1994 Articles

Insider Trading Deterrence versus Managerial Incentives: A Unified Theory of Section 16(b)

Fox, Merritt B.

Debate over section 16(b) has generated more heat than light. Critics assert that it is totally ineffective in combating insider trading because all that an insider needs to do to avoid its bite is to wait six months before reversing the trade. Supporters of section 16(b) ignore this criticism and assert that anything but the broadest application of the statute will impede the war against insider trading. The theory developed here refines and focuses this debate. It shows that a penalty on short-swing trading, by prolonging the period of dediversification, does reduce trades based on inside information. It also shows that the penalty has costs: it reduces the attractiveness of management share ownership and share-price-based compensation and detracts from their effectiveness as methods of reducing agency costs.

The theory does not definitely answer the question whether section 16(b) should be retained. It does, however, point to the critical factors for making that determination: one's assessments of the harm, if any, that results from insider trading and of the extent to which lower levels of share ownership and share-price-based compensation increase agency costs. It also identifies the minimum characteristics necessary to justify inclusion of a class of paired transactions within section 16(b)'s reach if the statute is retained: the class must contain a larger portion of potential transactions motivated by inside information than officer-and-director transactions generally.

This rule of statutory reach is important. Whatever one's individual assessments of the factors cited above, section 16(b) is unlikely to be repealed in the foreseeable future. Public sentiment against insider trading is sufficiently strong that a proposal to eliminate the only provision in the Federal securities law that explicitly deals with such trading would meet overwhelming political opposition. Thus we must be sure that this rule of thumb is no cruder than it needs to be. A review of judicial and SEC decisionmaking shows there is significant room for improvement.