Theories for Prohibiting Insider Trading III
Unlike the earlier theories on fraud and breach of the fiduciary obligation, that focus more on the individual losses and effect of insider trading to investors and managers, the third theory chooses to focus more on the effect of insider trading to the liquidity traders. The third theory also focuses more on the aggregate and big picture effect of insider trading to the market and economy as a whole and not just merely center on the individuals. The third theory that was made to further strengthen the argument for prohibiting and illegalizing insider trading has been called the �information access’ theory. According to this theory, insiders posses information that is special in their own way. The information that the insiders posses are important and special because of two things: the information can only be obtained by the insiders and therefore it would be illegal for the investors to obtain them and at the same time these information is only residual information.
Information possessed by insiders is important because only insiders can get this information without any legal consequences. This means that the insiders are put in a different and more advantageous position than the non-insiders or investors. This kind of advantage is deemed �insurmountable� for the investor and other market actors. The situation where insiders have an insurmountable advantage over other investors by virtue of the information makes the financial market unfair.
On the other hand, the information that is obtained by the insiders is only residual information. Residual information means that the information obtained by insiders is not created for the sake of having this information. The information is created or generated for other purposes and what is left of the information is what is being used by the insiders. It follows, therefore, that even if insiders are prohibited from trading using the information they obtained, valuable information will still be generated by the insiders, not for trading but as a necessary consequence of their work. There will be no loss for the corporation if insider trading were prohibited.
On the other hand, the prohibition of insider trading will produce the effect of strengthening the confidence of the non-informed investors in trading in securities. This would, in turn, lower any risks or costs that they may face in trading. They would then be more incentive in trading in the securities market, thereby making the markets more stable and liquid. According to the proponents of the information access theory, the primary motivation and intention of the legislative in enacting the Securities and Exchange Act of 1934, particularly Section 10(b)-5, is to increase the fairness of the security market as well as promote the security market’s stability and liquidity. Even if there are three theories that support the prohibition of insider trading, these theories still left many questions about the propriety of declaring insider trading as unlawful. These questions have been exploited by the proponents of legalizing insider trading. These gaps in the three theories enabled the other scholars to create their own rationales on why insider trading should be legalized. I will discuss what the counter-arguments and theories are that support legalizing insider trading in the following articles.