Now, however, as we are seeing the problems of stock-option plans, insider trading is beginning to look like an interesting alternative.

Properly Compensate

Many large corporations, especially the high-tech companies whose survival depends on new ideas and inventions, need to properly compensate for innovation. Without incentives for growth, the people who run publicly-held corporations will behave like salaried bureaucrats, averse to anything new and risky. Their interests will be peculiarly aligned with those of debt holders, not shareholders.

This point at least has been dimly understood in the various debates over the past 40 years or so about stock options. The problem was – and is -- that no one could suggest an alternative to stock options for encouraging management to behave in the interests of shareholders. A few academics have joined me in suggesting that insider trading was nearly ideal for that purpose. But politicians won't come near it, and the SEC gags at the suggestion.

Now look where we are. The problems with stock options I identified in my 1966 book, "Insider Trading and the Stock Market," are now apparent to everyone. But, crow not being the preferred diet of Washington officials, it still seems unlikely that the damage caused by the ban on insider trading will get a fair hearing inside the Beltway.

Stock options have always been inefficient at best. As compensation, they have incentive effects in two different ways. When the option is granted, it has a present value equal to the market price for a call on that number of shares. The incentive effect of this kind of compensation, which is more often granted as a reward than as an incentive, will generally be no greater than a bonus paid in shares would be.

After the option is exercised, the executive becomes a larger shareholder. Stock ownership pushes management to maximize share price, especially if the shares represent a substantial part of an employee's undiversified portfolio. But as the employee's shares represent only a tiny fraction of all shares outstanding, the induced incentive for risky choices may still fall short of what would be dictated by the interest of shareholders. In other words, stock options offer no greater incentive than would a similar number of shares held by the manager, however acquired.

Insider trading, on the other hand, allows the insiders to meticulously craft their own reward for innovations almost as soon as they occur and to trade without harm to any investors. The incentive is immediate and precise and is never confounded with stock-price changes that are not of the managers' making. The effect of this trading will always be to move the stock price in the correct direction quickly and accurately, irrespective of what accounting entries are made for the underlying event. Stock prices will, for example, reflect the present value of anticipated future gains from new developments, something accounting cannot and should not provide for.

Look at the alternative, as we have seen in recent months: When stock options are used to encourage risky decisions and insider trading is outlawed, the financial focus of corporate officials necessarily will be on accounting information. When real-world events underlying those entries cannot be traded on directly, the books become their crude proxies. The legal flow of information to the market will be via the formal release of SEC-sanctioned disclosures, such as quarterly reports and 10-Ks.

Since future expected profits can not be shown on the books and trading on the underlying information is not allowed, the urge to make the accounting picture look better in order to have it conform to management's view of the company's prospects may become irresistible. Arguably this is what occurred at Enron and WorldCom.

Currently, the SEC sees its job as regulating the entire market for information. This is madness. It starts at the supply side with accounting rules that began life as managerial tools and tries to make them into a valuation scheme. It finishes on the demand side by restricting insider trading, which merely shifts the identity of the people who may trade first on undisclosed information.

If insider trading were legal and used to replace or supplement stock options, there would be no "tragedies" of employees being left high and dry with options way out of the money. There would be no loss of reward when an innovation merely resulted in a reduction of an expected loss. There would be no unearned gain because a company's stock appreciated in line with a market or industry rise. And there would be no peculiar problems of accounting since such trading would be entirely extraneous to the company's accounts.

Regulate

There are plenty of ways companies could regulate their own insider trading to best fit their needs. Some might limit trading to buying on good news and prohibit selling on bad news. Some could limit the amount of stock an employee could purchase, or outlaw insider trading altogether. We would certainly see some innovation in enforcement techniques and perhaps in the publicity given to insider transactions.

There is no reason to believe that U.S. corporations are incapable of designing workable and safe programs of insider trading. All we have to do is make the present laws optional. Just one thing: I would require companies to disclose details when they had adopted an insider trading system. That way I could go load up on the company's shares.

Henry Manne, a resident of Naples, Florida, is Dean Emeritus of the George Mason University School of Law.  He teaches a course on insider trading at the University of Chicago Law School.

This article was originally published in the Wall Street Journal on August 2, 2002.