Insider Trading Deterrence Versus Managerial Incentives: A Unified Theory of Section 16(b)
Part I of this article assesses the social costs of a crude rule of thumb. Because section 16(b) applies to a given class of paired transactions, it deters both transactions based on inside information and transactions not so based. Each time section 16(b) is stretched to include a class of paired transactions, it deters some additional innocent transactions. This side effect will take the form of officers’ and directors’ purchasing fewer shares in their own companies and refusing to accept as large a portion of their compensation in a form based on share price. There are strong theoretical and empirical reasons to believe that managerial share ownership and share-price based compensation are important to the proper functioning of our economy because of the significant incentives they provide for aligning the otherwise divergent interests of management and ‘shareholders. The weakening of these incentives is a social cost of including a given class of paired transactions within the reach of section 16(b ).
Part II develops a theory of how a penalty on short-swing trades works in the case of transactions clearly covered by the statute ordinary cash purchases and sales of securities. It utilizes portfolio theory – the mainstay of modem financial economics – to predict the effect of a short-swing penalty on the respective behaviors of insiders who are and who are not trading on inside information. The fact that transactions occur within six months of each other increases the likelihood that one of them is based on inside information – an increase that is significant over a wide range of plausible values for the relevant parameters. Imposing a penalty on short-swing transactions discourages trades based on inside information by forcing those who would engage in them to remain “dediversified” for six months and hence to be at greater financial risk than they would be without the statute. This theory of section 16(b )’s operation, it will be shown, suggests that purchase and sale should be defined in terms of when the increase in portfolio risk is assumed and when it ends. This theory suggests that the statute should only be concerned with the possibility of abuse at the time of the first transaction.
Part III employs the lessons of Parts I and II to solve the actual problems faced by the SEC and the courts in applying section 16(b) to cases other than pairs of ordinary cash-for-security transactions clearly covered by the statute. It begins by proposing an overall principle of statutory reach derived from the statute’s internal logic, from other evidence of congressional intent, ~md from a concern for economic efficiency: a given class of paired transactions should be included within the coverage of section 16(b) only if the potential officer-and-director transactions belonging to the class, because they are separated by less than six months, contain a larger portion of transactions motivated by inside information than do potential officer-and-director transactions generally. Guided by the theory developed in Part II, this overall principle of statutory reach is then applied to a number of hypothetical examples. This approach is compared with the approaches used by the courts and the SEC dealing with the same issues. As will be seen, the approach based on the theory developed in Part II suggests simple, clear, supportable solutions to a number of problems with which the courts and the SEC have struggled for decades.