Insider trading refers to the transactions done by individuals on stock and securities, such as bonds owned by a public company. The people are said to have knowledge of information about the company that is not known to the public. In some countries, such business is deemed illegal as it seems to disadvantage the ordinary shareholders who have little information about the company hence making them earn less profit as compared to the people who have the said information. According to Dolgopolov (2008), the trading is beneficial and thus it should be encouraged. However, some scholars view transactions as disadvantageous as they inflate the volume of capital required for issuers of securities and thus retard economic growth in general. The employees of a company are also allowed to engage in the trading but on condition that the transaction should not entirely be based on the information that is not available to the public and thus in many countries the business is supposed to be registered so that it can be controlled or checked. Apart from the traders of these securities, the term ‘insider’ may broadly incorporate the associates, brokers, as well as kinsmen of these people. The trading is mainly conducted by directors, corporate officers, and key employees, as well as influential shareholders. The regulations that govern the trading differ from one country to another due to different constitutional laws.
The legal inside trading is well known in the United States of America as people working in public corporations own stock in such companies. The trading is publicized by the Securities and Exchange Commission through filings (Newkirk & Robertson, 1998). The laws concerning the trading in the U.S were enacted possibly due to the crash of the stock market in 1929. This trading may be controversial as it may lead to conflict of interest by the people involved and thus proper regulations need to be put in place and strictly effected so as to ensure that employees or any other people engaged in that business are disciplined. In the U.S., the trading is regulated by rules, whose adherence does not exempt even the members of the Congress who may treat themselves as immune from the law. The rules are:
The Security Act of 1933 (US Securities and Exchange Commission, 2012) restrained directors from engaging in securities-related fraud that may entail buying of shares when they know that the prices are about to rise so that they can sell them at high profits. The Securities Exchange Act of 1933 further illegalized buying and sale of shares within a period of less than six months by the directors of corporations, stock holders, or officers who exceed ownership of 10% of total shares in a company (US Securities and Exchange Commission, 2012). The laws also passed tough penalties on offenders and these acts as a check on discipline.
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US Securities and Exchange Commission (2014) drafted a rule referred to as “Fair Disclosure” that compels a company, which deliberately reveals non-public information to a single person to further reveal the same to the public as well (Harris, 2003). If the revelation was not intentional, the company is also compelled to unearth the same to the public, and this, therefore, makes companies guard their information to avoid leakage. The commission also makes it clear that being in possession of non-public information amounts to an offense, and the evidence that the same information was used in trading is not needed when prosecuting an individual.
The insider trading is controversial and thus it must have checks and measures. The following conditions make the trading efficient:
Non-public information is regulated by rules world over. However, the rules, as well as their effectiveness, differ from one country to another. In the U.S., for instance, the Securities Exchange Act of 1934 was enacted to deal with the issues of securities. The Act prohibits fraudulent transactions as well as employees of security companies putting their personal interests in front of those of the investors. The Act was enacted in 1933 as a control measure after the crash of the stock market in 1929 due to improper transactions (Newkirk & Robertson, 1998). In other countries, different regulations may apply for the same purpose and thus the efficiency of insider trading is ensured. For example, in the United Kingdom, there is the Financial Services and Markets Act 2000 that facilitates investigations as well as prosecution of offenders. However, the United States is regarded as the country possessing the most stringent rules pertaining security companies. All these rules, no matter how different they are, serve the same purpose and thus restoring sanity in the legal insider trading.
The definition of insiders also ensures that the insider trading is conducted in a proper way. In many countries, directors, officials, as well as shareholders with possessing more than 10% of a company’s total shares are regarded insiders and all of them are compelled by law to report their transactions to the relevant authorities for the purposes of monitoring. Any transaction that is based on non-public information is regarded as fraudulent, and by virtue of employment, all workers in security companies are supposed to put the interest of investors in front as compared to their own. When an insider conveys the non-public information to an outsider, the latter is also considered guilty of possessing that information and therefore, he/she is also prohibited from using it to transact business.
The liability of guilt for insider transactions applies both in the person who reveals the information and the recipient as well (Harris, 2003). Trading is a complicated issue as employees of security companies may use proxies to transact business. However, the law does not exonerate the recipient of information from guilt as long as the person knew that the information is non-public. This liability makes the insiders unable to hide their transactions by using friends or hired investors as the third party is also prohibited from using the information that is not publicly known in respect to a company.
