Insider Trading has been all over the news lately. First it was Enron and WorldCom. Then even the apparently squeaky clean Martha Stewart got pulled in. So just what is Insider Trading? How can you avoid problems with it, even if you are not classified as an insider?
Insider trading isn’t fraud. In most cases those prosecuted never had contact with the alleged victims on the other side of their trades. Although the victims chose to trade without prompting, the legal issue is only whether the trade was based on inside information.
How it occurs ?
Insider trading occurs (1) when an insider to a company, such as an officer or someone who owns a large percentage of the company, trades the company's stock. This is legal and acceptable, as long as that person is not trading based upon non-public company information.
Insider trading also occurs (2) when anyone, including employees, trades using non-public company information. This is considered illegal.
The illegal kind of Insider Trading is the trading in a security (buying or selling a stock) based on material information that is not available to the general public. It is prohibited by the US Securities and Exchange Commission (SEC) because it is unfair and would destroy the securities markets by destroying investor confidence.
The law bizarrely affects only one-half of the trading equation. People make money by not trading as well as trading. But it is virtually impossible to prove that someone chose not to buy or sell stock because of a legally improper tip. So hundreds, maybe thousands, of people get away with insider “not trading” every year. Yet it isn’t obvious that the operation of the financial markets is impaired in any way.
If there is a problem in the market about insider trading, it’s that the market is biased by imposing criminal sanctions on only one side of the transaction. Inside information should lead roughly equal numbers of people to buy, sell and do nothing. The criminal law encourages people to do nothing. Whatever the impact, it isn’t likely to be more efficient markets.
Insider-trading laws deny markets important information. The recent financial crisis was caused in large part by inadequate information. People didn’t know the true value of mortgage-backed securities, leading to a financial house of cards that crashed down on federal agencies, investment houses, commercial banks and average investors.
The distinction between public and non-public information is legally decisive but economically unimportant. Perversely, the insider-trading laws seek to prevent people from trading on the most accurate and up-to-date information. The law seeks to force everyone to make today’s decisions based on yesterday’s data. It’s a genuinely stupid thing to do.
The only plausible argument for ensuring that everyone trades on inadequate and outdated information is “fairness.” The Securities and Exchange Commission’s Enforcement Director, Robert Khuzami, says insider-trading prosecutions are aimed at restoring “the level playing field that is fundamental to our capital markets.”
That is, just because your brother-in-law works at the accounting firm, you shouldn’t be able to buy or sell based on his disclosure of a client company’s dire financial straits until everyone knows it.
But Wall Street is built on metaphorical hillsides. The market is suffused with this sort of unfairness. Professional investors make money because of asymmetries of information. Someone working on Wall Street is almost always going to be better versed on financial issues than a casual investor. People make careers picking up hints and suggestions to use in trading.
However unfair it might seem to trade on inside information, it is unfair to no particular person.
Unless you committed fraud as part of the transaction, the person who bought your shares or sold his did so because he wanted to do so based on his information. Your “inside” information had no impact on his decision, especially in the impersonal markets through which most security transactions occur.
Acting on new information moves the market toward the right or “honest” price, as economist Donald J. Boudreaux puts it. Prosecuting people for insider trading slows the price-adjustment process. That means the price shock when the relevant news hits the market will be more abrupt and the losses will be greater for some people.
In some insider-trading cases there is a genuine victim: individuals or companies whose proprietary information was improperly disclosed. That should be punished, but as a civil offense based on the relevant contractual or fiduciary relationship. This kind of disclosure shouldn’t be of concern to the feds, let alone be an offense serious enough to justify wiretaps and mass arrests.
Yet the SEC employs sophisticated computer software to identify a few “suspicious” trades out of hundreds of millions of transactions. Agency enforcement chief Khuzami wants greater access to grand-jury information and greater power to pressure defendants to turn in their confederates.
Insider trading shouldn’t be a crime. There typically is no victim. To the contrary, most of us benefit when prices move more rapidly to the right level.
Unfortunately, prosecutors, regulators and politicians alike periodically demonize insider trading to justify their offices and budgets. But there is no reason to punish investors who trade on accurate information. In fact, that is precisely what the financial markets should encourage.
