INSIDER TRADING AND THE PROBLEM OF CORPORATE AGENCY

This article models an economy in which managers, whose efforts affect firm performance, are able to make ''inside'' trades on claims whose value is also dependent on firm performance, It is shown that insider trading opportunities are a substitute for effort-assuring compensatio n packages. Insider-trading opportunities produce only partial effort incentives. However, they are sometimes less expensive incentive-align ment devices than effort-assuring compensation contracts, which may re quire payments to the manager in excess of reservation levels. Because some of the increase in value from permitting trade comes not from in creased output but rather from the reduction in managerial rents, shar eholders have an incentive to permit insider trade even when preventin g managerial trade and paying effort-assuring compensation to managers produces greater output.