price efficiency of the stock market, which is good for it leads to higher allocative efficiency of the economy. Although the model is not suitable to discuss expressly the price efficiency, this latter argument is not all lost here; for welfare in this model being created by the set of projects for which capital can be raised is a measure of allocative efficiency.

It is pointed out also in Repullo (1999) and Bhattacharya and Nicodano (2001) that the presence of a group of traders whose incentive to trade cannot be accounted for is problematic for a model concerned with making welfare comparisons.

It is not that tippees in this sense have never appeared in earlier models; rather it is that most these models make no distinction as to whether the informed traders are firm insiders in the strict sense or otherwise. The homogeneous group of informed traders in these models can be insiders, as in Ausubel (1990); or tippees, as in Leland (1992); or either, as in Manove (1989).

Implicit here is the assumption that the insider cannot satisfy his liquidity needs better by borrowing than by selling his shares, even though he has to sell at a price lower than the true expected asset payoff if x ₁ = x _g . It might be better for the insider to pledge his shares and borrow if the fact that he does not want to sell is a signal that the true expected asset payoff is \(x_g +\bar{{x}}.\) But that is impossible, for it would mean that it is better always, not just when the expected payoff is \(x_g +\bar{{x}},\) for the insider to deal with a lender, who values the asset at \(x_g +\bar{{x}},\) than with the market, which values the asset at \(2\bar{{x}}.\) So a lender upon being approached by the insider should value the asset no higher than the market. Also, since the lender does not share the upward potential of the pledged asset, the lending should be based on the lower potential of the asset, which means a smaller amount than the insider can get from selling.

If it is better to finance the operating assets with a combination of debt and equity, we need to interpret \(2\bar{{x}}\) as payoff attributable to only the equity holders, i.e., payoff after the claim of debt holders.

An alternative story is that the informed trader should want to bid for exactly his desired number of shares but at a price ever slightly higher than the market price. Then, assuming that auctioneer gives preference to higher bids in allocating the shares, the informed trader acquires his desired number of shares with certainty.

That is, we consider here only outsiders who are sophisticated in the words of Manove (1989), which mentions also the case with naïve outsiders.

We know from the extant literature that insiders have other considerations in this respect, such as those identified in Ritter (1984) and Shleifer and Vishny (1997), which will be mentioned later in connection with another scenario.

An analysis directly linked to Sections 16(a) and 16(b) of the Securities Exchange Act can be found in John and Narayanan (1997).

Two such concerns can be readily pointed out. One, as mentioned in Ritter (1984), is that by retaining ownership the insider can reduce the future agency problem as perceived by the market, and thus increase the firm value. The other, mentioned in Shleifer and Vishny (1997), is simply that the insider wants to maintain the control right.

The same point is shown in a slightly varied form by Bernhardt et al. (1995), in which capital investment is distorted toward the fixed-return project at the expense of the risky project as a result of insider trading.

Ausubel (1990) is an exception among the previous models, in that the situation effected by insider-trading regulation in that model is the symmetric-information situation with disclosed inside information, rather than that as if no one had the inside information. This difference is really the consequence of Ausubel (1990) specifying that the insiders’ utility function is Cobb-Douglas in two goods and that the insiders can consume only one of these goods without trading. The insiders in such a model naturally want to disclose his inside information, so as to be allowed to trade, when the alternative under regulation is to abstain from trading. It is arguable whether this is more appropriate for a model of insider trading than to specify the insiders’ utility as functions of monetary wealth. But our concern here is whether it is sufficient to refer to Ausubel (1990) when the question requires the situation with insider trading be compared to that with full information. We should not take it so, for the reason that inside information there is about the insiders’ preference rather than about the firm value.

Two points are noteworthy in relation to the extant literature on mandatory disclosure. First, the argument here runs counter to that of Dye (1990), which holds that mandating a disclosure policy that would be adopted voluntarily by firms would be a waste of resources by the regulator. We see in the present model that firms do wish to be committed to the policy of full disclosure, and yet the regulation mandating the same disclosure policy is still useful. Second, the role of mandatory disclosure identified here is different from the confirmative role in Gigler and the Hemmer (1998), although both are to address the credibility problem of disclosure made by firms on their own. The role of mandatory disclosure in their model is derived from a principal-agent setting, in which the agent can be motivated to disclose ex post. In contrast, the role of mandatory disclosure here is derived from a trading setting with parties having no contractual relationships, and the role is to address the very problem that the firm may not have the incentive ex post to disclose.