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Dolgopolov 2004 on bid-ask spread

Dolgopolov 2004 on bid-ask spread

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INSIDER TRADING AND THE BID-ASK SPREAD: ACRITICAL EVALUATION OF ADVERSE SELECTION INMARKET MAKING
 
S
TANISLAV
D
OLGOPOLOV
*
 In economic, finance, and legal literature, there is a widespread acceptance of the notion that market makers increase the bid-ask spread in response toinsider trading, as they consistently lose money by transacting with better-informed insiders. The development of this adverse selection model of market making was treated as proof that insider trading imposes a real cost onsecurities markets by decreasing liquidity and increasing the corporate cost of capital and was used as a justification for regulation. This Article is a criticalreview of the adverse selection literature. It discusses the model’s theoreticaldevelopment, its use in the regulation debates, a summary of the case law onthe harm from insider trading to market makers, and empirical research onthe link between insider trading and transaction costs. The adverse selectionargument is criticized from both theoretical and empirical standpoints: thereare limitations to the model due to required assumptions about the role and behavior of market makers’ inventories; different causal links among insider trading, firm size, quality of disclosure, stock price volatility, and the bid-ask spread are possible; the existing empirical studies may confuse variouscomponents of the spread; and information asymmetry may actually benefit market makers.
I.
 
I
NTRODUCTION
 
A
. Insider Trading Controversy
The issue of insider trading
1
has never disappeared from academic andpublic policy debates during the past four decades,
2
and this practice has
_______________________________________________________
(
continued 
)Copyright © 2004, Stanislav Dolgopolov.
*
Empire Education Corporation (Latham, NY) and the John M. Olin Center forLaw and Economics at the University of Michigan Law School (Ann Arbor, MI). Theauthor thanks Henry G. Manne for suggesting the topic and for his guidance and Faith A.Takes for her encouragement. The author also gratefully acknowledges the valuablecomments and help of Omri Ben-Shahar, Laura N. Beny, Laurence D. Connor, VladislavDolgopolov, Jon Garfinkel, Zohar Goshen, David R. Henderson,
 
David Humphreville, KjellHenry Knivsflå, Leonard P. Liggio, Edith Livermore, John Moore, John Papadopoulos,Paula Payton, David S. Ruder, Daniel F. Spulber, Michael Trebilcock, and Martin Young,as well as the Atlas Economic Research Foundation, the Earhart Foundation, and the JohnM. Olin Center for Law and Economics at the University of Michigan Law School.
1
“Insider trading” refers to transactions in company’s securities by corporateinsiders (such as executives, directors, large shareholders, and outside persons withprivileged access to corporate affairs) or their associates based on information originating
 
84 CAPITAL UNIVERSITY LAW REVIEW [33:83attracted a great deal of publicity and near-universal condemnation.
3
 Recently, and in the wake of the stock market decline and numerouscorporate scandals, insider trading, treated as one of the chief symptoms of the business world’s corruption, once again captured public attention.
4
 
(
continued 
)within the firm that would, once publicly disclosed, affect the prices of such securities. Thedefinition of “informed trading” is broader than “insider trading” because the former alsoincludes transactions on the basis of “market” or “outside” information, such as theknowledge of forthcoming market-wide or industry developments, competitors’ strategiesand products, or upcoming takeovers by a third party. There are arguments for regulatingthe use of external information as well: “The traditional fairness and market integrity basesfor regulating insider trading are still important to uphold when market information isinvolved.” Committee on Federal Regulation of Securities,
 Report of the Task Force on Regulation of Insider Trading, Part I: Regulation Under the Antifraud Provisions of theSecurities Exchange Act of 1934
, 41 B
US
.
 
L
AW
. 223, 229 (1985). Indeed, the use of suchinformation is, in some instances, covered by federal securities regulations.
See
John F.Barry III,
The Economics of Outside Information and Rule 10b-5
, 129 U.
 
P
A
.
 
L.
 
R
EV
. 1307,1308-09 (1981).
2
 
See
Paula J. Dalley,
From Horse Trading to Insider Trading: The Historical Antecedents of the Insider Trading Debate
, 39 W
M
.
 
&
 
M
ARY
L.
 
R
EV
. 1289 (1998)(discussing earlier controversies pertaining to the duty to disclose in transactions betweenasymmetrically informed parties). One of the earliest, and unsuccessful, attempts toregulate insider trading on the federal level occurred after the 1912-13 congressionalhearings before the Pujo Committee, which concluded that “[t]he scandalous practices of officers and directors in speculating upon inside and advance information as to the action of their corporations may be curtailed if not stopped.H.R. R
EP
.
 
N
O
.
 
