insider trading

Insider trading is the trading of a stock options) by individuals with access to non-public information about the company. In most countries, trading by corporate insiders such as officers, key employees, directors, and large shareholders may be legal, if this trading is done in a way that does not take advantage of non-public information.

However, the term is frequently used to refer to a practice in which an insider or a related party trades based on material non-public information obtained during the performance of the insider's duties at the corporation, or otherwise in breach of a fiduciary or other relationship of trust and confidence or where the non-public information was misappropriated from the company.[1]

In the United States and several other jurisdictions, trading conducted by corporate officers, key employees, directors, or significant shareholders (in the US, defined as beneficial owners of 10% or more of the firm's equity securities) must be reported to the regulator or publicly disclosed, usually within a few business days of the trade. Many investors follow the summaries of these insider trades in the hope that mimicking these trades will be profitable. While "legal" insider trading cannot be based on material non-public information, some investors believe corporate insiders nonetheless may have better insights into the health of a corporation (broadly speaking) and that their trades otherwise convey important information (such as about the pending retirement of an important officer selling shares, greater commitment to the corporation by officers purchasing shares).

The authors of one study claim that illegal insider trading raises the cost of capital for securities issuers, thus decreasing overall economic growth.[3]

Insiders can easily profit using "open market repurchases." Such transactions are legal and generally encouraged by regulators through safe harbors against insider trading liability.[5]

Contents

[edit] Legal insider trading

Legal trades by insiders are common, as employees of publicly traded corporations often have stock or stock options. These trades are made public in the United States through Securities and Exchange Commission filings, mainly Form 4. Prior to 2001, U.S. law restricted trading such that insiders mainly traded during windows when their inside information was public, such as soon after earnings releases.[6]

SEC Rule 10b5-1 clarified that the prohibition against insider trading does not require proof that an insider actually used material nonpublic information when conducting a trade; possession of such information alone is sufficient to violate the provision, and the SEC would infer that an insider in possession of material nonpublic information used this information when conducting a trade. However, SEC Rule 10b5-1 also created for insiders an affirmative defense if the insider can demonstrate that the trades conducted on behalf of the insider were conducted as part of a pre-existing contract or written binding plan for trading in the future.[6]

For example, if an insider expects to retire after a specific period of time and, as part of retirement planning, the insider has adopted a written binding plan to sell a specific amount of the company's stock every month for two years and later comes into possession of material nonpublic information about the company, trades based on the original plan might not constitute prohibited insider trading.

[edit] Illegal insider trading

Rules against insider trading on material non-public information exist in most jurisdictions around the world, but the details and the efforts to enforce them vary considerably. Sections 16(b) and 10(b) of the Securities Exchange Act of 1934 directly and indirectly address insider trading. Congress enacted this act after the stock market crash of 1929.[8]

[edit] Definition of "insider"

In the United States and Germany, for mandatory reporting purposes, corporate insiders are defined as a company's officers, directors and any beneficial owners of more than 10% 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 fiduciary duty that they owe to the shareholders. The corporate insider, simply by accepting employment, has undertaken a legal obligation to 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 obligation to 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 then bought shares in Company A while knowing that the share price would likely rise.

In the United States and many other jurisdictions, however, "insiders" are not just limited to corporate officials and major shareholders where illegal insider trading is concerned but can include any individual who trades shares based on material non-public information in violation of some duty of trust. This duty may be imputed; for example, in many jurisdictions, in cases of where a corporate insider "tips" a friend about non-public information likely to have an effect on the company's share price, the duty the corporate insider owes the company is now imputed to the friend and the friend violates a duty to the company if the corporate insider trades on the basis of this information.

[edit] Liability for insider trading

Liability for inside trading violations cannot be avoided by passing on the information in an "I scratch your back; you scratch mine" or quid pro quo arrangement as long as the person receiving the information knew or should have known that the information was company property. It should be noted that when allegations of a potential inside deal occur, all parties that may have been involved are at risk of being found guilty.

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 (albeit by proxy by passing it on to a "non-insider" so Company A's CEO wouldn't get his hands dirty).[9]

[edit] Misappropriation theory

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 (either the employer's stock or the company's competitor stocks) 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).[10]

[edit] Proof of responsibility

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 stock exchanges actively monitor trading, looking for suspicious activity.

[edit] Trading on information in general

Not all trading on information is illegal insider trading, however. For example, if while dining at a restaurant, one hears the CEO of Company A at the next table telling the CFO that the company's profits will be higher than expected and then buys the stock, one is not guilty of insider trading unless there was some closer connection between you, the company, or the company officers. However, information about a tender offer (usually regarding a merger or acquisition) is held to a higher standard. If this type of information is obtained (directly or indirectly) and there is reason to believe it is nonpublic, there is a duty to disclose it or abstain from trading.[11]

[edit] Tracking insider trades

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 (such as a desire to diversify or pay a personal expense).

