Insider Trading in the United States
Dr. M. Y. Khan*
The menace of insider trading has been haunting the regulators of the securities market.
They are adopting all possible means to prevent insider trading. Particularly in the USA,
the Securities and Exchange Commission (SEC) has been very aggressively
pursuing the objective of wiping out insider trading. This paper attempts to explain
the thinking about the insider trading in the United States.
Insiders have been identified as those persons who belong to the company and
have an advantage vis-à-vis the information flow, which they can manipulate also.
In addition to this, they are in a position to produce information; for instance, the
management of a profit making company can, if not restricted, reap personal gains
by selling stocks short while compromising the profitability of the firm. "Insiders"
are defined as the officers and directors of a corporation or any investor who owns
more than 10% of a corporation's outstanding shares. Such individuals are
required by the 1934 Act to report any transaction in the stock of their host
corporation within 10 days after the month of the transaction. This information by
and large forms part of the Official Summary of Securities Transactions and
Holdings, which is published every month by the SEC. Corporate insiders are
prohibited from selling shares short and must return all short-run (six months or
less) profits realized from trading their host company's stock.
According to SEC Rules 10b-5, it is illegal for insiders to trade on information that
has not yet been made public. "Made Public" means the information should be
published in daily newspapers or should be put on the notice board of stock
exchanges on which company is listed and traded. The information passed on to
any other party not related with the company, if used for trading, is also treated as
insider trading. This restriction, imposed by SEC Rule 10b-5, is known as the
‘disclose or abstain rule’, which provides the foundation for most federal
enforcements concerning fraudulent conduct. The specific criteria for determining
fraud under Rule 10b-5 has subsequently been established by the federal courts.
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The information used by a trader must be found to be in violation of the rule, and
must be of material importance. That is, if reversed, the information would have
to affect a contraparty's trading decision. The trader must also know that the
information is unavailable to the public. An individual in possession of such
nonpublic information has an obligation to disclose it before participating in a
trade based upon it. A failure to disclose such information thus constitutes fraud.
It is fraud and not unfairness or an inaccurate relationship between information
and prices, which Section 10(b) of the 1934 Act is intended to prevent.
Insider trading originates form a number of sources, like, takeover activity, profit
taking, etc. Takeover activities by and large involve numerous people, such as
lawyers, accountants, auditors, typists, publishers and executives of consultant
companies, to handle takeover. In normal course of their duties and jobs, they
come to possess sensitive information regarding merger and acquisition or relating
to any other activity of the company. These informations are not available to
public and are utilised by the insiders before they are publicly announced or they
are passed on to other parties for compensation.
There have been numerous controversies over the concept and definition of
'information'. The main question is whether information which is sensitive and
can be utilised by some persons related to company under reference for personal
gains and can harm the interest of company or shareholders. The definition of
information is ambiguous, for instance, a knowledge pertaining to request of
sanction of line of credit by a commercial bank, is not in itself information, but, if
the bank has indicated that the request is likely to be honoured, it would become
an information. Private information as a matter of fact differs from inside
information. It is argued that the trading which takes place on the basis of private
information is permissible and it is crucial and essential for obtaining the
informational efficiency of the market. The economic gains or profits which are
earned by stock analysts based on research undertaken by them work as incentive
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for information to be brought to light. In the absence of such an incentive,
sufficient amount of information would not be supplied to the market.
Restricting Insider Trading
Arguments both for and against insider trading restrictions are substantial. At the
heart of the issue is market failure - the failure of the free market to achieve an
efficient and equitable distribution of resources when the distribution of
information among market participants is asymmetric. The complexity of the
question is compounded by the fact that controlling insider trading is costly.
Manne was one of the first to argue against the trading restrictions. According to
Manne, profits realized through insider trading should be allowable as a reward for
entrepreneurship. He and other have argued further that insider trading, while
causing losses for those who are contraparties to the insider trades, benefits the
broader community of investors by keeping prices more closely aligned with the
underlying determinants of share value.
Insider trading restrictions have resulted in conflicts of interest. One department
of an investment bank may, for instance, be in possession of information
concerning a client firm that is relevant for customers of another department of the
bank. The bank's fiduciary responsibility to the client firm dictates that the
information be kept secret, but the bank's fiduciary responsibility to customers
calls for disclosure. Securities firms have attempted to avoid such conflicts of
interest by separating various departments with a mechanism known as a "Chinese
wall." Nevertheless, investment banks many times find themselves in a no-win
situation with regard to information that a client is unwilling to make public.
The following example suggests the difficulties involved. Assume that registered
representatives at a brokerage house are promoting the stock of a manufacturing
corporation at a time when the investment banking department of the securities
firm is well aware that serious technological problems have emerged at one of the
plants of the corporation of which the shares are under consideration. The
manufacturing corporation has directed the securities firm not to divulge the
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information, and a Chinese wall at the securities firm prevents the investment
bankers from passing the information on to the registered representatives. The
brokerage firm, however, is not allowed to solicit customers without revealing all
of the information that it has. They could, of course, stop trading in the client's
stock; however, the very act of not trading would signal the existence of new
information to the market. It appears that whichever way the securities firm turns,
it will not be able to satisfy the dictates of the law.
Difficulty of Control and Detection
The general experience is that the trading based on inside information is difficult
to control and to detect. In a global environment, trades can be made in countries
where restrictions do not exist. Bank secrecy laws in Switzerland, for example,
until recently prevented the disclosure of information concerning trades in U.S.
stocks which were made on the basis of nonpublic information. Other places with
bank secrecy laws include Bahamas, Panama, Bermuda, and the Cayman Islands.
In an environment of communication network and complex financial operations it
is exceedingly difficult to control informational leaks and to police those who
might use information for their personal gain. Berg wrote in a New York Times
article, "Wall Street is a warren of information 'networks' - cliques that exchange
information regularly to win out over investors who are not part of any clique."
Further, an insider can, without restriction, exploit information relating to his or
her own firm by trading the equity shares of a competitor, supplier, or customer
firms that is also affected by the information. This further distorts the relationship
between information and prices.
* Economic Adviser, SEBI. The views expressed in this paper are of the author and not
necessarily of his employer.
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