A debate rages on in the financial community among professionals and academics as to whether insider trading is good or bad for financial markets. Insider trading refers to the purchase or sale of securities by someone with information that is material and not in the public realm. It can be done by not only company management, directors and employees but also by outside investors, brokers and fund managers.

The Legality of Insider Trading

In the United States, there is no law that specifically bars investors from partaking in insider trading; instead, certain types of insider trading have become illegal through interpretation of other laws, such as the Securities Exchange Act of 1934, by the courts. Insider trading by a company's directors can be legal as long as they disclose their buying or selling activity to the Securities and Exchange Commission (SEC) and that information subsequently becomes public.

Why Insider Trading Is Bad

One argument against insider trading is that if a select few people trade on material nonpublic information, the integrity of the markets will be damaged and investors will be discouraged from partaking in them. Insiders with nonpublic information will be able to avoid losses and benefit from gains, effectively eliminating the inherent risk that investors without the undisclosed information take on by investing in the markets. If those investors in the dark begin to withdraw from the markets, there would be no other investors for those partaking in insider trading to sell to or buy from, and insider trading would effectively eliminate itself.

Another argument against insider trading is that it robs the investors who do not have nonpublic information of receiving the full value for their securities. If nonpublic information became widely known before an insider trading situation took place, the markets would integrate that information and the securities in question would become more accurately priced as a result.

If, for instance, a pharmaceutical company is having success in Phase 3 trials for one of its new drugs and will make that information public in a week, there exists an opportunity for an investor with that nonpublic information to exploit it. Such an investor could purchase the pharmaceutical company's stock prior to the public release of the information and benefit from a rise in the price after the news is made public. The investor who sold the stock without knowledge of the success from the Phase 3 trials might have kept his or her stock and could have benefited from the price appreciation if the success in the clinical trials was widely known.

Examples of Insider Trading

Martha Stewart was infamously convicted of insider trading in 2003. ImClone Systems, a biopharmaceutical company that Stewart owned stock in, was on the verge of having the Food and Drug Administration (FDA) reject its experimental cancer treatment, Erbitux. Stewart's broker informed her that ImClone Systems' CEO, Samuel Waksal, sold all of his shares in the company on the bad news. On the tip, Stewart sold her shares in ImClone Systems and avoided a loss, as the stock dropped 16% once the news became public. She was eventually found guilty of insider trading and served five months in prison, in addition to house arrest and probation.

The investors on the other side of Martha Stewart's trade might not have bought her stock if they had known ImClone Systems' CEO was selling his position and why he was selling his position. The courts found that Stewart benefited at the expense of other investors.

Another example of insider trading involves Michael Milken, known as the Junk Bond King throughout the 1980s. Milken was famous for trading junk bonds and helped develop the market for below-investment-grade debt during his tenure at the now-defunct investment bank Drexel Burnham Lambert. Milken was accused of using nonpublic information related to junk bond deals that were being orchestrated by investors and companies to take over other companies. He was accused of using such information to purchase stock in the takeover targets and benefiting from the rise in their stock prices on the takeover announcements.

If the investors selling their stock to Milken had known that bond deals were being arranged to finance the purchase of the companies that they partially owned, they likely would have held onto their shares to benefit from the appreciation. Instead, the information was nonpublic and only people in Milken's position could benefit. Milken eventually pled guilty to securities fraud, paid a $600 million fine, was banned from the securities industry for life and served two years in prison.

Arguments for Insider Trading

Not all arguments regarding insider trading are against it. One argument in favor of insider trading is that it allows for all information to be reflected in a security's price and not just public information. This makes the markets more efficient. As insiders and others with nonpublic information buy or sell the shares of a company, for example, the direction in price conveys information to other investors. Current investors can buy or sell on the price movements and prospective investors can do the same. Prospective investors could buy at better prices and current ones could sell at better prices.

Another argument in favor of insider trading is that barring the practice only delays what will eventually happen: A security's price will rise or fall based on material information. If an insider has good news about a company but is barred from buying its stock, for example, then those who sell in the time between when the insider knows the information and when it becomes public are prevented from seeing a price increase. Barring investors from readily receiving information or getting that information indirectly through price movements can condemn them to buy or sell a stock that they otherwise would not have traded if the information had been available earlier.

Yet another argument for insider trading is that its costs do not outweigh its benefits. Enforcing laws related to insider trading and prosecuting insider-trading cases cost the government resources, time and people that could otherwise be used to pursue crimes considered more serious, such as organized crime and murder.