The Truth About Insider Trading

By Tim Begany | May 03, 2011 AAA
The Truth About Insider Trading

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

Raj Rajaratnam
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

Adverse Consequences
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?)

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