978-0136118671 Chapter 6 Solution Manual Part 2

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6. Insider trading. On November 17, 2008, the SEC filed charges against Mark

Cuban for insider trading. The SEC complaint said that Momma.com, an

Internet search engine firm, gave Cuban advance notice of a stock offering at

below-market price, on the condition that he would keep this information

confidential. Cuban already held a good deal of stock in the company and

predicted that the new offering would bring down the market price. As a result,

he sold all of his stock. The market price in fact fell the day after the offering was

announced to the public. Cuban’s early sale allowed him to avoid losses of

$750,000. An SEC official stated, “Mamma.com entrusted Mr. Cuban with

nonpublic information after he promised to keep the information confidential.

Less than four hours later, Mr. Cuban betrayed that trust by placing an order to

sell all his shares. It is fundamentally unfair for someone to use access to

nonpublic information to improperly gain an edge on the market.” Mark Cuban

(allegedly) broke the insider trading law, which is unethical because breaking the

law is normally ungeneralizable. But is there anything inherently wrong with

insider trading? Would it be ethical if it were legal?

Hints. Several arguments have been advanced against insider trading. Do valid

applications of the conditions for rational argument underlie any of these

arguments?



It reduces utility. If the trade affects the stock price, a major stockholder

can dump his holdings just before bad news is released to the public. This

could depress the stock price even more and harm the company. Yet some

economists argue that insider trades make everyone better off in the long

run because the market has more and earlier information about the

company, which leads to more rational investment. If an insider trade has

no effect on the stock price, then the trade benefits the trader and

presumably hurts no one. (Remember that the utilitarian test is not

whether a general practice of insider trading maximizes utility, but

whether a particular investor’s trade does so.)



It results in an “unlevel playing field” or, to quote the SEC official, is

“fundamentally unfair.” Should we treat investment as a competition or

sports event that has to be “fair” in some sense? Some argue that if inside

trading were standard practice, fewer ordinary investors would buy

stocks, because insiders would reap a greater share of the rewards of

investing, and less capital would be raised. (Note that the generalization

test doesn’t ask whether the market would be less efficient, but whether

one can rationally believe that inside traders would still be able to

achieve their purpose of making more money.)



It is misappropriation of company information, which is shareholder

property, and is therefore essentially theft. Can information about

company plans be viewed as property?



It violates fiduciary duty when the insider is a company officer, because

insider trading can harm the company more than it benefits the trader.

This doesn’t apply to Mark Cuban, but is it a valid argument for company

officers?



It redistributes wealth unjustly because it benefits wealthy inside traders

at the expense of small investors.

Let’s begin with a utilitarian analysis. If an insider trade has no effect on the

stock price, then at least on the face of it, it passes the utilitarian test. The trade

benefits the trader and hurts no one and so increases utility. If the trade affects the

stock price, things could go either way. A wealthy inside investor who knows that

To apply the generalization test, we ask whether an inside trader could achieve his

purposes if everyone with the same reason for insider trading practiced it. His

reason is presumably that he is privy to company information that allows him to

make greater gains by buying or selling company stock. Some argue that if inside

trading were standard practice, fewer ordinary investors would buy stocks,

Two additional arguments have the character of generalization tests. One is that

insider trading is wrong because it is misappropriation of company information,

which is shareholder property. Misappropriation of property is similar to theft

and is ungeneralizable for much the same reasons. Yet it is unclear why

information about company plans is property. It is valuable and can be “sold” by

A second argument against insider trading is that it violates fiduciary duty. It

applies only to traders that have fiduciary duty to the company and so would not

apply, for example, to Mark Cuban. It is a generalization argument, because

It all boils down to what the insider has explicitly or implicitly promised to do for

the owners, and this can be vague. If the “sacrifice” implies a net reduction in the

insider’s wealth, as opposed to forgoing an opportunity to increase wealth, then I

The situation is less clear if the insider’s sacrifice is to pass up a chance to make

more money. If an executive can make a windfall on an inside trade that slightly

Let’s return for a moment to the SEC officer’s statement quoted above. He said

that Mark Cuban’s inside trading was fundamentally unfair, presumably because it

So it is unclear how Cuban “betrayed trust.” One might argue that by promising

So far we have found little reason to oppose insider trading on an ethical basis,

except when it demonstrably harms the firm more than it benefits the trader.

If a firm is in trouble, an insider selloff could be seen as a breach of loyalty. The

famous Enron saga poses the issue clearly. Top executives sold off their Enron

holdings just before making announcements that sent the stock price to rock

bottom and left thousands of employees with worthless retirement portfolios.

If there are no loyalty bonds between executives and their associates, this

argument doesn’t work. But in this case virtue has already been compromised. If

There is also an issue of honor and professional mission. An executive who has a

sense of mission in his/her career will feel reluctant to save or make a bundle by

To conclude, insider trading is unethical if it is illegal. If an insider trade is legal,

then it is ethical if it has no effect on the company’s stock price and does not

compromise loyalty or professional honor. In particular, Mark Cuban’s selloff

would have been ethical if it were legal. If an insider trade affects stock price, it

A breach of loyalty or professional honor is hard to define precisely but can be an

important factor. It occurs when an executive has a sense of loyalty to employees

Given this analysis, a case for criminalizing insider trades would have to rest on

utilitarianism or fiduciary duty, not on a “level playing field” argument. The

utilitarian case is hard to make, because economists disagree over the economic

A type of fairness argument I did not discuss would maintain that a public policy

of allowing insider trading violates the Rawlsian difference principle. That is, by

7.* Consulting for Carnegie Foods. The Pet Food Division of Carnegie Foods

operates the world’s second largest pet food cannery at Allentown, Pennsylvania.

