INSIDER TRADING REGULATION IN TRANSITION ECONOMIES

ABSTRACT

Insider trading in the United States has been receiving a lot of press coverage in recent years. The press has given the public the impression that insider trading is evil, unethical and illegal, when in fact such is not always the case. In some cases, insider trading is beneficial to the economy and to shareholders. It is not always unethical and it is not always illegal. Whether insider trading is harmful, unethical or illegal depends on many factors, yet the press ignores such nuances. A number of economists have pointed out some beneficial effects of insider trading and legal theorists have written treatises discussing when insider trading is illegal and when it is not. Philosophers have said some good things about insider trading, too, but their scholarly treatises have, understandably, been ignored by journalists.

Policymakers in transition economies are trying to reform their legal and economic systems to more closely reflect those of the developed market economies. The OECD, World Bank, IMF and other organizations are assisting them in this endeavor. One aspect of their reform is to adopt insider trading laws and regulations that mirror those of the developed western economies. However,

those policies are often flawed because they tend to outlaw some forms of insider trading that are beneficial to the economy and not unethical in nature.

This paper begins with an overview of the different philosophical approaches that may be taken toward insider trading, then reviews the basic theoretical and empirical literature on insider trading in an attempt to differentiate good insider trading from bad insider trading. The paper then examines some documents that policy makers in transition economies rely on when making laws and regulations regarding insider trading. The paper concludes with some recommendations and guidelines.

INSIDER TRADING REGULATION IN TRANSITION

ECONOMIES

INTRODUCTION

Insider trading is generally perceived as evil or at least unethical. The press and television show people being arrested and led away in handcuffs for engaging in it. The media has nothing good to say about the practice. Politicians enhance their careers by being against it. Commentators make it sound like all insider trading is illegal. Yet some forms of insider trading are perfectly legal (Shell 2001) and some kinds of insider trading are not unethical. In other words, there is a widespread misperception on the part of the public about insider trading.

This misperception has spread to the transition economies that are in the process of converting from centrally planned systems to market systems. This is unfortunate, since there is evidence to suggest that at least some kinds of insider trading are healthy and beneficial for an economy. Thus, transition economies that blindly outlaw all insider trading are unknowingly harming themselves and doing an injustice to the people they are supposed to represent.

THE PHILOSOPHICAL BASE Envy and the Labor Theory of Value

Those who think all insider trading should be illegal think so for a variety of reasons. Some say it is inherently immoral to trade on inside information because making a large profit with such little effort is somehow wrong. Others say that there should be a level playing field, and the playing field cannot be level when some individuals enjoy informational advantages over others. A third group takes the position that insiders have some fiduciary duty not to benefit from the information they have access to as part of their position with the corporation. A fourth group subscribes to some kind of misappropriation theory, which basically holds that the information they are using for personal gain belongs to someone else, and using the information results in a violation of property rights or contract rights.

All of these views have received a wide degree of support. However, upon closer analysis, each of these views has major weaknesses. One weakness is that those who advocate outlawing insider trading resort to emotional appeals rather than sound economic or philosophical analysis. There is often a certain amount of envy or jealousy included in the subtext of their arguments (Schoeck 1987). Many of those who would like to see all inside traders punished have what Ludwig von Mises has called the anti-capitalist mentality (Mises 1956). They just don’t like the free enterprise system, think it is inherently evil, and think that individuals should not be able to make millions of dollars with so little apparent effort. This latter view is a subconscious application of the labor theory of value, which was subscribed to by both Karl Marx and Adam Smith and, in fact, every other economist prior to the 1870s, when the labor theory of value was replaced by the marginal utility theory and the theory of subjective value (Menger 1871

The problem with applying the labor theory of value to insider trading is that not all value comes from labor. Things are worth whatever someone is willing to pay. The amount of labor that went into the product or service is completely irrelevant. Thus, the fact that someone can make millions of dollars by trading on information that was obtained with little apparent effort has nothing to do with whether the practice is immoral or whether it should be outlawed.

