Insider trading

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"Insider trading" is the trading of a corporation's stock or other securities (e.g. bonds or stock options) by corporate insiders such as officers, directors, or holders of more than ten percent of the firm's shares. Insider trading may be perfectly legal, but often the term is used to refer to a practice, which is illegal in many jurisdictions, in which an insider or a related party trades based on material non-public information which was obtained during the performance of the insider's duties at the corporation, or otherwise misappropriated.

All insider trades must be reported in the United States. Many investors follow the summaries of insider trades, published by the United States Securities and Exchange Commission (SEC), in the hope that mimicking these trades will be profitable. Legal "insider trading" may not be based on material non-public information. Illegal insider trading in the US requires the participation (perhaps indirectly) of a corporate insider or other person who is violating his fiduciary duty or misappropriating private information, and trading on it or secretly relaying it.

1 Illegal insider trading
2 American insider trading law
3 Security analysis and insider trading
4 Arguments in favor of insider trading
5 Legal differences among jurisdictions
6 References
7 External links
8 See also

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Illegal insider trading

Rules against "insider trading" on material non-public information exist in most jurisdictions around the world, though the details and the efforts to enforce them vary considerably.

According to the U.S. SEC, corporate insiders are a company's officers, directors and any beneficial owners of more than ten percent of a class of the company's equity securities. Trades made by these types of insiders in the company's own stock, based on material non-public information, are considered to be fraudulent since the insiders are violating the trust or the fiduciary duty that they owe to the shareholders. The corporate insider has made a contract with the shareholders to put the shareholders' interests before their own, in matters related to the corporation. When the insider buys or sells based upon company owned information, he is violating his contract with the shareholders.

For example, illegal insider trading would occur if the chief executive officer of Company A learned (prior to a public announcement) that Company A will be taken over, and bought shares in Company A knowing that the share price would likely rise.

Liability for insider trading violations cannot be avoided by passing on the information in a "I scratch your back, you scratch mine" arrangement, as long as the person receiving the information knew or should have known that the information was company property. For example, if Company A's CEO did not trade on the undisclosed takeover news, but instead passed the information on to his brother-in-law who traded on it, illegal insider trading would still have occurred.

A newer view of insider trading, the "misappropriation theory" is now part of US law. It states that anyone who misappropriates (steals) information from their employer and trades on that information in any stock (not just the employer's stock) is guilty of insider trading. For example, if a journalist who worked for Company B learned about the takeover of Company A while performing his work duties, and bought stock in Company A, illegal insider trading might still have occurred. Even though the journalist did not violate a fiduciary duty to Company A's shareholders, he might have violated a fiduciary duty to Company B's shareholders (assuming the newspaper had a policy of not allowing reporters to trade on stories they were covering).

Proving that someone has been responsible for a trade can be difficult, because traders may try to hide behind nominees, offshore companies, and other proxies. Nevertheless, the U.S. Securities and Exchange Commission prosecutes over 50 cases each year, with many being settled administratively out of court.

Not all trading on information is illegal inside trading, however. For example, while dining at a restaurant, you hear the CEO of Company A at the next table telling the CFO that the company will be taken over, and then you buy the stock, you wouldn't be guilty of insider trading unless there was some closer connection between you, the company, or the company officers.

Since insiders are required to report their trades, others often track these traders, and there is a school of investing which follows the lead of insiders. This is of course subject to the risk that an insider is making a buy specifically to increase investor confidence, or making a sell for reasons unrelated to the health of the company (e.g. a desire to diversify or buy a house).

As of December 2005 companies are required to announce times to their employees as to when they can safely trade without being accused of trading on inside information.

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American insider trading law

The United States has been the leading country in prohibiting insider trading. Thomas Newkirk and Melissa Robertson of the SEC, summarize the development of U.S. insider trading laws [1].

U.S. insider trading prohibitions are based on English and American common law prohibitions against fraud. In 1909, well before the Securities Exchange Act was passed, the United States Supreme Court ruled that a corporate director who bought that company’s stock when he knew is was about to jump up in price committed fraud by buying while not disclosing his inside information.

Section 17 of the Securities Act of 1933 contained prohibitions of fraud in the sale of securities which were greatly strengthened by the Securities Exchange Act of 1934.

