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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 (e.g. a desire to diversify or buy a house).
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 (e.g. a desire to diversify or buy a house).


Some companies announce times to their employees when they can safely trade without being accused of trading on inside information.
As of December 2005 companies are required by the FEA to announce times to their employees as to when they can safely trade without being accused of trading on inside information.


== Arguments in favour of insider trading ==
== Arguments in favour of insider trading ==

Revision as of 04:01, 9 December 2005

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

  • Usually illegal: Trading of a security of a company (e.g., stocks, bonds or stock options) based on material non-public information. The trader may be a corporate "insider" or someone unlawfully obtaining the non-public information (which may constitute a separate offence of spying on trade secrets).
  • Usually legal: Trading not based on material non-public information by "insiders" of a corporation. (legal)

Trading on material non-public 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 of the United States' interpretation of Section 10(b) of the Securities Exchange Act of 1934, and in particular of SEC Rule 10b-5, prohibiting fraud in connection with the purchase or sale of securities (see Securities & Exch. Comm'n v. Texas Gulf Sulphur Co., 258 F. Supp. 262 (S.D.N.Y. 1966)). Insider trading has been outlawed in the U.S. since 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 officially disclosed publicly. Knowing that such a move is likely to cause the price to rise, you buy shares in the company and subsequently profit from the transaction. A less dramatic (but still potentially lucrative) example would be trading on the quarterly earnings/losses shortly before they are announced.

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 someone has been responsible for a trade can also be difficult, because a clever trader can hide behind a variety of nominees, companies, and proxies, perhaps located offshore in jurisdictions that do not 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 has been committed can be difficult. The complexity may be because the transactions are inherently complicated, because the transactions were made so to evade prosecution, or as Brian Doughery claims in Reason magazine, the regulations are "designed, like most law, to be understood by trained professionals, not the citizens who have to live under it" [1].

Trading by "insiders" of a corporation

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 (e.g. a desire to diversify or buy a house).

As of December 2005 companies are required by the FEA to announce times to their employees as to when they can safely trade without being accused of trading on inside information.

Arguments in favour of insider trading

Although insider trading is often illegal, there are arguments in its favour. Insider trading amounts to a consensual act between adults, i.e. a victimless act. A willing buyer and a willing seller agree to trade property which they rightfully own, with no prior contract having been made between the parties to refrain from trading if equal knowledge is not possessed. Hence, it is maintained that no one's rights are violated.

A stock will eventually move when the non-public information is released regardless and investors will lose or make money as a result. Many hold that making money by having superior information is what trading is "all about": A trader does not sell his stock unless he believes he knows information that is more indicative of the future move of a stock than his buyer, and vice versa.

Insider trading can make markets more efficient by increasing the amount of information that is known about the company, and can motivate outsiders such as analysts to increase their knowledge about the company. The costs of complying with anti-insider-trading laws are also thus avoided. Nobel prize-winning economist Milton Friedman says: "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 does not believe that the trader should be required to make his trade known to the public (to reveal his identity or the reason for his trade), but says that the buying or selling pressure itself is information for the market.

Some of those who favour regulations against insider trading assert that market liquidity comes from confidence that all participants have equal access to information. A counter-rebuttal to this is that a significant motivation of trading is the belief on the part of a trader that he has better knowledge than others do in the market and that therefore a stock is improperly priced. If a stock was always accurately priced, there would no point in speculative trading, which would result in decreased liquidity in the market. Indeed, all estimates indicate that speculative trading accounts for the lion's share of buying and selling of stocks.

Advocates of legalisation sometimes also make free speech arguments. Punishment for telling someone else about a development pertinent to the next day's likely stock moves would seem, prima facie, to be one of prohibited speech, i.e. an act of censorship [2]. A counter-argument is that public interest may be strong enough to make individual freedom of speech subservient.

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? Also, there are no laws against insider trading in the commodities markets.

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 Financial Services Act 1986 and the Financial Services and Markets Act 2000, which defines an offence of Market Abuse.

It is not illegal to fail to trade based on inside information (whereas without the inside information the trade would have taken place), since from a practical point of view this is too difficult to enforce.

It is often legal to deal ahead of a takeover bid, where a party deliberately buys shares in a company in the knowledge that it will be launching a takeover bid.

Stephen M. Bainbridge, Securities Law: Insider Trading (1999) ISBN: 1566627370

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