It ships to five regional distribution centers, which serve such customers as

Wal-Mart (40% of its business), BJs, Target, Costco, and others. Despite

inventory levels that are substantially higher than the industry average, the

company has experienced difficulty maintaining the service levels its customers

want. Wal-Mart, in particular, demands a high service level, and it usually gets

what it wants due to its market dominance. Adroit Consulting has been engaged

to advise the Pet Food Division on how to manage its supply chain to reduce

inventory and improve service. One option that is being pushed internally is to

install a two-tier system in which a holding warehouse is placed between the

cannery and the distribution centers. Adroit must evaluate this proposal as part

of its recommendations. In the meantime, Carnegie Foods has authorized its

chief information officer (CIO) to acquire Advanced Planning and Scheduling

(APS) software to manage its supply chain. Due to limited resources, the

company will not implement APS and Adroit’s recommendations simultaneously,

and Adroit must advise which to do first. The case raises at least two ethical

issues:



Should Adroit advise Carnegie to use APS, perhaps at the cost of losing a

customer? Supply chain systems like APS are well developed; it is very

possible that once Carnegie implements APS, it will have no further need

for Adroit’s supply chain recommendations.



Is it ethical to provide Wal-Mart better service than other clients simply

because Wal Mart has the clout to demand it—even though Wal-Mart is

paying the same price as the others, or even less?

Let’s begin with the issue of how Adroit should advise Carnegie Foods. To make

the situation more concrete, suppose that Emma Embiyay is the head consultant

on this project and has the authority to sign off on Adroit’s recommendations. If

This brings us to a utilitarian analysis. Although we don’t know how exactly

Emma’s personal utility would be affected by a recommendation in favor of APS,

The utilitarian test therefore requires Emma to recommend APS, unless this

Am I asking Emma to be a martyr? Not necessarily. Maybe she can get creative

and dream up some additional work that Adroit can do for Carnegie Foods, even

This analysis presupposes that Carnegie Foods will actually take Emma’s advice,

An interesting dilemma arises if Carnegie will implement APS first no matter

what Emma recommends. Perhaps the CIO is really sold on this system and is

We just observed that recommending APS may violate fiduciary duty even if it

maximizes utility. Yet as explained in Chapter 2 of the text, fiduciary duty is

Let’s move on to the generalization test. One might argue that giving bad advice

fails the test because it is a form of deception. By giving bad advice, Emma

causes the Carnegie Foods executives to believe that it is her professional

Emma is subject to this argument only if her purpose is to deceive. If she wants to

persuade Carnegie to postpone ASP, then she wants to deceive them into thinking

that this is her honest opinion. But if she doesn’t care whether Adroit loses a

This is not so obvious, however. Even if consultants always fudged their advice

when it promoted their careers, there would be many occasions on which they

So we conclude that Emma’s bad advice is ungeneralizable if her intent is to

Deliberately giving bad advice is a clear violation of virtue ethics. It is

If this is the only virtue at stake, then the choice is clear. Emma must always

give her clients the benefit of her best judgment. However, she might argue that

If there is really a competing virtue, then the virtue ethics test no longer delivers a

clear verdict against giving bad advice. But loyalty to an abstract entity like a

This is a hard case to make. If everyone’s jobs were at stake, then the pull of

loyalty would be a factor to consider—although even in this event, it is unclear

To conclude, we are assuming that APS is best for Carnegie Foods and that

Emma knows it. Given this, the utilitarian test requires her to recommend

implementation of APS first, despite possible negative consequences to her career

Emma’s failure to give the best advice therefore violates at least one condition of

rational choice, very probably violates two, and violates all three unless Emma’s

If Carnegie is likely to implement APS first regardless of Emma’s advice, then

We now take up the matter of how to deal with Wal-Mart. The issue is only

Two lines of argument immediately come to mind. One is that it is unfair to

provide superior service to a customer simply because it has the clout to demand

The opposite argument begins by pointing out that businesses have preferred

customers all the time. If a vendor offers a special deal to attract a preferred

Both arguments sound convincing. To make some progress, let’s apply the

conditions of rational choice.

To run a utilitarian analysis, let’s make the reasonable assumption that if

Wal-Mart doesn’t get the service it wants from Carnegie Foods, it will get equally

It is plausible, however, that Carnegie’s loss of 40% of its business will result in

more harm to itself than good to the competitor. Dog Eat Dog will benefit from

the additional business, but cutbacks at Carnegie will have multiple repercussions

We therefore have a utilitarian argument that if Carnegie must give Wal-Mart

To apply the generalization test, we ask whether Carnegie could achieve the

purposes of providing Wal-Mart better services than other customers—namely,

One of the arguments I initially considered claimed that it is an abuse of the free

As for Carnegie’s conduct, generalizing it may well have an effect on the market

Most computer users cave in to Microsoft’s monopolistic ambitions for the sake

We conclude that there is nothing wrong with Carnegie’s showing favoritism to