Insider Trading: When, Why, How, Where - Essay Example

?Insider Trading: When, Why, How, Where [ID [Section # Insider trading in the wake of Martha Stewart attracted much attention. It turns out, however, that while insider trading is sometimes illegal, it is not always so. Recent attention caused by a wave of SEC probes and insider trading allegations has renewed concerns over and confusion about insider trading. When is it legal and why? What is the intent of the law? This paper will analyze these factors and come down in favor of insider-trading provisions. Insider trading laws are intended to give some equality to the market. It's important to note that many argue that insider trading is not market manipulation per se: “It is not hard to see that when company insiders trade on the secondary market, they speed up the flow of information and forecasts into prices. Company insiders are in a unique position to make forecasts about the future risk and return of the shares and bonds of their company, hence they might often correctly perceive market prices to be "too low" or "too high". When they trade on the secondary market, they serve to feed their knowledge into prices, thus making markets more efficient. Insider trading is often equated with market manipulation, yet the two phenomena are completely different. Manipulation is intrinsically about making market prices move away from their fair values; manipulators reduce market efficiency. Insider trading brings prices closer to their fair values; insiders enhance market efficiency” (Shah, 1998). Shah points out, however, that even under this assumption about insider-trading which is largely favorable, that the efficiency gains only trickle out throughout the economy and prevent unjust inequality when there are reporting requirements so that non-insiders can benefit (in theory) from insider gains. However, as Insider Today (2011) points out, “[T]here are normally around 2000 filings each day and many of them are of no value to individual investors. It is very hard for an individual to digest the amount of information and still have the time to act on it”. Unfortunately, there is a direct tradeoff between enforcement and preserving a signal-to-noise ratio. Enforcement of insider trading laws has two intents: First, it requires reporting of legitimate insider trading so that the knowledge that insiders have is able to trickle into the general economy; second, it punishes illegitimate trading. Increasing enforcement to get the bad guys requires reporting that reduces the value of the information from the good guys. Nonetheless, insider trading's intent is highly justified. One can make an argument that insider trading leads to greater market efficiency in the short-term, but the problem is that it clearly leads to inequality in the medium term and therefore inefficiency in the long-term. Seyhun (2000, 300-350) found that people trading insider stocks made on average 8.9% more than the market when stocks were good and lost 5.4% less when they were bad. People with insider information are generally, though not always (as we shall see with the example of the railroad workers), people with privileged access to the top of a hierarchy. They're already people like Martha Stewart, Madoff, CEOs or brokers: People who have superior access to information. Based on past societal inequalities, it is likely that those people will be of favored ethnic groups, of the favored gender, etc. These people see their stocks grow more, while investors outside their circle can't compete. These investors then become richer, which leads to increased inequality, which leads to decreased growth over time for a variety of reasons: The newly rich can engage in bona fide market distortion, amassed wealth allows people to ignore market discipline, inequality requires a larger state sector, inequality tends to lead to more capital shocks, etc. (Rodrik, 1999; Reich; Knowles, 2005; Klein, 2010). Worse, if someone within the company divests stock before shareholders can, that is fraud against shareholders who are being given slow or inaccurate information as regards their investment, which violates the fundamental legal requirement of a company making profit for shareholders. It is deeply ironic that Friedman, the man who argues that a company has no responsibility to do anything but generate growth, defends insider trading! Nick Baily, a green businessman, argues, “Insider trading transfers wealth from shareholders to company insiders. That's OK when it's transparent and not based on one party having a monopoly on information...”; however, it becomes illegal and fraudulent when it is not transparent (2011). In essence, it is theft of information that truly belongs to the shareholders. There is also a conflict of interest problem: “To be extremely reductionist, insider trading is like making money betting on a boxing match you helped "fix” (Borodkin, 2011). People who can insider trade are people who can materially alter the behavior of the company: This allows them to game the market in a way that not only violates the shareholder-company or broker-brokered relationship but also in a way that a truly efficient market would not allow. Insider trading is simply defined: “It is against the Rules and Regulations of the Securities Industry to