The Level Playing Field Argument

The level playing field argument has been used to justify any number of economic regulations. Trade cannot be free, it must be fair, whatever that means (Bovard 1991). People who have accumulated a great deal of wealth during their lifetimes must have it confiscated when they die so that those who are less fortunate will be able to compete with the children and grandchildren of the rich, who would otherwise leave their wealth to their children. Such thinking is one of the main reasons why some countries have adopted punitive estate and inheritance taxes (Buchanan and Flowers1975). The level playing field argument has been applied to insider trading to argue that all investors should have the same information at the same time, regardless of what they have done, if anything, to earn the information.

The problem with this level playing field argument is that it is not possible or desirable to ever have a level playing field in the realm of economics. The level playing field argument is appropriate to apply to sporting events but not to economics. It would not be fair for one football team to have to run uphill for the entire game while its opponent can run downhill. It is not fair for one basketball team to have a larger hoop to shoot at than its opponent. But there is nothing unfair about allowing banana farmers in Alaska to compete with banana farmers in Honduras. Alaska banana farmers should not be subsidized so that they can compete more effectively with

banana farmers from Honduras, and banana farmers from Honduras should not have to comply with punitive regulations or higher tax burdens to make them less able to compete with banana farmers from Alaska. Likewise, there is nothing unfair about allowing experts who work 60 hours a week to gather financial information as part of their job to profit from that information. What is unfair is to force them to disclose such information to people who have done nothing to earn it.

Ricardo’s theory of comparative advantage (1817) is at work here. Some individuals or groups are naturally better at some things than others, and some individuals or groups develop skills that are better than those of their competitors. Penalizing those who are better at something or subsidizing those who are worse at something results in inefficient outcomes and is unfair to some groups.

Comparative advantage works to the benefit of the vast majority of the population. It allows specialization and division of labor, which Adam Smith pointed out in his pin factory example (1776) leads to far greater efficiency, higher quality and lower prices. Not allowing individuals to use their special talents harms the entire community as well as the individuals who are being held back by some government law or regulation. Forcing a level playing field on people is always harmful because it reduces efficiency and violates rights. Using the level playing field argument to prevent individuals from using their insider knowledge for personal gain does not hold up under analysis. If insider trading is to be made illegal and if inside traders are to be punished, some other justification must be found.

Two Philosophical Approaches to the Issue

There are basically two ways to evaluate economic and public policy issues. The utilitarian approach, which is subscribed to by the vast majority of economists, views an action as being good if the result is the greatest good for the greatest number (Bentham 1781

One problem with the utilitarian approach is that it is impossible to precisely measure gains and losses (Smart and Williams 1973). One may only make estimates. Another related problem is that individuals rank their choices, they do not calculate that Option A is 20 percent better than Option B. If a consumer prefers McDonald’s hamburgers over Burger King hamburgers, it cannot be said that he likes McDonald’s hamburgers 20 percent more than Burger King hamburgers, but only that he prefers McDonald’s hamburgers to Burger King hamburgers. Furthermore, after he has consumed a few McDonald’s hamburgers, he probably prefers no additional hamburgers to a McDonald’s hamburger because he is no longer hungry. Not only can individual preferences not be measured, they also change over time. They are not constant. Thus, any precise measurement is impossible.

