Rule 10b 5 of the Securities Exchange Act of 1934, the primary instrument for regulating insider trading, prohibits insiders from trading on material inside information. However, Rule 10b 5 does not prohibit insiders from using inside information to abstain from trading. For example, a CEO who learns that good news will emerge shortly is permitted to postpone an intended sale until after the good news has emerged and boosted the stock price. Because of this "abstention problem," legal commentators both those opposed to Rule 10b 5 and those favoring it have concluded that even when insiders are prevented from trading on inside information, they still retain an unerodable advantage over public shareholders. This paper shows that, contrary to the received wisdom, insiders who are prevented from trading while in possession of inside information cannot out perform public shareholders in their trading even if they are free to use such information to abstain from trading. In fact, insiders who could neither trade nor abstain while in possession of inside information would be systematically worse off than public shareholders. After Examining the distributional effects of insider abstention, the paper considers the efficiency effects of insider abstention namely, its effect on managerial incentives and the cost of capital. The paper explains that while insider trading has the potential to distort managerial incentives and increase the cost of capital, insider abstention does not. The paper concludes by examining the implications of the analysis for various issues in insider trading regulation including the long standing "use vs. possession" debate under Rule 10b 5 and Rule 10b5 1(c), the SEC regulation that provides a safe harbor from Rule 10b 5 liability.
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