[edit] American insider trading law

The United States has been the leading country in prohibiting insider trading made on the basis of material non-public information. Thomas Newkirk and Melissa Robertson of the [13]

Members of the US Congress are not exempt from the laws that ban insider trading, but as they generally do not have a confidential or fiduciary relationship with the source of the information they receive and accordingly, they do not meet the definition of an "insider."[14]

[edit] Common law

US 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 it was about to jump up in price, committed fraud by buying but not disclosing his inside information.

Section 15 of the [16]

Section 16(b) of the SEC Rule 10b-5, prohibits fraud related to securities trading.

The Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 provide for penalties for illegal insider trading to be as high as three times the profit gained or the loss avoided from the illegal trading.[17]

[edit] SEC regulations

SEC regulation FD ("Fair Disclosure") requires that if a company intentionally discloses material non-public information to one person, it must simultaneously disclose that information to the public at large. In the case of an unintentional disclosure of material non-public information to one person, the company must make a public disclosure "promptly."[18]

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

[edit] Court decisions

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.[19]

In 1909, the Supreme Court of the United States ruled in Strong v. Repide[20] that a director upon whose action the value of the shares depends cannot avail of his knowledge of what his own action will be to acquire shares from those whom he intentionally keeps in ignorance of his expected action and the resulting value of the shares. Even though in general, ordinary relations between directors and shareholders in a business corporation are not of such a fiduciary nature as to make it the duty of a director to disclose to a shareholder the general knowledge which he may possess regarding the value of the shares of the company before he purchases any from a shareholder, yet there are cases where, by reason of the special facts, such duty exists.

In 1984, the Supreme Court of the United States ruled in the case of Dirks v. SEC[21] 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[23]

The court ruled in Carpenter: "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 principal for any profits derived therefrom."

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

In 1997, the [25]

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."

In 2000, the SEC enacted affirmative defense for pre-planned trades.

[edit] Insider trading by members of Congress

[29]

[edit] 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.[30] This information may include non-material nonpublic information as well as material public information, which may increase in value when properly compiled and documented.

In May 2007, a bill entitled the "Stop Trading on Congressional Knowledge Act, or STOCK Act" was introduced that would hold congressional and federal employees liable for stock trades they made using information they gained through their jobs and also regulate analysts or "Political Intelligence" firms that research government activities.[32]

[edit] Arguments for legalizing insider trading

Some economists and legal scholars (such as Henry Manne, Milton Friedman, Thomas Sowell, Daniel Fischel, and Frank H. Easterbrook) argue that laws making insider trading illegal should be revoked. They claim that insider trading based on material nonpublic information benefits investors, in general, by more quickly introducing new information into the market.[33]

Friedman, laureate of the Nobel Memorial Prize in Economics, said: "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 did not believe that the trader should be required to make his trade known to the public, because the buying or selling pressure itself is information for the market.[34]

Other critics argue that insider trading is a victimless act: a willing buyer and a willing seller agree to trade property which the seller rightfully owns, with no prior contract (according to this view) having been made between the parties to refrain from trading if there is asymmetric information. The Atlantic has described the process as "arguably the closest thing that modern finance has to a victimless crime".[35]

Legalization advocates also question why "trading" where one party has more information than the other is legal in other markets, such as real estate, but not in the stock market. For example, if a geologist knows there is a high likelihood of the discovery of petroleum under Farmer Smith's land, he may be entitled to make Smith an offer for the land, and buy it, without first telling Farmer Smith of the geological data.[19] Nevertheless, circumstances can occur when the geologist would be committing fraud if, because he owes a duty to the farmer, he did not disclose the information; for example, if he had been hired by Farmer Smith to assess the geology of the farm.

Advocates of legalization make free speech arguments. Punishment for communicating about a development pertinent to the next day's stock price might seem to be an act of censorship.[36] If the information being conveyed is proprietary information and the corporate insider has contracted to not expose it, he has no more right to communicate it than he would to tell others about the company's confidential new product designs, formulas, or bank account passwords.

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 (corn, wheat, steel, etc.). However, analogous activities such as commodity broker can be charged with fraud by receiving a large purchase order from a client (one likely to affect the price of that commodity) and then purchaseing that commodity before executing the client's order to benefit from the anticipated price increase.