An Insider
A company insider is someone who has access to the important information about a company that affects its stock price or might influence investors decisions. This is called material information.
The company executives obviously have material information. The Vice President of Sales, for example, knows how much the company has sold and whether it will meet the estimates it has provided to investors. Others within the company also have material information. The accountant who prepares the sales forecast spreadsheet and the administrative assistant who types up the press release also are insiders.
A public company, if it is smart, limits the number of people who have access to material information and, therefore, are considered insiders. This is done for a couple of reasons. First, they want to limit the likelihood that anyone will "leak" the information. Second, being an insider means being subject to severe limits on when you can trade in the company stock, usually only the middle month of each quarter.
The company's senior management are insiders. So are some of the financial analysts. The top sales people usually also are insiders, although a regional sales manager who only sees his or her own region's results may not be one. The individuals in Investor Relations and/or Public Relations who prepare the public announcements also are insiders.
If the company is developing a new product that could be a big seller, the key people in the Research & Development team would also be considered insiders, provided the information they have is material, as defined above.
Other individuals who are not employees, but with whom the company needs to share material information, are also insiders. This list could include brokers, bankers, lawyers, etc.
Not An Insider
So does that mean you are not an insider unless you are on the company's management team, financial or development teams, or someone hired to handle the material information? In a word, "No".
The SEC includes in its definition of insiders those who have "temporary" or "constructive" access to the material information. If the President of a company tells you that the company's best hope for a breakthrough product isn't going to get regulatory approval, you are now every bit as much an insider as he is, with respect to that information. It is illegal for him to trade based on that knowledge before it becomes public knowledge. It is equally illegal for you to do so because you are now a "temporary insider". This remains true regardless of how many times the information is passed. If the president tells his barber, who tells her baby sitter, who tells her doctor, who tells you, the barber, baby sitter, doctor and you are all "temporary insiders".
Anyone who has material information is prohibited from trading, based on that knowledge, until the information is available to the general public. The US Supreme Court ruled recently, that this even applies to someone with no ties to the company. Possession of material information makes you an insider, even if you stole the information.
Insider trading isn’t fraud. In most cases those prosecuted never had contact with the alleged victims on the other side of their trades. Although the victims chose to trade without prompting, the legal issue is only whether the trade was based on inside information.
How it occurs ?
Insider trading occurs (1) when an insider to a company, such as an officer or someone who owns a large percentage of the company, trades the company's stock. This is legal and acceptable, as long as that person is not trading based upon non-public company information.
Insider trading also occurs (2) when anyone, including employees, trades using non-public company information. This is considered illegal.
The illegal kind of Insider Trading is the trading in a security (buying or selling a stock) based on material information that is not available to the general public. It is prohibited by the US Securities and Exchange Commission (SEC) because it is unfair and would destroy the securities markets by destroying investor confidence.
The law bizarrely affects only one-half of the trading equation. People make money by not trading as well as trading. But it is virtually impossible to prove that someone chose not to buy or sell stock because of a legally improper tip. So hundreds, maybe thousands, of people get away with insider “not trading” every year. Yet it isn’t obvious that the operation of the financial markets is impaired in any way.
If there is a problem in the market about insider trading, it’s that the market is biased by imposing criminal sanctions on only one side of the transaction. Inside information should lead roughly equal numbers of people to buy, sell and do nothing. The criminal law encourages people to do nothing. Whatever the impact, it isn’t likely to be more efficient markets.
Insider-trading laws deny markets important information. The recent financial crisis was caused in large part by inadequate information. People didn’t know the true value of mortgage-backed securities, leading to a financial house of cards that crashed down on federal agencies, investment houses, commercial banks and average investors.
The distinction between public and non-public information is legally decisive but economically unimportant. Perversely, the insider-trading laws seek to prevent people from trading on the most accurate and up-to-date information. The law seeks to force everyone to make today’s decisions based on yesterday’s data. It’s a genuinely stupid thing to do.