Another problem with utilitarian approaches, related to the measurement issue, is that there is no way to precisely measure total gains and losses when some minority of individuals or groups benefit a lot from some rule while the vast majority are harmed (Shaw 1999). For example, can it be determined mathematically whether imposing a $5 tariff on the importation of foreign shirts is a good public policy if doing so protects the jobs of 10,000 textile workers but forces 100 million domestic consumers to pay an extra $5 for a shirt? Many empirical studies have found that imposing tariffs results in a negative-sum game, but scholars cannot agree on

how negative the result is. Some studies conclude that two jobs are lost for every job saved by some protectionist measure (Baughman and Emrich 1985

Another problem with the utilitarian approach is that it is not possible to compare interpersonal utilities (Rothbard 1997

Perhaps the strongest criticism that can be made against a utilitarian approach is that it completely and totally ignores rights (Frey 1984

The other approach to analyzing public policy issues is that of rights. The question to be asked is whether someone’s rights are violated. If someone’s rights are violated, the act is automatically wrong, even if the result would be a positive-sum game. Dostoevsky provides perhaps the strongest illustration of this view in The Brothers Karamazov, when he asks whether it would be acceptable to torture one small child to death if the result would be eternal happiness for every other member of the community (1952: 126-7). Although it is not possible to precisely measure the child’s pain and compare it to the happiness of the rest of the community, a utilitarian would probably conclude that such an act is just because it results in the greatest good

for the greatest number. A rights theorist would reach the opposite conclusion because of the belief that the violation of anyone’s rights makes the act automatically wrong.

Most western legal systems are a mixture of utilitarianism and rights theory. Welfare legislation is at least partially based on utilitarian beliefs. The General Welfare Clause of the U.S. Constitution and the general welfare clauses of other constitutions are also rooted in utilitarianism. The fact that some individuals must be forced to subsidize the existence of others is utilitarian based and necessarily violates rights. But constitutions and laws sometimes protect individuals rights, however defined. So legal systems are a combination of these two competing and sometimes contradictory philosophies.

Another issue to be considered is whether something that is immoral should automatically be declared illegal. The answer to this question depends on which philosophy of law one subscribes to. In a theocratic state, what is deemed to be immoral is also illegal. The law in such countries is a mirror image of the theology being practiced in the community. One may be burned at the stake for being insufficiently Catholic in Spain during the Inquisition or one may be stoned or beheaded for adultery or for saying something unflattering about Islam if one lives in a theocratic Islamic state.

This philosophy of law does not have widespread support in the developed western democracies, for a variety of reasons. For one thing, these countries are not theocracies. They are basically secular, although their legal systems may contain some religious based philosophy. Thou shalt not kill and thou shalt not steal are religious values that are shared by every religion to a certain extent. But they are more than just religious values. They are values that are subscribed to by atheists and agnostics as well, so we cannot label them purely religious values.

These countries are also pluralist. In a pluralist state, it is difficult to attempt to impose one set of moral values one the entire group, since the population living within the borders of such a state subscribe to different moral values. One may not outlaw alcohol just because some religious minority thinks that imbibing alcoholic beverages is immoral. One may not outlaw pork or require church attendance just because some religious groups think they are morally bound not to eat pork or to attend services on some regular basis. What is immoral to one individual or group may not be considered immoral to another individual or group. In a pluralist society, allowances must be made for such differences if one is to have domestic peace. Trying to make illegal those acts that are considered immoral only by some segment of the community is not good public policy in a pluralist state (Berlin 1991

That being the case, we will not go into a detailed analysis of whether insider trading is immoral, since immorality, in and of itself, is irrelevant in a pluralist state. What is immoral should not necessarily be illegal. Our analysis will be confined to a determination of whether insider trading results in a positive sum game or whether it violates anyone’s rights. The morality of insider trading will be discussed from these two ethical perspectives.

WHAT’S WRONG WITH INSIDER TRADING?

Lekkas (1998) provides a brief summary of the arguments that have been made for and against insider trading. Bainbridge (2000) also summarizes the pro and con arguments and provides a bibliography as well. Their arguments against insider trading include the previously mentioned level playing field argument

corporate property

The main argument supporting insider trading is efficiency. Trading on inside information causes information to be released into the marketplace sooner rather than later, thus causing stock prices to move in the right direction quicker than would otherwise be the case. Studies by Meulbroek (1992), Cornell and Sirri (1992) and Chakravarty and McConnell (1997) support this position. Another argument in favor of insider trading is that inside information is property, and preventing individuals from trading their property violates their property rights.