[edit] 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 Criminal Justice Act 1993, Part V, Schedule 1, and the Financial Services and Markets Act 2000, which defines an offence of Market Abuse.[37] It is also illegal to fail to trade based on inside information (whereas without the inside information the trade would have taken place). The principle is that it is illegal to trade on the basis of market-sensitive information that is not generally known. No relationship to the issuer of the security is required; all that is required is that the guilty party traded (or caused trading) whilst having inside information.

Japan enacted its first law against insider trading in 1988. Roderick Seeman said, "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."[38]

In accordance with Insider Dealing and Market Abuse Act of 1994.

The "Objectives and Principles of Securities Regulation"[39] 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. Insuring 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 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.

Larry Harris claims that differences in the effectiveness with which countries restrict insider trading help to explain the differences in executive compensation among those countries. The US, for example, has much higher CEO salaries than do Japan or Germany, where insider trading is less effectively restrained.[40]

[edit] By nation

[edit] Norway

In 2009, a journalist in Nettavisen (Thomas Gulbrandsen) was sentenced to 4 months in prison for insider trading.[41]

The longest prison sentence in a Norwegian trial where the main charge was insider trading, was for 8 years (2 of which suspended) when [43]

[edit] United States

Rajat Gupta, who reached the pinnacle of corporate America as managing partner of McKinsey & Co. and director at Goldman Sachs Group Inc. (GS) and Procter & Gamble Co. (PG), was convicted by a federal jury of leaking inside information to hedge fund manager Raj Rajaratnam.[44]

