Inside-Trading and Incentives

This paper analyzes shareholders' incentives to sanction inside trading. I show that if a manager of a firm is initially compensated with earnings-contingent contracts, then the welfare of that manager and all of the firm's shareholders can be improved by allowing the manager to trade on his private information. This result is established in the context of a multiple principal (the shareholders)/single agent (the manager) model, with the manager's trades observable ex post, and is robust with respect to the specification of investors' preferences and the definition of stock market equilibrium.