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.)

Legalize It!

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%.

Related Articles
  1. Active Trading Fundamentals

    This Is How 3 Investors Made a Billion Dollars

    Read about three major hedge fund managers who are worth at least $1 billion and who made large amounts of money on a single trade idea.
  2. Investing News

    Mexican Energy, Telecom Reforms Please Foreign Investors

    Two years into his first term, Mexican President Enrique Peña Nieto is following through on radical campaign promises he made to Mexican citizens for sweeping multi-industry reform.
  3. Investing

    Top Cities Where Airbnb Is Legal Or Illegal

    Thinking of subletting your apartment on Airbnb? Make sure that you meet your city's regulations first.
  4. Active Trading Fundamentals

    How Hedge Funds Front-Run Index Funds to Profit

    Understand what front running is, and learn how hedge funds use this investing strategy to profit from the anticipated stock buys of index funds.
  5. Professionals

    Are Hedge Fund ETFs Suitable for Your Portfolio?

    Are hedge fund ETFs right for you? Here's what investors need to consider.
  6. Investing Basics

    How AQR Places Bets Against Beta

    Learn how the bet against beta strategy is used by a large hedge fund to profit from a pricing anomaly in the stock market caused by high stock prices.
  7. Term

    Understanding the Maintenance Margin

    A maintenance margin is the minimum amount of equity that must be kept in a margin account.
  8. Investing Basics

    Explaining the High-Water Mark

    A high-water mark ensures fund managers are not paid performance fees when they perform poorly.
  9. Credit & Loans

    Co-signing a Loan? Make Sure You Know The Risks

    Contractually, co-signers are just as responsible for the loan as the person actually borrowing the money. Be careful not to put yourself at risk.
  10. Professionals

    State Street Shifts to Hedge Funds

    ETF pioneer State Street has been losing market share to its peers. Here's how it plans to turn that around.
RELATED TERMS
  1. Black Money

    Money earned through any illegal activity controlled by country ...
  2. Emergency Banking Act Of 1933

    A bill passed during the administration of former U.S. President ...
  3. Slander

    Slander is the act of harming one person’s reputation by telling ...
  4. Libel

    Libel is publishing a statement about someone in written form ...
  5. Defamation

    Defamation is any statement (written or spoken) that damages ...
  6. Fair Housing Act

    This law (Title VIII of the Civil Rights Act of 1968) forbids ...
RELATED FAQS
  1. What are some high-profile examples of wash trading schemes?

    In 2012, the Royal Bank of Canada (RBC) was accused of a complex wash trading scheme to profit from a Canadian tax provision, ... Read Full Answer >>
  2. Is there a situation in which wash trading is legal?

    Wash trading, the intentional practice of manipulating a stock's activity level to deceive other investors, is not a legal ... Read Full Answer >>
  3. What is the 12b-1 fee meant to cover?

    A 12b-1 fee in a mutual fund is meant to cover the fees of companies and individuals through which investors of a fund buy ... Read Full Answer >>
  4. What are examples of inherent risk?

    Inherent risk is the risk imposed by complex transactions that require significant estimation in assessing the impact on ... Read Full Answer >>
  5. Which federal regulatory agencies approved and are now responsible for enforcing ...

    Five federal regulatory agencies approved and are jointly responsible for enforcing the Volcker rule. These agencies include ... Read Full Answer >>
  6. What is the purpose of the Volcker Rule?

    The Volcker rule limits two main types of activities by large institutional banks. Banks are prohibited from engaging in ... Read Full Answer >>

You May Also Like

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!