Bernardo (2001) sees the right to trade on insider information as a contractual problem of allocating property rights between shareholders and stakeholders. Allowing insiders to deal in insider information has also been viewed as a kind of compensation, a salary supplement or a bonus to be given as a reward for performance.

Henry Manne (1966) was the first to do a detailed study of insider trading and his study has become a classic. He concluded that insider trading does not result in any significant injury to long-term investors and causes the market to act more efficiently. He has called it a victimless crime (Manne 1985), as there are no identifiable victims. Those who sell their stock anonymously to a broker would have done so anyway, so they are no worse off then they would have been if the inside trader had not traded.

Jeng, Metrick and Zeckhauser (2003) conducted an empirical study that reached basically the same conclusion. They estimated that the expected costs of insider trading to noninsiders was about 10 cents per $10,000 transaction. Allen (1984), Leland (1992) and Repullo (1994) conducted studies concluding that insider trading was beneficial to other shareholders.

The insider trading law does not consider the possibility that an inside trader may profit from inside information by not trading. For example, if the insider knows that the stock price is likely to go up, he can refrain from selling the shares he already owns. Likewise, if he knows the stock price is likely to fall he can refrain from buying shares. These activities are not prohibited by insider trading laws but they are examples of insiders profiting from nonpublic information.

One conceptual problem with insider trading is determining ownership of the property in question. Information can be viewed as property, but it is not always clear who owns the right to use nonpublic information. The misappropriation theory tries to solve this problem but commentators are not in agreement as to whether this problem has been solved. Quinn (2003), Weiss (1998) and Seligman (1998) think that it has while Swanson (1997) and a plethora of other commentators (Quinn 2003) think it has not. The property issue is one of the keys to solving the problem of whether insider trading should be outlawed or regulated, yet it is unclear in some cases who can claim an ownership right to the property or when it has been misappropriated.

INSIDER TRADING IN TRANSITION ECONOMIES

The regulation of insider trading is a relatively recent phenomenon. The United States was the first major country to enact an insider trading law and to place restrictions on insider trading. The roots of the U. S. insider law sprouted from the securities legislation that was enacted in 1934 to prohibit other kinds of stock manipulation (Bernardo 2001). France was the second country to enact an insider trading law but France did not place prohibitions on insider trading until 1967 (Gevurtz 2002). Other countries have followed, but slowly. The UK, Australia and Japan have adopted insider trading laws along the American model (O’Hara 2001). As of 1990, only thirty-four countries had laws restricting or prohibiting insider trading, and only nine

of them had prosecuted anyone for insider trading. By 2000, eighty-seven countries had passed insider trading laws and thirty-eight had prosecuted at least one insider trading case (Gevurtz 2002). China’s insider trading law was not enacted until December 29, 1998 and was drafted with the assistance of the United States (Qu 2001). In 1989, the EU passed a directive that required all member countries to pass legislation prohibiting certain kinds of insider trading by 1992. Any country that wants to join the EU must also have an insider trading law on the books.

There is a widespread belief that American laws are the best laws (Gevurtz 2002). This view is prevalent among American lawyers and law students in the United States, partly because of their ignorance of laws in other countries, but it is also widespread in developing countries. As a result, policymakers in developing countries often have little resistance to the adoption of American laws when the opportunity presents itself. Indeed, some bureaucrats and political leaders actively encourage such assistance from the United States.

The United States Agency for International Development (USAID) has spent tens of billions of dollars sending U.S. “experts” to dozens of countries to give advice and to help them reform their legal systems by adopting laws that more closely resemble the laws of the United States. The American Bar Association supports programs to send American attorneys to numerous developing countries to give advice and assistance in legal reform as well.