Section 16(b) of the Securities Exchange Act of 1934 prohibits short-swing profits (from any purchases and sales within any six month period) made by corporate directors, officers, or stockholders owning more than 10% of a firm’s shares. Under Section 10(b) of the 1934 Act, SEC Rule 10b-5, prohibits fraud related to securities trading.

The Insider Trading Sanctions Act of 1984 provides for penalties for illegal insider trading to be as high as three times the profit gained or the loss avoided from the illegal trading.

Insider trading, or similar practices, are also regulated by the SEC under its rules on takeovers and tender offers under the Williams Act.

Much of the development of insider trading law has resulted from court decisions. In SEC v. Texas Gulf Sulphur Co. (1966), a federal circuit court stated that anyone in possession of inside information must either disclose the information or refrain from trading.

In 1984, the Supreme Court of the United States ruled in the case of Dirks v. SEC that tippees (receivers of second-hand information) are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information and the tipper received any personal benefit from the disclosure. (Since Dirks disclosed the information in order to expose a fraud, rather than for personal gain, nobody was liable for insider trading violations in his case.)

The Dirks case also defined the concept of "constructive insiders," who are lawyers, investment bankers and others who receive confidential information from a corporation while providing services to the corporation. Constructive insiders are also liable for insider trading violations if the corporation expects the information to remain confidential, since they acquire the fiduciary duties of the true insider.

In United States v. Carpenter (1986) the U.S. Supreme Court cited an earlier ruling while unanimously upholding mail and wire fraud convictions for a defendant who received his information from a journalist rather than from the company itself.

"It is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principle for any profits derived therefrom."

However, in upholding the securities fraud (insider trading) convictions, the justices were evenly split.

1n 1997 the Supreme Court adopted the misappropriation theory of insider trading in United States v. O'Hagan. O'Hagan was a partner in a law firm representing Grand Met, while it was considering a tender offer for Pillsbury Co. O'Hagan used this inside information by buying call options on Pillsbury stock, resulting in profits of over $4 million. O'Hagan claimed that neither he nor his firm owed a fiduciary duty to Pillsbury, so that he did not commit fraud by purchasing Pillsbury options.

The Court rejected O'Hagan's arguments and upheld his conviction.

’The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information.’

The Court specifically recognized that a corporation’s information is its property: 'A company's confidential information . . .qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty . . . constitutes fraud akin to embezzlement – the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another.'

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Security analysis and insider trading

Security analysts gather and compile information, talk to corporate officers and other insiders, and issue recommendations to traders. Thus their activities may easily cross legal lines if they are not especially careful. The CFA Institute in its code of ethics states that analysts should make every effort to make all reports available to all the broker's clients on a timely basis. Analysts should never report material nonpublic information, except in an effort to make that information available to the general public. Nevertheless, analysts' reports may contain a variety of information that is "pieced together" without violating insider trading laws, under the mosaic theory. This information may include non-material nonpublic information as well as material public information, which may increase in value when properly complied and documented.

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Arguments in favor of insider trading

Some economists (e.g. Milton Friedman) argue that laws making insider trading illegal should be revoked. They do not consider insider trading to be fraud. Rather they claim that insider trading amounts to a consensual act between adults, i.e. a victimless act. A willing buyer and a willing seller agree to trade property which they rightfully own, with no prior contract (according to this view) having been made between the parties to refrain from trading if equal knowledge is not possessed. Hence, it is maintained that since traders willingly take the risk that the party on the others side of the trade is more knowledgeable, no one's rights are violated.

Insider trading is considered to be "unfair," but modern financial markets do not operate under conditions of "fairness," but rather under specific, enforceable laws. Those in favor of legalizing all insider trading hold that making money by having superior information is the essence of financial markets. A trader only sells stock if he believes the price is going down, and the buyer on the other side of the trade only buys when he believes the price is going up. One of the two traders always has superior information, whether or not it is "inside information." The effort and fine distinctions needed to separate "insider" from other types of information, make insider trading laws fairly arbitrary and inherently difficult to enforce.

Insider trading will make the market price of a stock more accurately reflect all the information known about the stock and can motivate outsiders such as analysts to increase their knowledge about the company. The costs of complying with anti-insider-trading laws are also thus avoided.