make any use, or enter into any securities transactions while in possession of nonpublic information or to place an order on the basis of "nonpublic" information regarding pending orders in the marketplace” (Huberman and Associates, 2011). But what exactly constitutes material and nonpublic information is up for interpretation, and after United States v. O'Hagan, there is a requirement to prove “culpable intent” (Carr, 1999). The SEC offers a simple bright line: “Insider trading" is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC” (2001). Indeed, there are many arguments that this is good (Seyhun, 2000; Insider Today, 2011; Shah, 1998). The problem comes about when a few things aren't done. First: A non-reported insider trade is always illegal. “Culpable intent” can be inferred by failure to file. Second: If information isn't reported to relevant stakeholders, like shareholders or people one is brokering for, that is illegal. One kind of transaction that is always illegal is liquidating one's own position in an asset or security without informing the people one is brokering for (Huberman and Associates, 2011). One must inform the brokered of any relevant moves. Third: Any other fiduciary duty or confidence that is being violated is an insider trading violation. Fourth: “Tipping” people who one does not have a fiduciary duty to, as happened in the Martha Stewart case, is also illegal. It becomes a violation of the duty one is being paid for and is a version of fraud. Fifth: When that becomes part of business transactions, such as when a transaction includes insider information to sweeten the pot, that is also a form of fraud. Recent events since 2007 have sparked a resurgence in insider trading claims. The SEC is conducting the investigation, as is their duty (Sorkin, 2010). The wave of insider trading isn't just the standard malfactors: “The people cheating the system include bad actors not only at Wall Street firms, but also at Main Street companies” (Sorkin, 2010). Recently, railroad workers were brought in on charges of insider trading when they saw an unusual amount of white-collar workers during the day time examining and using the train, which they expected might be part of actions against their company by creditors and divested their stock. Mark Cuban, owner of the Dallas Mavericks, was charged. Don Ching Trang Chu was “the first arrest in its current investigation of insider trading on Wall Street”, suspected of conspiracy for “allegedly hooking up hedge fund operators with corporate executives who provided the hedge funds with inside information about their companies” (Los Angeles Times, 2010). The SEC has made a “shift in insider-trading jurisprudence away from its roots in deterring and punishing those who abuse special relationships at the expense of shareholders and into a murkier area where the S.E.C. is policing general financial unfairness that has traditionally been considered beyond its authority to regulate” (Sorkin, 2010). This spate of cases may be caused by the bad economy, or by recent high-profile takeovers, or other factors, but one thing is clear: There is an epidemic (Sorkin, 2010; Brush, 2007);. Yet it's important to note that it might be the SEC just looking for violations: Insider trading is omnipresent, even the illegal form (Shah, 1998). The SEC may overreach its bounds in this current investigation, but that should not be allowed to color people against the need for a fair investment market. Insider trading enforcement is a legitimate policy and it is here to stay. Works Cited Bailey, Nick. “Why is insider trading considered bad?” Quora. Retrieved 2/28/2011 from http://www.quora.com/Why-is-insider-trading-considered-bad Borodkin, Lisa. "Why is insider trading considered bad?" Quora. 2011. Retrieved 2/28/2011 from http://www.quora.com/Why-is-insider-trading-considered-bad Brush, Michael. “A new wave of insider trading”, MSN, May 5, 2007. Carr, Brian J. “Culpable Intent Required For All Criminal Insider Trading Convictions After United States v O'Hagan”, Boston College Law Review, Volume 40, Issue 5 Number 5, September 1, 1999. Huberman & Associates. “Sales Abuse”, 2011, Retrieved 2/28/2011 from http://www.ninthhole.com/fraud/index.html Insider Today. “FAQ – Insider Trading”. 2011. Retrieved 2/28/2011 from http://www.insidertoday.com/?faq=abc Knowles, S. 2005, “Inequality and Economic Growth: The Empirical Relationship Reconsidered in the Light of Comparable Data”, Journal of Development Studies, January vol. 41, no. 1. Los Angeles Times. “Feds make first arrest in latest insider trading investigation”. November 20, 2010. Reich, RB. The Great Recession, the Great Recession, and What's Ahead. Rodrik, D. 1999, " Where Did All the Growth Go? External Shocks, Social Conflict, and Growth Collapses," Journal of Economic Growth, Springer, vol. 4(4), pages 385-412, December. Securities and Exchange Commission. “Insider Trading”. 2011. Retrieved 2/28/2011 from http://www.sec.gov/answers/insider.htm Seyhun, Hasan Nejat. Investment Intelligence from Insider Trading. MIT Press: Massachusetts. 2000. Shah, Ajay. “Why forbid insider trading?”, 1998, Retrieved 2/28/2011 from http://www.mayin.org/ajayshah/MEDIA/1998/insider.html Sorkin, Andrew Ross. “Sorkin: So, What Is Insider Trading?”, New York Times, October 25, 2010. Read More