Insider trading was at the heart of the legislation that brought the Securities and Exchange Commission (SEC) into existence. Albert H. Wiggin, the head of the Chase National Bank had actually shorted 40,000 shares of his own company. Simply put, he had a significant interest in running his company into the ground. This led to a 1934 revision of the Securities Act of 1933 that was much tougher on insider trading. Ever since Wiggin, insider trading has been one of the most contentious issues on Wall Street. In this article we will look at some bizarre and significant cases that have changed the way we view insider trading. (To learn more, see Policing The Securities Market: An Overview Of The SEC.)

Defining Insiders
One of the first challenges faced by the SEC in the '30s and '40s was how to define an insider. They settled on company officers, directors, and shareholders with 5% or more interest (called beneficial owners). These people had access to information, either formally or informally, before it was made public. Shorting your own company was outlawed and new disclosure requirements were set for insiders. If they did trade using their insider's edge, their profits would be forcibly returned, a fine levied, and they'd face possible jail time. The problem with the new rules was that no firm definition was made as to what constituted material facts, a.k.a. material insider information. (To learn more, see Defining Illegal Insider Trading.)

A Great Deal of Trouble
Two cases over the next two decades left Wall Street deeply confused over what counted as insider trading. In a 1942 case pitting Transamerica Corp against Axton-Fisher minority shareholders, Transamerica - a majority holder of Axton-Fisher - bought out the minority shareholders and then announced that it was liquidating an undervalued inventory of tobacco. The SEC ruled that giving the minority shareholders a lower price than they would have demanded had they realized the inventory was undervalued counted as fraud/insider trading. Before, this was simply smart business. This case effectively put the duty of disclosure on insiders, even if it hurt their potential profits.

The Waiting Period
The water was muddied further in 1959 when a geologist for Texas Gulf Sulphur Company discovered that a site up in Canada was rich in minerals. Not classified as an insider, the geologist told his friends to buy in to his company and bought in himself. Managers and other employees also increased their stock holdings in the company leading up to the official announcement. The SEC took everyone to court and lost - the court ruled that an educated guess can go both ways and employees investing in their company was a positive thing. It was a legitimate way for employees and management to derive additional compensation from their employers while also benefiting industry.

The SEC appealed and got all the decisions reversed, including the directors and managers who bought after the announcement because they did not allow enough time for the news to reach regular investors, Unfortunately, the court refused to define an amount of time that would have been sufficient to act as a future measure. The principle behind the decision was that all market participants must have equal information, and any with an informational edge must disclose or abstain before trading – a decision reinforcing the earlier Transamerica decision.

Raymond Dirks - Falling upon Deaf Ears
Clarity came in 1973 through one of the most flawed cases ever pursued by the SEC. Ronald Secrist, a former Equity Funding Corporation executive, wanted to act as a whistleblower and expose the insurance company's massive fraud. Other employees had attempted this, approaching both state regulators and the SEC at great personal and professional risk, only to be rebuffed. Instead, Secrist turned to analyst Raymond Dirks who believed his story and began to dig into the details. Dirks found ample evidence and took it to the Wall Street Journal. The Journal wouldn't publish anything about the case, delaying until a meeting could be held with Dirks, the whistleblowers and the SEC.

While his message was being ignored, Dirks advised his institutional clients get out of the stock. The Wall Street Journal helped break the news as the selling by Dirk's clients brought broad scrutiny to Equity Funding. When the SEC charges were finally laid, however, Dirks' name was on the list. Because Dirk received material insider information from a former exec and had his clients act upon it, he was guilty of facilitating insider trading. More significantly, these charges exposed him to Equity Funding shareholder lawsuits because he used insider info to damage their holdings.

Whereas management settled for fines or a little jail time, the charges were the start of a 10-year legal battle for Dirks that would go all the way to the Supreme Court. The SEC charged that Dirks was duty bound not to act on the info even though he was unable to turn the matter over to authorities. The Supreme Court found in Dirks' favor. It didn't want to discourage analysts from helping to uncover fraud. Dirks never made any money from exposing Equity Funding, and his case set the criteria to protect whistleblowers and others who expose information that is ultimately beneficial to society. (For more, read Uncovering Insider Trading.)