Nobel prize-winning economist Milton Friedman says: "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that." Friedman does not believe that the trader should be required to make his trade known to the public (to reveal his identity or the reason for his trade), but says that the buying or selling pressure itself is information for the market. A practical counter-argument to this, however, might be empirical research purporting to show that those markets with strongly enforced laws against insider trading tend to have lower costs of capital for security issuers. (See, for example, "The World Price of Insider Trading" by Utphal Bhattacharya and Hazem Daouk in the Journal of Finance, Vol. LVII, No. 1 (Feb. 2002). [2]) In other words, where certain individuals are permitted to buy and sell shares based on inside information, other investors will be more wary and demand a premium for their investment. This, in turn, raises the cost of capital for all issuers.

Some of those who favor regulations against insider trading assert that market liquidity comes from confidence that all participants have equal access to information. A counter-argument to this is that a significant motivation of trading is the belief on the part of a trader that he has better knowledge than others do in the market and that therefore a stock is improperly priced. If a stock was always accurately priced, there would no point in speculative trading, which would result in decreased liquidity in the market.

Advocates of legalization sometimes also make free speech arguments. Punishment for telling someone else about a development pertinent to the next day's likely stock moves would seem, prima facie, to be one of prohibited speech, i.e. an act of censorship [3]. A counter-argument is that information being conveyed is proprietary information and that a corporate insider, if he has contracted to not expose it, has no more of a free speech right to tell another individual about confidential information that insider acquired by ways of his or her position than to tell others about the company's new product designs, formulas, or bank account passwords. However, communicating inside information is illegal even if it's not by a corporate insider.

There are very limited laws against "insider trading" in the commodities markets, if, for no other reason, than that the concept of an "insider" is not immediately analogous to commodities themselves (e.g., corn, wheat, steel, etc.) (By contrast, "insiders" in a company typically have special access to non-public information about the company's financial performance and future activities that may have an impact on the issuer's stock price.) However, analogous activities such as front running are illegal under U.S. commodity and futures trading laws. For example, a commodity broker can be charged with fraud if he or she receives a large purchase order from a client (one likely to affect the price of that commodity) and then purchases that commodity before executing the client's order in order to benefit from the anticipated price increase. Likewise, an individual employed by the U.S. Agricultural Department, for example, could be charged with fraud if he or she were to receive a draft of the Department's crop report before it is released to the public and then buy or sell commodities or futures contracts based on this non-public information. (This situation was implicit in the Eddie Murphy movie Trading Places.)

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Legal differences among jurisdictions

The US and the UK vary in the way the law is interpreted and applied with regard to insider trading.

In the UK, the relevant laws are the Financial Services Act 1986 and the Financial Services and Markets Act 2000, which defines an offense of Market Abuse. [4] It is not illegal to fail to trade based on inside information (whereas without the inside information the trade would have taken place), since from a practical point of view this is too difficult to enforce. It is often legal to deal ahead of a takeover bid, where a party deliberately buys shares in a company in the knowledge that it will be launching a takeover bid.

Japan enacted its first law against insider trading in 1988. Roderick Seeman says: "Even today many Japanese do not understand why this is illegal. Indeed, previously it was regarded as common sense to make a profit from your knowledge." [5].

The "Objectives and Principles of Securities Regulation" [6] published by the International Organization of Securities Commissions (IOSCO) in 1998 and updated in 2003 states that the three objectives of good securities market regulation are (1) investor protection, (2) ensuring that markets are fair, efficient and transparent, and (3) reducing systemic risk. The discussion of these "Core Principles" state that "investor protection" in this context means "Investors should be protected from misleading, manipulative or fraudulent practices, including insider trading, front running or trading ahead of customers and the misuse of client assets." More than 85 percent of the world's securities and commodities market regulators are members of IOSCO and have signed on to these Core Principles.

The World Bank and International Monetary Fund now use the IOSCO Core Principles in reviewing the financial health of different country's regulatory systems as part of these organization's financial sector assessment program, so laws against insider trading based on non-public information are now expected by the international community. Enforcement of insider trading laws varies widely from country to country, but the vast majority of jurisdictions now outlaw the practice, at least in principle.

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