What's up with Wall Street? It seems all you hear about lately are insider trading scandals involving scads of money and high-profile executives previously thought beyond reproach. (For related reading, also see Top 4 Most Scandalous Insider Trading Debacles.)
TUTORIAL: Stock Basics
It was a major shock when, in October 2009, trusted hedge fund manager Raj Rajaratnam was charged with insider trading after making $45 million with nonpublic information from corporate insiders and hedge-fund traders. The ensuing court drama is still playing out, and Rajaratnam may spend up to 20 years in prison if convicted.
Buffett and Sokol
The sudden resignation of Berkshire Hathaway heir apparent David Sokol in March due to accusations of insider trading was an even bigger shock. It sullied the reputation of Berkshire founder Warren Buffett, who has always been seen as the epitome of trustworthiness.
In that case, Sokol made about $3 million from the stock of a chemical company Berkshire planned to acquire only a couple months after Sokol purchased the shares. Those plans hadn't yet been announced to the public, though, which is why Sokol is under the media spotlight.
A Culture of Success
Although financial professionals would probably say Wall Street generally operates in an ethical fashion, ethics do occasionally fall by the wayside for a number of reasons. Obviously, extreme circumstances that make it more difficult to do business profitably like the recent financial crisis and recession could prompt someone to resort to insider trading. However, Wall Street scandals occur in all sorts of conditions, suggesting there's more to it than simple economics.
"It's the culture of success," explains Jeffrey Leeds, president of Leeds Equity Partners in his article "Are Ethics for Suckers?" published in Newsweek, "Where people are playing for super-high stakes and where you're attracting alpha men and women, you're going to see more people tend to bend the rules, because what you get for success is out of proportion."
Conflicting rules and incentives promote insider trading, too. Although it's illegal to trade on material nonpublic information, professional investors may be more apt to because their pay is usually tied to performance. That can make the temptation to use inside information irresistible, especially now that the financial markets are larger and more competitive than ever.
Insider trading isn't always about success, money and greed, though. It can also result from simple negligence where an employee inadvertently reveals confidential information about a company to an outsider, who then succumbs to the temptation to act on the information.
TUTORIAL: Risk and Diversification
Insider trading is illegal because it can negatively impact the financial system in a variety of ways. These include:
Reduced Trust in the System
Fair and efficient stock market operation depends on all investors having the same access to information about publicly traded companies. When investors act on inside information before it becomes widely available, they get an unfair advantage that shakes peoples' trust in the financial system and economy.
Increased Confusion and Volatility
Because they often involve large amounts of stock, insider trades can produce major shifts in a stock's price. Other investors may notice this and overreact, causing even more price volatility. The confusion and volatility may spread to similar stocks or even the overall stock market.
Loss of Confidence in the Company
Generally, significant shifts in a company stock can be traced to public announcements, changes in the economy or company performance reports. But when a stock fluctuates for no apparent reason - like it might with insider trading - the public may lose confidence in the company and that could hurt it for real if it fewer people are willing to invest in it or buy its products or services.
The Bottom Line
Insider trading can hurt people. For example, those who trade a lot can easily lose money in a stock that becomes very volatile due to insider trades. If an insider trading scandal damages a company's finances or reputation enough, long-term shareholders might lose money as a result of an extended drop in the firm's stock. Allowing insider trading to go unchecked could hurt confidence in the system enough to hinder the economy in general. (For additional reading, also see Should Insider Trading Be Legal?)
ProfessionalsWorkplace stress can cost companies tons of money in lost productivity and absenteeism. Some of that is out of their control, but often they are the cause.
ProfessionalsFind out about some of the best documentaries that finance professionals can watch to gain a better understanding of their industry.
InvestingThe 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.
EconomicsLearn about the top five countries, China, the United States, India, Russia and Japan, that are the largest contributors to carbon dioxide emissions.
SavingsLearn how Facebook employs strong measures to keep your information safe when sending money, but understand the rare threats that still exist.
EconomicsThe Tier 1 leverage ratio measures a bank’s core capital against its total assets.
Investing BasicsSchedule 13G is an SEC form an investor must file upon taking ownership of 5% or more of a company’s outstanding shares.
InvestingFATCA regulations have cast a wide net on offshore banking activities, and many innocent account holders might get caught in its tangle.
InvestingThanks to the growth of conscious consumerism, corporations must evolve or lose ground to new, ethos-based entrepreneurial models.
Investing BasicsEssentially, internal controls limit fraud and other illegal activities.
The Securities and Exchange Commission (SEC) requires mutual funds to report complete lists of their holdings on a quarterly ... Read Full Answer >>
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 >>
Inherent risk is the risk imposed by complex transactions that require significant estimation in assessing the impact on ... Read Full Answer >>
Wash trading is an illegal trading activity that artificially pumps up trading volume in a stock without the stock ever changing ... Read Full Answer >>
After a prolonged period of corporate scandals involving large public companies from 2000 to 2002, the Sarbanes-Oxley Act ... Read Full Answer >>
Since markets experience asymmetric information between parties, monitor whether there is an imbalance between the open interest ... Read Full Answer >>