[edit] See also

[edit] Notes

  1. ^ "Insider Trading". U.S. Securities and Exchange Commission. http://www.sec.gov/answers/insider.htm. Retrieved May 7, 2008.
  2. ^ "The World Price of Insider Trading" by Utpal Bhattacharya and Hazem Daouk in the Journal of Finance, Vol. LVII, No. 1 (Feb. 2002)
  3. ^ "Insider Trading" in The Concise Encyclopedia of Economics
  4. ^ Michael Simkovic, "The Effect of Enhanced Disclosure on Open Market Stock Repurchases", 6 Berkeley Bus. L.J. 96 (2009).
  5. ^ Amedeo De Cesari, Susanne Espenlaub, Arif Khurshed and Michael Simkovic, "The Effects of Ownership and Stock Liquidity on the Timing of Repurchase Transactions", 2010
  6. ^ New standards for "legal" insider trading. Community Banker.
  7. ^ "Speech by SEC Staff: Insider Trading - A U.S. Perspective" by Thomas C. Newkirk, Associate Director, Division of Enforcement (September 1998)
  8. ^ "Law and the Market: The Impact of Enforcement" by John C. Coffee, University of Pennsylvania Law Review (December 2007)
  9. ^ Larry Harris, Trading & Exchanges, Oxford Press, Oxford, 2003. Chapter 29 "Insider Trading" p. 589
  10. ^ Larry Harris, Trading & Exchanges, Oxford Press, Oxford, 2003. Chapter 29 "Insider Trading" p. 586-587
  11. ^ 17 C.F.R. 240.14e-3
  12. ^ "Insider Trading – A U.S. Perspective". Sec.gov. http://www.sec.gov/news/speech/speecharchive/1998/spch221.htm. Retrieved 2011-12-21.
  13. ^ "U.S.S.G. §2B1.4". http://www.ussc.gov/2009guid/2b1_4.htm
  14. ^ Congress: Trading stock on inside information?, CBS News, November 13, 2011
  15. ^ "E:COMPIL~1SECURI~1NONOTESSECURI~1.LOC" (PDF). http://www.sec.gov/about/laws/sa33.pdf. Retrieved 2011-12-21.
  16. ^ "Securities Exchange Act of 1934" (PDF). http://www.sec.gov/about/laws/sea34.pdf. Retrieved 2011-12-21.
  17. ^ "Testimony, at". Sec.gov. http://www.sec.gov/news/testimony/2006/ts092606lct.htm. Retrieved 2011-12-21.
  18. ^ Larry Harris, Trading & Exchanges, Oxford Press, Oxford, 2003. Chapter 29 "Insider Trading" p. 586
  19. ^ http://www.econlib.org/library/Enc/InsiderTrading.html. Retrieved 2008-01-22.
  20. http://supreme.justia.com/us/213/419/. Retrieved 2012-08-20.
  21. ^ "FindLaw | Cases and Codes". Caselaw.lp.findlaw.com. http://caselaw.lp.findlaw.com/scripts/getcase.pl?court=US&vol=463&invol=646. Retrieved 2012-08-20.
  22. ^ "FindLaw | Cases and Codes". Caselaw.lp.findlaw.com. http://caselaw.lp.findlaw.com/scripts/getcase.pl?court=US&vol=484&invol=19. Retrieved 2012-08-20.
  23. ^ Cox, Christopher. "Speech by SEC Chairman: Remarks at the Annual Meeting of the Society of American Business Editors and Writers". U.S. Securities and Exchange Commission. http://www.sec.gov/news/speech/2006/spch050106cc.htm.
  24. ^ "United States v. O'Hagan, 117 S.Ct. 2199, 138 L.Ed.2d 724 (1997)". Law.cornell.edu. http://www.law.cornell.edu/supct/html/96-842.ZO.html. Retrieved 2012-08-20.
  25. ^ "Law.com". Law.com. 1997-06-25. http://www.law.com/regionals/ca/briefing/wilson/wilson21.html. Retrieved 2011-12-21.
  26. ^ "House Ethics Manual (2008)" (PDF). http://oce.house.gov/pdf/2008_House_Ethics_Manual.pdf. Retrieved 2011-12-21.
  27. ^ Henry Blodget (November 14, 2011). "THE CONGRESS INSIDER TRADING SCANDAL IS OUTRAGEOUS: Rep. Spencer Bachus Should Resign In Disgrace". Business Insider. http://www.businessinsider.com/the-congress-insider-trading-scandal-is-a-disgrace-rep-spencer-bachus-should-resign-immediately-2011-11. Retrieved Novemver 17, 2011.
  28. ^ "Lawmakers’ inside advantage to trading". Marketplace.publicradio.org. September 17, 2009. http://marketplace.publicradio.org/display/web/2009/09/17/pm-inside-dope/. Retrieved September 20, 2009.
  29. ^ "Durbin Invests With Buffett After Funds Sale Amid Market Plunge". Bloomberg.com. June 13, 2008. http://www.bloomberg.com/apps/news?pid=20601087&sid=aQyYKbwMItyc. Retrieved September 14, 2008.
  30. ^ "Investopedia.com - Mosaic Theory". Investopedia.com. http://www.investopedia.com/terms/m/mosaictheory.asp. Retrieved 2011-12-21.
  31. ^ Gross, Daniel (2007-05-21). "Insider Trading, Congressional-Style". Slate (The Washington Post Company). http://www.slate.com/id/2166664/fr/rss/%20slate.com. Retrieved 2007-05-29.
  32. ^ H.R. 2341 GovTrack.us
  33. ^ "James Altucher: Should Insider Trading Be Made Legal?". Huffingtonpost.com. 2009-10-20. http://www.huffingtonpost.com/james-altucher/should-insider-trading-be_b_324409.html. Retrieved 2011-12-21.
  34. ^ Larry Harris, Trading & Exchanges, Oxford Press, Oxford, 2003. Chapter 29 "Insider Trading" p. 591-597
  35. ^ "Capitol Gains - Magazine". The Atlantic. 2011-10-03. http://www.theatlantic.com/magazine/archive/2011/11/capitol-gains/8692/. Retrieved 2011-12-21.
  36. ^ "Information, Privilege, Opportunity, and Insider Trading" in the Northern Illinois University Law Review
  37. ^ "cato.org". cato.org. 2002-10-24. http://www.cato.org/research/articles/reynolds-021024.html. Retrieved 2011-12-21.
  38. ^ "Japanlaw.info". Japanlaw.info. http://www.japanlaw.info/law2004/JAPANBIZLAWLITE4GAIJIN_INSIDER_TRADING.html. Retrieved 2011-12-21.
  39. ^ "Microsoft Word - No-154.doc" (PDF). http://www.iosco.org/library/pubdocs/pdf/IOSCOPD154.pdf. Retrieved 2011-12-21.
  40. ^ Larry Harris, Trading & Exchanges, Oxford Press, Oxford, 2003. Chapter 29 "Insider Trading" p. 593
  41. Jacobsen. Gulbrandsen var også tiltalt for innsidehandel i DNO-aksjen, men ble frikjent for dette."
  42. ^ Bente Bjørndal (2011-12-13). "Åtte års fengsel for Alain Angelil". DN.no. http://www.dn.no/forsiden/politikkSamfunn/article2284283.ece. Retrieved 2011-12-21.
  43. ^ "Eltek Founder Sentenced to Eight Years in Prison, Police Says". Newsorganizer.com. http://www.newsorganizer.com/article/eltek-founder-sentenced-to-eig-492fa131fb28639ec98bf58368655323/. Retrieved 2012-08-15.
  44. ^ June 16, 2012 1:53 PM ET

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