Internalizing Outsider Trading

Abstract

Investing in the United States has become a hobby for many. Individual ownership of equity, moreover, has increased over the past decade due in part to the introduction of internet-based trading. While providing the possibility for greater returns compared with bank savings accounts, among other investment alternatives, the public capital markets also pose greater risks for investors. Many individual investors lack both the resources and the incentive to analyze the value of any particular security in the market. Such investors thus trade at a systematic disadvantage relative to more informed parties. In response, regulators have asserted that certain informational disparities cause uninformed investors to lose confidence in the market, thereby justifying stringent regulation. This Article analyzes the impact of information advantages in the market and proposes a unified approach to regulating such advantages. Informational disparities in the market arise from a number of different sources. An individual investor may contemplate a trade in a particular publicly traded company. Call the company whose securities are being traded the "traded firm". In a world without regulatory prohibitions, individual investors first face the possibility that the traded firm itself will provide nonpublic material information to only a subset of investors in the market. Insiders at the traded firm, for example, may enjoy preferential access to confidential information about the company's business prospects and expansion plans, among other things. Insiders may then exploit this information to profit from trades in the market at the expense of outside investors. The traded firm may also provide internal information to outside investors selectively; for example, giving nonpublic material information solely to a group of analysts that regularly follow the firm.