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The misappropriation theory is recognized by different countries, among which is the United States. The theory postulates that an employee who illegally uses information from the company, in which he/she is employed, to transact business in stocks of the employer company or its rival, this act is considered offensive and thus punishable by law (Harris, 2003). The application of this theory therefore, plays a good role in restraining employees from misusing company’s information that is considered as non-public.
The proof of responsibility is a difficult issue as it is hard to prove that an individual is behind a transaction. However, much evidence may not be needed in prosecution, for instance, in the United States of America, whereby if a person is found in possession of non-public information, the Securities Exchange Committee may not need evidence to prove that the person used the information in transactions. The committee therefore, initiates prosecution of the person and thus the defendant cannot use evidence as an excuse. The committee monitors transactions and either prosecutes or forwards the cases to the office of attorney for further screening (Cox, 1986). This measure ensures that illegal insider trading is lowered to the minimal level.
Trading on information in general is also approached at an angle that compels employees of security companies to restrain themselves. Very sensitive information about a company, for instance, regarding acquisition or merger, is treated as non-public and therefore, if it is accessed either directly or indirectly, an individual should either reveal it to the public or avoid transacting business by use of it. This classification of information is a broad step towards reduction of illegal insider trading.
Tracking of insider trading is also a measure towards effectiveness of legal trading. All insiders are supposed to report their transactions to the relevant authorities, for instance, the Securities Exchange Committee in the United States of America. However, such authorities additionally conduct market surveillance to trace those people who do not comply with the directive. The tracking helps to compel people to adhere to the rules concerning the use of non-public information and thus it is a step towards eradication of illegal insider trading.
The insider trading is multifaceted and therefore, it has both advantages and disadvantages. Below is a discussion of both merits and demerits of trading.
The insider trading is a means of communication about the market conditions. When insiders of a company reveal information that is not publicly known, they equip investors with the necessary information that guides their investment decisions. This information acts as investment guidance whereby a shareholder knows the right time to buy more shares so as to avoid or minimize loss while at the same time maximizing profits. It is the right of investors to have information regarding their investment and thus because the insider trading conveys information, it is advantageous to all investors if the information is made public. The increase in demand of a given stock in the market is made noticeable by the insider job. However, if such information is revealed to a small group of investors, it may be disadvantageous to the uninformed people and therefore, the management of security companies should consider publicizing information so as to benefit the investors.
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Insider trading helps to drift stock prices to the right angle as well as direction. This trading has an impact of pushing transactions of stocks to a level that signifies the company’s actual or real status. When insiders are allowed to purchase shares or stock, the company is likely to sail in the correct direction because insiders are very keen to ensure that the company engages in right transactions so as to avoid losing. When legal insider trading is achieved by the use of rules to regulate transactions, the interests of both the insiders and investors are met and thus the investment becomes beneficial to both of the two parties.
Professionals, such as analysts of securities, have got an advantage of economies of scale as well as the scope of processing external as well as specific information related to a firm and they are not included in decision making when it comes to running the company. Allowing such people to transact business based on insider information allows more liquidity of securities that arouses competition in pursuit of information (Dolgopolov, 2008). The insider’s job positively affects the way a company communicates to the investors by pumping more information out to the public.
The insider trading is of paramount importance to the owners of large stock blocks. These shareholders avail substantial monitoring of corporate activities and in most cases they are incapable of making their portfolios diverse (Dolgopolov, 2008). This inability makes them susceptible to losses associated with fluctuation of prices and thus insider trading helps to compensate or alleviate their losses by using the inside information to sell or purchase stock during the favorable times so as to earn abnormal profits.
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When a market is efficient in terms of information, the cost of purchasing the stock/shares reflects the information available in the market. This is because transactions involving insiders help to reveal private information hence making the market have sufficient data. The insider trading, therefore, reflects the real value of shares by bringing in private information and thus making the market allocation of shares to be efficient.
Allowing insiders to transact business based on inside information is beneficial as it may reduce the burden of managerial costs by lowering the amount of money paid to the managers as their salaries package because the managers are offered opportunities to trade in the companies (Dolgopolov, 2008). Research conducted in both the United States and Japan shows that when trading profits are high, salaries of the management reduce thus reducing the operational costs of a company.
The inside trading improves efficiency of security markets by propelling the current prices closer to the prices that are likely to be in place in future after the disclosure of information to the general public. In a nutshell, insider’s deals/transactions send a signal to the ordinary investors about the trend of future prices and thus making relevant information to be reflected sooner by the present price of stock (Dolgopolov, 2008). The prices attached to the stock avail valuable hints to the shareholders hence making them allocate capital in an efficient manner.