There has been somewhat of a shift away from adopting American-like laws in recent years, especially in the developing countries of Eastern Europe. This shift is partly because many of the countries in this region of the world want to become part of the European Union, and the EU has laws that are different from those of the United States. However, many EU laws are not all that different from their American counterparts in terms of substance. The EU laws on antidumping, acquisitions and mergers, antitrust and insider trading are substantially the same as

their U.S. counterparts, although perhaps a bit less friendly toward business. The EU economic system is more socialistic than the U. S. system, and this difference is reflected in EU corporate law. However, many corporate laws adopted by the EU are modeled to a certain extent on U. S. law.

The countries in Eastern Europe that want to become part of the EU and countries in other parts of the world that want to join the World Trade Organization (WTO) or that want to obtain loans from the World Bank, the International Monetary Fund (IMF), the European Bank for Reconstruction and Development (EBRD) or other such lenders of last resort often do not take a critical look at the laws the EU, the World Bank, the IMF et al. want to impose on them. As a result, there is a tendency to “reform” their legal systems to bring their laws into closer compliance with the laws of the more developed countries without critically analyzing whether the laws they adopt are good laws or are in their own best interests. Thus, countries that are in transition often adopt the bad laws along with the good laws when in fact they should be taking a more cafeteria approach by selecting the laws they find attractive and passing on the laws that do not suit them.

One reason they do not use this approach is because they lack expertise in deciding which laws are good and which ones are bad or defective. One reason why they allow USAID or World Bank experts to give them advice is because the local bureaucrats do not have any experience living in or working in a developed market economy. Thus, they rely on advisors who do have this kind of background. As a result, they sometimes follow bad advice without knowing that it is bad advice. Just because the advice comes from someone who is perceived as being an expert from a developed economy does not mean that the advice is good.

Taking the advice of such experts in the area of insider trading is a case in point. Very few of the experts giving advice to transition economies are advocating that the country in question not adopt any prohibitions against insider trading. Indeed, such experts who are funded by USAID or Tacis, their EU equivalent, would likely be fired for giving such advice. Thus, such advice is not given. Instead, these experts are advising the bureaucrats and legislators in transition economies to enact insider trading legislation that mirrors either the EU or U. S. law. The local bureaucrats and legislators often listen to such advice uncritically and often enact the legislation that these foreign experts draft for them.

OECD’s Position on Insider Trading

As was mentioned previously, various nongovernmental and quasi-governmental organizations are providing advice on economic restructuring in various transition economies. The Organisation for Economic Cooperation and Development (OECD) is one such organization. It has poured a great deal of resources into economic restructuring. It has hosted seminars and conferences on corporate governance issues and has published numerous White Papers and other documents on the topic.

It began its program to develop corporate governance standards in the aftermath of the

Asian Financial Crisis of 1997. In 1999 it issued the OECD Principles of Corporate Governance,

which has become internationally recognized as a major source of guidance. It has become an important component of the Review of Standards and Codes (ROSC) project undertaken by the International Monetary Fund (IMF) and World Bank. It has been endorsed by the International Organisation of Securities Commissions (IOSCO) and by private bodies, including the International Corporate Governance Network. In January, 2004 it published its revised OECD

Principles of Corporate Governance: Draft Revised, which also addresses insider trading. In Section II.B. of the revise draft it states:

“Abusive self-dealing occurs when persons having close relationships to the company, including controlling shareholders, exploit those relationships to the detriment of the company and investors. Since insider trading entails manipulation of the capital markets, it is prohibited by securities regulations, company law and/or criminal law in most OECD countries. However, not all jurisdictions prohibit such practices, and in some cases enforcement is not vigorous. These practices can be seen as constituting a breach of good corporate governance inasmuch as they violate the principle of equitable treatment of shareholders.”

“The Principles reaffirm that it is reasonable for investors to expect that the abuse of insider power be prohibited. In cases where such abuses are not specifically forbidden by legislation or where enforcement is not effective, it will be important for governments to take measures to remove any such gaps.”