SEC Bulks Up Enforcement
Another case in the '70s imposed some more limits on the SEC's power to prosecute insider trading. Vincent Chiarella worked for a company specializing in financial printing, including tender offer sheets. Chiarella broke the code used to keep the takeover targets confidential and bought stock in the companies prior to takeover announcements. The Supreme Court ruled in favor of Chiarella because he had no fiduciary responsibility to the companies involved and thus could trade as he pleased. The court also commented on the impossibility of legislating equal information to all investors as well as the concept of information earned through intensive research as a type of property. In this view, property rights support those with informational edges making a profit from their knowledge.

As the Supreme Court tried to rein in the SEC's vague definitions and far-reaching enforcement powers, the SEC was beefing itself up. The 1984 and 1988 insider trading acts upped the penalties while still avoiding a true definition. Penalties were upped from five-10 years and fines jumped from $100,000-1 million for individuals and from $500,000-2.5 million for corporations who were found guilty. New rules made every company culpable for their employees' trades, not just executives, and special rules targeted tender sheet/takeover knowledge. In the SEC's eyes, everyone was an insider until proven guilty.

Conclusion: Should it be Illegal?
The argument against regulation is that insider trading adds a source of information to the market. By reacting to information earlier via insider buying or selling, a stock's price will not get terribly over- or undervalued. Buyers with insider knowledge are also likely to pay more for a stock, passing more to the seller who was ready to sell anyway. Whether or not we'll see insider trading legalized one day, it's clear there are strong arguments on both sides of the debate. And, although investors like Warren Buffett and Peter Lynch consider insider buying positive, the practice has become more risky for insiders.(For more, see Top 4 Most Scandalous Insider Trading Debacles.)

Related Articles
  1. Professionals

    10 Must Watch Documentaries For Finance Professionals

    Find out about some of the best documentaries that finance professionals can watch to gain a better understanding of their industry.
  2. Options & Futures

    Pick 401(k) Assets Like A Pro

    Professionals choose the options available to you in your plan, making your decisions easier.
  3. Investing

    Asset Manager Ethics: Rules Governing Capital Markets

    The integrity of the capital markets needs to be kept at utmost importance for all investors. This article shows how to maintain the integrity while investing.
  4. Economics

    The 5 Countries That Produce the Most Carbon Dioxide (CO2)

    Learn about the top five countries, China, the United States, India, Russia and Japan, that are the largest contributors to carbon dioxide emissions.
  5. Professionals

    How to Launch a Wealth Management Firm

    Opening a wealth management firm is a complex process. By keeping these rules in mind, financial advisors can increase the odds of success.
  6. Economics

    What Do Central Counterparty Clearing Houses Do?

    A central counterparty clearing house facilitates trading in European derivatives and equities markets.
  7. Investing Basics

    Explaining the 10-K

    A 10-K is an annual comprehensive report that thoroughly recaps a company’s performance.
  8. Investing News

    Why Are So Few Women in Finance? It's Complicated

    The number of women entering the finance world continues to decline for a variety of reasons but a game-changing new nonprofit challenges the status quo.
  9. Savings

    Is It Safe to Send Money Through Facebook?

    Learn how Facebook employs strong measures to keep your information safe when sending money, but understand the rare threats that still exist.
  10. Professionals

    Why Advisors Trust These Fund Firms the Most

    These fund firms are tops when it comes to being trusted choices for financial advisors. But Why?
  1. Is a financial advisor allowed to pay a referral fee?

    A financial advisor is allowed to pay a referral fee to a third party for soliciting clients. However, the Securities and ... Read Full Answer >>
  2. How often do mutual funds report their holdings?

    The Securities and Exchange Commission (SEC) requires mutual funds to report complete lists of their holdings on a quarterly ... Read Full Answer >>
  3. Do financial advisors need to be approved by FINRA?

    The term "financial advisor" can refer to a couple of different roles. It most often refers to a broker-dealer or an investment ... Read Full Answer >>
  4. What are the disclosure requirements for a private placement?

    The U.S. Securities and Exchange Commission (SEC) has set forth disclosure requirements for private placements, including ... Read Full Answer >>
  5. What role does the Inspector General play with the Securities and Exchange Commission?

    The inspector general of the U.S. Securities and Exchange Commission (SEC) oversees, audits and conducts investigations of ... Read Full Answer >>
  6. How long does it take to execute an M&A deal?

    Even the simplest merger and acquisition (M&A) deals are challenging. It takes a lot for two previously independent enterprises ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!