The only plausible argument for ensuring that everyone trades on inadequate and outdated information is “fairness.” The Securities and Exchange Commission’s Enforcement Director, Robert Khuzami, says insider-trading prosecutions are aimed at restoring “the level playing field that is fundamental to our capital markets.”
That is, just because your brother-in-law works at the accounting firm, you shouldn’t be able to buy or sell based on his disclosure of a client company’s dire financial straits until everyone knows it.
But Wall Street is built on metaphorical hillsides. The market is suffused with this sort of unfairness. Professional investors make money because of asymmetries of information. Someone working on Wall Street is almost always going to be better versed on financial issues than a casual investor. People make careers picking up hints and suggestions to use in trading.
However unfair it might seem to trade on inside information, it is unfair to no particular person.
Unless you committed fraud as part of the transaction, the person who bought your shares or sold his did so because he wanted to do so based on his information. Your “inside” information had no impact on his decision, especially in the impersonal markets through which most security transactions occur.
Acting on new information moves the market toward the right or “honest” price, as economist Donald J. Boudreaux puts it. Prosecuting people for insider trading slows the price-adjustment process. That means the price shock when the relevant news hits the market will be more abrupt and the losses will be greater for some people.
In some insider-trading cases there is a genuine victim: individuals or companies whose proprietary information was improperly disclosed. That should be punished, but as a civil offense based on the relevant contractual or fiduciary relationship. This kind of disclosure shouldn’t be of concern to the feds, let alone be an offense serious enough to justify wiretaps and mass arrests.
Yet the SEC employs sophisticated computer software to identify a few “suspicious” trades out of hundreds of millions of transactions. Agency enforcement chief Khuzami wants greater access to grand-jury information and greater power to pressure defendants to turn in their confederates.
Insider trading shouldn’t be a crime. There typically is no victim. To the contrary, most of us benefit when prices move more rapidly to the right level.
Unfortunately, prosecutors, regulators and politicians alike periodically demonize insider trading to justify their offices and budgets. But there is no reason to punish investors who trade on accurate information. In fact, that is precisely what the financial markets should encourage.
An Insider
A company insider is someone who has access to the important information about a company that affects its stock price or might influence investors decisions. This is called material information.
The company executives obviously have material information. The Vice President of Sales, for example, knows how much the company has sold and whether it will meet the estimates it has provided to investors. Others within the company also have material information. The accountant who prepares the sales forecast spreadsheet and the administrative assistant who types up the press release also are insiders.
A public company, if it is smart, limits the number of people who have access to material information and, therefore, are considered insiders. This is done for a couple of reasons. First, they want to limit the likelihood that anyone will "leak" the information. Second, being an insider means being subject to severe limits on when you can trade in the company stock, usually only the middle month of each quarter.
The company's senior management are insiders. So are some of the financial analysts. The top sales people usually also are insiders, although a regional sales manager who only sees his or her own region's results may not be one. The individuals in Investor Relations and/or Public Relations who prepare the public announcements also are insiders.
If the company is developing a new product that could be a big seller, the key people in the Research & Development team would also be considered insiders, provided the information they have is material, as defined above.
Other individuals who are not employees, but with whom the company needs to share material information, are also insiders. This list could include brokers, bankers, lawyers, etc.
Not An Insider
So does that mean you are not an insider unless you are on the company's management team, financial or development teams, or someone hired to handle the material information? In a word, "No".
The SEC includes in its definition of insiders those who have "temporary" or "constructive" access to the material information. If the President of a company tells you that the company's best hope for a breakthrough product isn't going to get regulatory approval, you are now every bit as much an insider as he is, with respect to that information. It is illegal for him to trade based on that knowledge before it becomes public knowledge. It is equally illegal for you to do so because you are now a "temporary insider". This remains true regardless of how many times the information is passed. If the president tells his barber, who tells her baby sitter, who tells her doctor, who tells you, the barber, baby sitter, doctor and you are all "temporary insiders".
Anyone who has material information is prohibited from trading, based on that knowledge, until the information is available to the general public. The US Supreme Court ruled recently, that this even applies to someone with no ties to the company. Possession of material information makes you an insider, even if you stole the information.