The language in the 2004 revised draft is basically unchanged from the original 1999 document. There are several problems with the language used in the OECD documents. For one, they seemingly advocate outlawing all insider trading, which would result in punishing individuals who have not violated any rights or breached any fiduciary duties. Such blanket prohibitions would punish some individuals who have done nothing wrong, but who have merely exercised their right to sell their property or to buy new property with information that has been

justly acquired. Such blanket prohibitions would also result in making capital markets work less efficiently, to the detriment of the vast majority of the public.

There is also a problem with the statement that “Abusive self-dealing occurs when persons having close relationships to the company, including controlling shareholders, exploit those relationships to the detriment of the company and investors.” The word “exploit” is used pejoratively in this statement. A better word to use would be “use.” But a more important error in the statement has to do with the presumption that the company or investors are harmed as a result of the inside trade. Some studies have shown that the company and investors stand to gain as a result of insider trading and that the market in general also benefits by such trades, since insider trading causes prices to move in the right direction sooner than would otherwise be the case.

It is also not at all clear that insider trading entails “manipulation of the capital markets.” Manipulation is one thing

It is difficult to see how shareholders are not being treated equitably if an insider buys shares when the price is expected to rise. The purchase of shares by an insider helps the stock price to rise sooner than would otherwise be the case as soon as the word gets out that an insider has bought shares. Such a price rise works to the benefit of existing shareholders. If the stock price is expected to decline, it is not always clear that the insider who decides to sell is treating

shareholders inequitably. The sale would result in inequitable treatment only if the insider were under some duty to announce the expected price decline to shareholders before making the sale.

The OECD has published several White Papers on corporate governance that provide guidance for transition and developing countries in various regions of the world. One such document is its White Paper on Corporate Governance in South Eastern Europe (2003). This White Paper refers to insider trading at least nine times. Chapter 1: Shareholders Rights and Equitable Treatment, para. 111 (p. 20) states: “Insider trading should be forbidden by legislation or securities regulation and monitoring and enforcement of such abusive practiced reinforced.” Some of the other relevant paragraphs state the following:

Para. 112 – Frequent cases of market manipulation occur in SEE financial markets, due to insiders trading while in possession of confidential information. These abusive practices breach the principle of equitable treatment of shareholders. Moreover, they prevent full market transparency, thus harming the integrity of financial markets and public confidence in securities.

Para. 113 – When necessary, legislation or securities regulations should be completed to bring about prohibition of insider dealing and market manipulation. Any person in possession of inside information should abstain from trading on the related security. This concerns primarily managers and board members, but also any person who has access to specific information by exercising his/her profession or duties, such as the auditors or professionals from the regulatory authorities as well as any persons who have been tipped off by insiders. They should abstain from trading directly or indirectly, for their own account as well as for the account of a third party.

Para. 114 – Regulatory authorities should monitor more rigorously insider trading and market manipulation. They should to this effect actively supervise the market and effectively investigate suspicious transactions. Such investigations should include requiring any relevant documentation and data, as well as testimony, and carrying out on-site inspections when necessary. Finally, they should be able to impose sanctions on wrongdoing, by freezing assets, prohibiting professional activity or imposing any other adequate administrative and criminal sanctions, as appropriate in co-operation with the judicial authorities.

Again, the language of these paragraphs would seemingly prohibit all insider trading, which goes too far. An outright ban on insider trading would delay the movement of stock prices in the correct direction, to the detriment of the capital market. In cases where the inside information has been acquired justly, it appears to be a violation of property rights for some government to prevent individuals from trading in such property. The fact that the property in question is knowledge rather than something tangible merely obscures the substance of the basic transaction, which involves the trading of property – cash for shares.

