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Insider trading

From Academic Kids

There are two kinds of trading that are referred to as "insider trading":

  • Trading of a security of a company (e.g., shares or options) based on material nonpublic information. The trader need not be a corporate "insider." (illegal in some jurisdictions)
  • Trading not based on material nonpublic information by "insiders" of a corporation. (legal)
Contents

Trading on material nonpublic information

There are rules against this type of "insider trading" in most jurisdictions around the world, though the details and the efforts to enforce them vary considerably. In the United States, for example, there is no general federal law directly prohibiting insider trading. Authority to prosecute cases of insider trading came from the Supreme Court's interpretation of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, prohibiting fraud in connection with the purchase or sale of securities. Insider trading was legal in the U.S. until the 1960's.

An example of illegal insider trading may be that you, as an assistant to the Chief Executive Officer, learn that your company is going to be taken over before it is announced to the stock exchange. Knowing that such a move is liable to cause the price to rise, you buy shares in the company and subsequently profit from the transaction.

In practice, prosecutions for insider trading tend to be rare and difficult to win for a variety of reasons. It can be difficult to prove what the accused actually knew at the time the trades were made -- and people may not even be told directly but merely advised to buy or sell with a nudge and wink. Proving that a particular individual was responsible for a trade can also be difficult, because a clever trader can hide behind a variety of nominees, companies, and proxies, some of which may be located offshore in jurisdictions that don't cooperate with the local authorities. Insider trading is usually performed by the already wealthy, who can afford the best lawyers available and have the resources to drag a case out and cost the prosecutors millions along the way. Finally, the details of insider trading can be highly confusing to non-experts, and convincing a randomly-selected jury, many with no experience of share trading, that a crime was committed can be difficult.

Advocates of legalizing insider trading assert that insider trading is a victimless act, pointing out that a stock will eventually move when the non-public information is released regardless. It is claimed that insider trading laws are not aimed at protecting the general public from a crime perpetrated against them but rather serve to relieve what some believe to be a matter of "unfairness" if someone profits by having more information than them. Advocates will claim that making money by having superior information is what the stock market is "all about" and that allowing trading by anyone based on any information they have available will increase the efficiency of the stock market.

Advocates of legalization sometimes also make free speech arguments. Imprisoning someone for telling someone else about a development pertinent to the next day's likely stock moves would seem, prima facie, to be a punishment of prohibited speech, i.e. an act of censorship. [1] (http://www.walterblock.com/publications/information_privilege.pdf)

Also, there is the question of why what amounts to insider trading 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 is entitled to make Smith an offer for the land, and buy it, without first telling Farmer Smith, or competing potential buyers, of the geological data and reasoning that justify his interest. If the value of the hidden oil can be acquired in such a manner in real estate transactions, some ask: why not unlock hidden values in the stock market through the same mechanism?

Trading by "insiders" of a corporation.

Since insiders are required to report their trades, these trades are often tracked by others, and there as a school of investing which follows the lead of insiders.

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