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Wednesday, February 8, 2023

Arguments for and Against Insider Trading

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A debate rages on in the financial community among professionals and academics about whether insider trading is good or bad for markets. Insider trading refers to the purchase or sale of securities by someone with information that is material and not in the public realm. Insider trading is not limited to company management, directors, and employees. Outside investors, brokers, and fund managers can also violate insider trading laws if they gain access to nonpublic information.

Key Takeaways

  • Critics of insider trading laws claim it should be legal because it provides useful information to markets and laws against it can harm innocent people, while the offense itself causes little damage to others.
  • The main argument against insider trading is that it is unfair and discourages ordinary people from participating in markets, making it more difficult for companies to raise capital.
  • Insider trading based on material nonpublic information is illegal.

Arguments for Insider Trading

One argument in favor of insider trading is that it allows nonpublic information to be reflected in a security’s price and not just public information. Critics of insider trading claim that would make the markets more efficient. As insiders and others with nonpublic information buy or sell the shares of a company, for example, the direction in price conveys information to other investors. Current investors can buy or sell on the price movements, and prospective investors can do the same. Prospective investors could buy at better prices, while current ones could sell at better prices.

Another argument in favor of insider trading is that barring the practice only delays the inevitable and leads to investor errors. A security’s price will rise or fall based on material information. Suppose an insider has good news about a company but cannot buy its stock. Then those who sell in the time between when the insider knows the information and when it becomes public are prevented from seeing a price increase. Barring investors from readily receiving information or getting that information indirectly through price movements can lead to errors. They might buy or sell a stock that they otherwise would not have traded if the information had been available earlier.

Laws against insider trading, especially when vigorously enforced, can result in innocent people going to prison. As rules become more complex, it becomes harder to know what is or is not legal and accidentally break the law. For example, someone with access to material nonpublic information might accidentally disclose it to a visiting relative while talking over the phone. If the relative acts on that information and gets caught, the person who accidentally disclosed it might also go to prison. These sorts of risks increase fear to the point where talented people pursue careers elsewhere.

If you happen to get material nonpublic information, do not make any investment decisions based on it until that information becomes public. Also, never share material nonpublic information information with outsiders.

Yet another argument for allowing insider trading is that it is not serious enough to be worth prosecuting. The government must spend its limited resources on catching nonviolent traders to enforce laws against insider trading. There is an opportunity cost to going after insider trading because the government must divert those resources from cases of outright theft, violent assaults, and even murder.

Why Insider Trading Should Be Illegal

One argument against insider trading is that if a select few people trade on material nonpublic information, then the public might perceive markets as unfair. That could undermine confidence in the financial system, and retail investors will not want to participate in rigged markets. Insiders with nonpublic information would be able to avoid losses and benefit from gains. That effectively eliminates the inherent risk that investors without the undisclosed information take on by investing. As the public gave up on markets, firms would have more difficulty raising funds. Eventually, there might be few outsiders left. At that point, insider trading could eliminate itself.

Another argument against insider trading is that it robs the investors without nonpublic information of receiving the full value for their securities. If nonpublic information became widely known before insider trading occurred, the markets would integrate that information, resulting in accurately priced securities.

Suppose a pharmaceutical company has success in Phase 3 trials for a new vaccine and will make that information public in a week. Then, there is an opportunity for an investor with that nonpublic information to exploit it. Such an investor could purchase the pharmaceutical company’s stock before the public release of the information. The investor could significantly benefit from a rise in the price after the news is made public by buying call options. The investor who sold the options without knowledge of the success of the Phase 3 trials probably would not have done so with full information.

The Legality of Insider Trading

Certain types of insider trading have become illegal through court interpretations of other laws, such as the Securities Exchange Act of 1934. Insider trading by a company’s directors can be legal as long as they disclose their buying or selling activity to the Securities and Exchange Commission (SEC) and that information subsequently becomes public.

For many years, insider trading laws did not apply to members of Congress. Some lawmakers sought to profit from material nonpublic information during the 2008 financial crisis, bringing this issue to the public’s attention. Congress overwhelmingly passed the STOCK Act to remedy this situation, and President Barack Obama signed it into law in 2012.

Examples of Insider Trading

Martha Stewart was infamously convicted of insider trading in 2003. ImClone Systems, a biopharmaceutical company that Stewart owned stock in, was on the verge of having the Food and Drug Administration (FDA) reject its experimental cancer treatment, Erbitux. Stewart’s broker informed her that ImClone Systems’ CEO, Samuel Waksal, sold all of his shares in the company on the bad news. On the tip, Stewart sold her shares in ImClone Systems and avoided a loss, as the stock dropped 16% once the information became public. She was eventually found guilty of insider trading and served five months in prison.

The investors on the other side of Martha Stewart’s trade might not have bought her stock if they had known the full truth. The courts found that Stewart benefited at the expense of other investors.

Another example of insider trading involves Michael Milken, known as the Junk Bond King throughout the 1980s. Milken was famous for trading junk bonds and helped develop the market for below-investment-grade debt during his tenure at the now-defunct investment bank Drexel Burnham Lambert. Milken was accused of using nonpublic information related to junk bond deals that were being orchestrated by investors and companies to take over other companies. He was charged with using such information to purchase stock in the takeover targets and benefiting from the rise in their stock prices on the takeover announcements.

Suppose the investors selling their stock to Milken had known that bond deals were being arranged to finance the purchase of those companies. There’s a good chance they would have held onto their shares to gain from the appreciation. Instead, the information was nonpublic and only people in Milken’s position could benefit. Milken eventually pleaded guilty to securities fraud, paid a $600 million fine, was banned from the securities industry for life, and served two years in prison.

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