On a sad note, insider trading is detrimental to the liquidity in the market as it leads to a rise in the cost of transactions due to the losses incurred by specialized intermediaries/market makers who make liquidity exist through continuous purchase and sale of securities (Dolgopolov, 2008). The losses are incurred because of numerous transactions of business with insiders who are always aware of potential market instabilities and therefore, exploit the knowledge in either buying or selling their shares, respectively. However, in order to recover from the losses incurred in such deals, the intermediaries tend to raise the selling price of shares hence negatively affecting the liquidity of shares in the market.
Insider trading may taint the image of the company thus lowering the public confidence and consequently discouraging potential equity market investors as the practice tends to disadvantage the ordinary shareholders in favor of the influential ones as well as employees of the company. The insider trading may lead to the systematic change of wealth from the hands of smaller investors to those of bigger investors (Dolgopolov, 2008) and this may lead to wrangles and confrontations between the two groups of investors.
The insider trading is undesirable as it diverts remuneration and rewards from the basis of productivity and performance to that of sheer access to corporate information. Managers may prematurely reveal information or delay the release in order to manipulate the trading of stocks. Additionally, the managers may delay to relay the necessary information to the decision makers of the corporate affairs and run after extremely risky investments that increase the trading profits at the expense of the value of the corporation. In addition, tolerance on bad performance of the corporation may increase as a result of allowing insiders to make profits on improper development projects (Cox, 1986).
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Insider trading leads to deliberate disruption of trading patterns by the few people who have access to that information. An insider may intend to sell his/her shares but upon receiving positive non-public information he/she may abstain from selling them thus denying the would-be buyers the availability of stocks to buy and thus disrupting the normal flow of trading (Dolgopolov, 2008). This act amounts to an indirect transfer of wealth from the potential purchaser to the would-be seller and thus disruption of the normal trend of transactions.
Many scholars argue that insider trading benefits insiders at the expense of general shareholders. Marketing professionals, security analysts, brokers/dealers, and institutional investors among others have a competitive edge over the ordinary shareholders in terms of access as well as analysis of information (Dolgopolov, 2008) and thus the insider deals tend to favor the former while oppressing the latter.
Cases of people violating the rules governing insider information are rampant and the following are examples of the recent cases whereby Americans were charged with illegal insider trading transactions.
In 2014, the U.S. Securities and Exchange Commission prepared charges for William Redmond, a Chief Executive Officer of GenTek Inc., a company in New Jersey, for briefing his friend Stefano Signorastri before the company was offered for sale. Stefano used the insider information to purchase shares whose value shot up during the sale of the hotel leading to abnormal profits (U.S. Securities and Exchange Commission, 2014a). Redmond was charged for revealing non-public information to Signorastri as well as violating his obligations to the company while the latter was charged for using the information to buy shares, which he later sold after the price shot up by 40% hence making a profit of $164,260. Two other people are said to have obtained the same information from Redmond and they also bought shares to make profit. Redmond and Signorastri were charged by the Commission and they agreed to pay a fine of more than $234,000 so as to clear with the Commission.
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In the same year, the Commission also charged Shvibir Grewal, an attorney providing legal consul to Spectrum Pharmaceuticals, as well as being the owner of shares in the pharmacy. The pharmacy foresaw a decline in expected revenue due to decline in orders placed by its clients. The officials of the company approached the lawyer seeking advice regarding the sale of shares. The lawyer, on the other hand, used the non-public information to sell his shares in the next two days and also instructed his wife to sell hers, too. When the company declared the loss with a 35% decline in share value, the couple avoided a loss of $45,000. As a result, the Commission charged them a fine of $90,000, and Grewal was additionally barred from legally representing any client company.
In conclusion, the insider trading is both beneficial as well as detrimental to the securities trading. The worse side of it is epitomized by advantages that insiders have over the ordinary shareholders by using non-public information to sell the shares when they anticipate decline in share value or to purchase more/abstain from selling so as to increase profit. The ordinary shareholders seem to be disadvantaged because of lack of this information and therefore they are vulnerable to adverse effects of price fluctuations in the stock market. However, on the other hand, insider trading makes the flow of information easy hence making the market effective as well as increasing the competitiveness in the market. Since the trading has got benefits as well as demerits in equal measure, the best way is to encourage the use of legal insider trading so as to distribute non-public information equally to all investors so as to ensure that no investor is advantaged at the expense of others.