62-1593,
 
at 115 (1913).
3
Insider trading is quite different from market manipulation, false disclosure, ordirect expropriation of the company’s wealth by corporate insiders, and trading onasymmetric information is common in many other markets. Nevertheless, insider tradingseems objectionable for many reasons. First, corporate employees as “agents” owefiduciary duties to shareholders as their “principals.” Second, “unfairness” results fromtrading on information obtained as a byproduct of employment or privileged access tocorporate affairs. Third, insider trading is objectionable because of the extent of managerialcontrol over the production, disclosure, and access to inside information, which may giverise to arbitrary, costless, and non-transparent wealth transfers from outside investors tomanagers. Fourth, insider trading may lead to possible conflicts between maximizinginsiders’ trading profits and maximizing the firm’s value. These concerns are very muchunique to securities markets.
See generally
Victor Brudney,
 Insiders, Outsiders, and  Informational Advantages Under the Federal Securities Laws
, 93 H
ARV
.
 
L.
 
R
EV
. 322(1979).
4
In fact, one empirical study posits that selling by corporate insiders after theexpiration of lockup provisions was one of the most important immediate factors that led tothe New Economy market burst. Eli Ofek & Matthew Richardson,
 DotCom Mania: The Rise and Fall of Internet Stock Prices
, 58 J. F
IN
. 1113, 1131 (2003). While this study does
 
2004] INSIDER TRADING AND THE BID-ASK SPREAD 85Academic analysis has considered insider trading from theperspectives of such diverse disciplines as economics,
5
ethics,
6
feministstudies,
7
and psychology.
8
It has been hailed as a mechanism of enhancingstock price accuracy and an efficient compensation scheme forentrepreneurial services,
9
a stimulus of producing information at a lowcost,
compensation for undiversified risk for controlling shareholders,
areward to blockholders for their monitoring activities,
a device mitigatingagency costs,
and a mechanism of credible signaling to the market.
 
not suggest that insider selling by itself led to the market crash, the implication is that, inmany instances, the outside investors, not the insiders, largely absorbed the loss.
See also
Mark Gimein,
You Bought. They Sold.
, F
ORTUNE
, Sept. 2, 2002, at 64 (documentingmassive insider selling in such companies as Enron, Global Crossing, Tyco, and othersbefore the sharp drop in their shares’ prices).
5
 
See generally
H
ENRY
G.
 
M
ANNE
,
 
I
NSIDER
T
RADING AND THE
S
TOCK
M
ARKET
 (1966); Javier Estrada,
 Insider Trading: Regulation, Securities Markets, and Welfare Under  Risk Aversion
, 35 Q.
 
R
EV
.
 
E
CON
.
 
&
 
F
IN
. 421 (1995); Norman S. Douglas,
 Insider Trading:The Case Against the “Victimless Crime” Hypothesis
, F
IN
.
 
R
EV
., May 1988, at 127.
6
 
See
 
generally
Gary Lawson,
The Ethics of Insider Trading
, 11
 
H
ARV
.
 
J.L.
 
&
 
P
UB
.
 
P
OL
Y
727 (1988); Ian B. Lee,
Fairness and Insider Trading
, 2002 C
OLUM
.
 
B
US
.
 
L.
 
R
EV
.119; Kim Lane Scheppele,
“It’s Just Not Right”: The Ethics of Insider Trading
, 56 L
AW
&
 
C
ONTEMP
.
 
P
ROBS
. 123 (1993).
7
 
See
 
generally
Theresa A. Gabaldon,
 Assumptions About Relationships Reflected in the Federal Securities Laws
, 17 W
IS
.
 
W
OMEN
S
L.J. 215 (2002); Judith G. Greenberg,
 Insider Trading and Family Values
, 4 W
M
.
 
&
 
M
ARY
J.
 
W
OMEN
&
 
L. 303 (1998).
8
 
See
 
generally
John Dunkelberg & Debra Ragin Jessup,
So Then Why Did You Do It?
, 29 J. B
US
.
 
E
THICS
51 (2001); David E. Terpstra et al.,
The Influence of Personality and  Demographic Variables on Ethical Decisions Related to Insider Trading
, 127 J. P
SYCHOL
.375 (1993).
9
 
See
M
ANNE
,
supra
note 5, at 81-90, 131-58 (discussing the “smoothing” effect of insider trading on the stock price and arguing that insider trading constitutes efficientcompensation for entrepreneurial services rendered to the corporation).
10
 
See
David D. Haddock & Jonathan R. Macey,
 Regulation on Demand: A Private Interest Model, with an Application to Insider Trading Regulation
, 30 J.L.
 
&
 
E
CON
. 311,318 (1987) (arguing that “insiders are the low-cost suppliers of most of the [firm-specific]information that is useful to securities markets”).
11
 
See
Harold Demsetz,
Corporate Control, Insider Trading, and Rates of Return
,76 A
M
.
 
E
CON
.
 
R
EV
. (P
APERS
&
 
P
ROC
.)
 
313, 315 (1986).
12
 
See
Stephen Thurber,
The Insider Trading Compensation Contract as an Inducement to Monitoring by the Institutional Investor 
, 1 G
EO
.
 
M
ASON
L.
 
R
EV
. (n.s.) 119,119 (1994).
13
 
See
Dennis W. Carlton & Daniel R. Fischel,
The Regulation of Insider Trading
,35 S
TAN
.
 
L.
 
R
EV
.
 
857,
 
870-71
 
(1983)
 
(discussing how insider trading may align the interestsof shareholders and managers).

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