Overview of Henry Manne’s, “Insider Trading: Hayek, Virtual Markets, and the Dog that Did Not Bark”

Michael Giberson October 31st, 2007

In “Insider Trading: Hayek, Virtual Markets, and the Dog that Did Not Bark,” Henry Manne reflects on the insider trading literature in law, economics, and finance and considers how well his initial arguments have stood the test of time. His book Insider Trading and the Stock Market was published in 1966. In brief, his answer is that his market efficiency argument still appears correct, his no-significant-harm to long-term investors position still appears correct, and his corporate compensation suggestion doesn’t appear to work well.

He acknowledges one counter-argument may have some merit – short-term traders may suffer an adverse selection risk which will be priced into the market in the form of larger bid ask spreads – but he suggests these costs are probably more important in theory than in practice.

Manne then adds a new line of argument, suggesting that efficient stock prices serve a corporate governance function by aggregating information about the firm that doesn’t always flow smoothly to upper management through normal channels. One of his examples:

Consider the plight of a top manager of a corporation considering the expansion of a major division of the company. He has probably received rosy reports about the division’s performance even though, perhaps contemporaneously, the price of the company’s stock is in sharp decline. … Clearly that manager has some unbiased information that things are not all they appear in his reports to be, and prudence dictates finding out what is really wrong with that division before approving the expansion.

A scenario like that would not be realistic unless someone with information more reliable than that given to the top executives was trading in the company’s stock.

Manne counts this corporate-governance argument as a significant addition to the discussion about insider trading launched by his book over forty years ago.

Given regulation of insider trading, Manne suggests that today companies could use prediction markets to generate some of the same kinds of information. He doesn’t develop the prediction market argument much, it mostly serves as a tool for developing the information aggregation and corporate governance discussion. However, the article may be of interest to prediction market specialists because it highlights the value to corporate executives from access to an aggregated, anonymous opinion about the company, and suggests that prediction markets can help companies capture that kind of value.

(Published in Journal of Corporation Law, volume 31, No. 1, Fall 2005, pp. 167-185. Larry Ribstein invoked Manne’s views on prediction markets in discussing Boeing’s multi-million dollar surprise in the form of hidden (from top management) flaws in the development of the 787. Ribstein’s post was discussed here a few days ago. See also the overview of a related paper by Robin Hanson, “Insider Trading and Prediction Markets.”)