Late last year, federal prosecutors announced criminal and civil charges against 21 individuals who allegedly participated in an insider trading conspiracy. The Galleon hedge fund case brought insider trading back into the spotlight, but the debate regarding regulation of insider trading never left.
Legal insider trades take place regularly. Company officers, employees or large shareholders place trades and the details of those trades are reported to the Securities and Exchange Commission (SEC). Illegal insider trading occurs when an insider buys or sells securities based on information which is non-public and material.
"Non-public" simply means the information is private or not readily available to the general public. "Material" information is knowledge that if it were public would cause a substantial change in price. (Check out these bizarre insider trading cases that helped define the SEC's laws against it in Infamous Insider Traders.)
Investors go to great lengths to unearth valuable information. As the saying goes, "the early bird gets the worm." Should the early bird be punished? Let's take a look at the arguments for and against regulation of insider trading.
Keep It Illegal!
Exploitation of the Advantage
Insiders have an undeniable advantage, which wouldn't change regardless of whether currently illegal practices are made legal. With the legalization of insider trading, they will be able to more easily exploit that edge to generate abnormal returns.
Further Alienation of Average Investor
In recent years, Wall Street has taken a beating in the court of public opinion. Quite arguably, much of the disdain is deserved. Legalizing insider trading could create greater animosity towards the "fat cat" bankers, further perpetuating the Wall Street versus Main Street polarization.
Loss of Faith in the Markets
Markets are supposed to be fair and orderly, but for those without access to private information or the means to acquire it, the fairness part can get tricky. Investors may become discouraged, and in the worst case, may refrain from investing. (We look at some of the landmark incidents of insider trading. Don't miss Top 4 Most Scandalous Insider Trading Debacles.)
More Efficient Reaction to Information
In theory, as relevant information becomes available a security's price will reflect the information by rising or falling to its equilibrium price. With illegal insider trading, prices usually pop because investors are rushing to exploit the information. By legalizing insider trading, perhaps a stock would chart a more gradual path to its appropriate value.
For example, in the case of an acquisition, the targeted firm's price usually rises substantially on the day of the announcement. But we all know, acquisitions do not happen overnight. In theory, if insiders were able to trade on non-public information, they would do so over the course of the acquisition, thus preventing sudden jumps in price.
The Charges Don't Stick Anyway
Even if illegal insider trading charges are brought against someone, the case would be difficult to prove. For example, Martha Stewart was associated with an insider trading case, but instead she went to prison for lying to investigators.
The lack of concrete proof leads to many cases being closed by way of a settlement or the offender being found guilty of another charge. In the Galleon case, authorities used wiretapping to intercept over 14,000 phone calls, marking the first time such tactics were used in such a case. (Predated trades at regular intervals can instill confidence, not fear, for investors. Check out Insider Selling Isn't Always A Bad Sign.)
Other Markets Use Inside Information
Many critics point to the real estate market because it functions with insider information being acted upon. For instance, if you think a house is worth more than the offering price, you buy the house that you want and the seller, who was ready to sell anyway, gets what he or she wants. Both go away feeling that they got the best deal, but only time can reveal who really made the best decision.
The Bottom Line
The debate surrounding insider trading is a passionate one, with no end in sight. There is nothing wrong with trying to find information that can make or save you money, but there is something wrong with using illegal ways to gain information. Regardless of what is legal and what is not, one point is not up for debate: people are going to do it anyway.
If you are thinking about engaging in illegal insider trading, beware. The SEC turned up the heat in 2009. Year over year, criminal investigations rose 43%, the number of defendants rose 58% and disgorgement (payback from illegally obtained profits) ordered rose 182%.