Actually, not all insider trading is illegal. The laws in a number of countries allow it, provided that disclosure of the insider trades is made within some short period of time. Furthermore, not all insider trading is considered abusive, even by OECD standards. The OECD White Paper on Corporate Governance in Asia (2003) admits as much. At page 27 it states: “With regard to self-dealing/related-party transactions involving the properly disclosed participation of an insider, it is important to remember that not all self-dealing/related-party transactions are abusive, and that some – e.g. executive-compensation arrangements – are

unavoidable. A transaction between the company and its insider(s) is only considered abusive when the price is unfair to the company by reference to the price the company would have received from an unrelated party dealing at arm’s length.”

At pages 72-73 it summarizes the various insider trading civil and criminal penalties for 13 Asian countries. Eleven countries provide some kind of civil liability, all 13 assess fines in some cases and eleven countries have penalties that include possible imprisonment, ranging from a maximum of 2 years in Thailand to 21 years in the Philippines.

The World Bank and IMF Position

The World Bank and IMF have a joint project to issue Reports on the Observance of Standards and Codes (ROSC). Their reports benchmark the state of corporate governance in several countries against the OECD Principles of Corporate Governance. Their report on the Czech Republic (World Bank 2002) is indicative of the kind of reports they have been issuing on the subject of corporate governance in general, and insider trading in particular. At page 8 it states:”Self-dealing and insider trading have been reported and appear to be pervasive….Securities laws prohibit the use of inside information for personal benefit. Breaches of the law are punishable by fines up to CZK 20 million (USD 567,000).”

The report on Bulgaria (World Bank 2002) states that the law

“provides for extensive prohibitions of insider trading and market manipulation, including prohibition against entering into transactions, spreading false rumors and forecasts or other acts with the intent of creating of false perception of the prices or volume of traded securities. An insider is defined to include members of management and boards of directors, persons holding ten percent of the shares of

a company (directly or through related parties) or someone who due to his profession, activities, duties or relations of connection of a traded company has access to privileged information. Insider trading and market manipulation are subject only to civil sanctions and do not carry criminal liability. However, market participants complain that information regarding tender offers is distributed very slowly, allowing for the potential for insider trading.” (page 8)

The report recommends instituting criminal penalties in addition to the already existing

civil penalties once the market becomes more active (p. 9).

The World Bank report on Croatia reveals that the securities law prohibits insider trading and provides for fines and imprisonment. However, the law requires insider trades to be reported to the Securities Commission and to the stock exchange within 7 days, so apparently some insider trading is not illegal (World Bank 2001: 10-11).

The World Bank report on Georgia also addresses the issue of insider trading (World Bank 2002). The rules in Georgia prohibit the use of insider information to: “(1) acquire or dispose of shares, (2) disclose insider information to any third party unless the disclosure is made in the normal course of professional duties, or (3) recommend or procure a third party to acquire or dispose of shares.” (p. 10) The Georgia Stock Exchange Code of Ethics prohibits member¬brokers from using information regarding security ownership to increase, decrease or create purchases, sales or exchanges of securities except when the beneficial owner of the security approves.

The World Bank Report on Hungary (2003) states that the Hungarian laws on insider trading largely follow the EU rules. The rules are well-defined. Insider trades must be reported within 2 days. Civil penalties are provided for violating the law and are equal to the amount of

profit generated by the insider trade. The World Bank recommends that the level of fines should be greatly increased. The criminal law has a slightly different definition of insider trading and has penalties of up to 3 years in prison for violation of the law.

The World Bank also has a report on the Republic of Korea (2003). Korean law strictly prohibits trading in material non-public information. Violators are subject to fines and imprisonment and may be held liable for damages. Short-swing profits must be disgorged and profits earned within 6 months must be returned to the firm. Self dealing involving directors requires board approval.

The World Bank report on Latvia (2002) reveals that the civil law and securities law prohibit insider trading by employees, brokers, the Central Depository and third persons who have information from inside sources (p. 8). Criminal law provisions were in the draft stage at the time the World Bank report was issued.

The law in Lithuania (World Bank 2002) provides for both fines and imprisonment for insider trading violations. The World Bank recommends that insider trading be required for 5 percent shareholders and that monetary fines should be increased. It also recommended that the evidentiary burden for proving insider trading violations should be reduced and that there should be clear disclosure of and approval for potential self dealing actions (p. 6)

The Slovak Republic prohibits insider trading (World Bank 2003). The law defines inside traders as shareholders, employees, professionals, or other positions or offices authorized to acquire inside information. Inside information is defined as “information which has not been published, but which could significantly influence the price of securities.” (p. 8) The report also mentions that, although insider trading is illegal, there appears to be no enforcement or

surveillance programs that attempt to prevent or detect it. The World Bank recommends adopting some enforcement authority.

The 16 World Bank Report on the Observance of Standards and Codes (ROSC), Corporate Governance Country Assessment studies that have been completed as of this writing categorized the extent of compliance with the OECD benchmark on insider trading into the following five categories: (1) Observed, (2) Largely observed, (3) Partially observed, (4) Materially not observed, and (5) Not observed. Table 1 shows how closely some countries comply with the OECD benchmark rule on insider trading.

Table 1

Extent of Compliance with OECD Benchmark on Insider Trading

Source: World Bank ROSC Reports www.worldbank.org

As can be seen, most countries miss the OECD benchmark, some by a considerable degree. One might expect that the more developed countries and the countries that either recently

became EU members or that are aiming at near-term EU membership would come closer to the OECD benchmark than the other countries, but such is not necessarily the case. The Czech Republic had one of the lowest rankings. Slovakia ranked only slightly higher. Of the Eastern and Central European countries, Hungary did best, with the highest ranking.

CONCLUDING COMMENTS

Several studies show that insider trading results in a positive-sum game. There are more winners than losers. Thus, it is ethically justified from a utilitarian perspective, at least in the cases where the result is a positive-sum game. However, gathering reliable data to conduct such studies is hampered because of the fact that some insider trading activity is illegal (Bainbridge 2000). Also, it is not always possible to know whether the result is a positive-sum game, even after the fact. That is one of the insoluble structural deficiencies of the utilitarian approach. Thus, utilitarian ethics is not a good tool for analysis of insider trading cases.

Not all insider trading results in the violation of anyone’s rights. In many cases, insider trading is merely the exercise of property rights. Thus, from a rights perspective, it cannot be said that there is necessarily anything wrong with insider trading. It depends on whether anyone’s rights are violated in a particular instance. That being the case, any laws that transition economies adopt that outlaw all forms of insider trading are bad laws. There should be no blanket prohibitions of insider trading because such laws violate property rights, the right to sell information.

The governments of transition economies should not be so quick to adopt laws that mirror the laws of developed countries, even if the OECD, the World Bank, the IMF or other organizations put pressure on them to do so. The main responsibility of the political leaders in

these countries is to their people, not to some far-off organization that may or may not have the best interests of the people in mind. Legislators have a fiduciary duty to their constituents to make good laws and not to make bad laws. Any insider trading laws they make should be based on the application of some recognized value system. Rights theory seems to be the superior approach, since utilitarianism has so many insoluble structural defects. But even applying utilitarianism to insider trading legislation is better than relying on emotional appeals to determine what form legislation should take.

The presumption should be that all capitalist acts between consenting adults should be legal and unregulated. The only exceptions should be in cases where someone’s rights are violated or where some fiduciary duty has been breached. In cases where rights have been violated, the perpetrators should be punished. There are already laws on the books that prohibit the violation of rights, in most cases. Transition economies need to enact such laws where they do not already exist. In cases where a fiduciary duty has been breached, there are already laws on the books, or should be. There is no need to have a special law for breaches of fiduciary duty that involve insider trading.

REFERENCES

Allen, Franklin. 1984. A Welfare Analysis of Rational Expectations Equilibria in Markets. Manuscript, Wharton School, University of Pennsylvania, cited in Bhattacharya and Nicodano (2001).

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