Financial Ethics 101: Insider Trading

By John Lalli

Financial Ethics 101: Insider Trading

A Brief Primer on Insider Trading

Insider trading occurs when a company insider engages in the buying or selling of the company’s stock or other securities. A company insider is defined by the United States Securities and Exchange Committee (SEC) as an individual who is an officer, director, above ten percent shareholder in the company or anyone who possesses information about the company the public is not aware of [1]. It is worth noting other countries have slightly different laws concerning insider trading though trading using private information has been made illegal throughout the European Union and in several Asian countries [2]. That said, this essay focuses on the consequences, prevention, and ethics of insider trading in the U.S. 

Although insider trading can be a serious crime, not all transactions made by insiders are illegal. Individuals who (1) possess material knowledge the public is not aware of and (2) who trade using this information, or (3) insiders that violate SEC regulations, are breaking the law. An insider with no private information is technically allowed to trade that company’s stock and other securities provided trading is disclosed in the proper manner [1]. Most employees do not possess insider information and may trade as they please. It is in the individual’s and the company’s best interest to avoid all suspicion through full disclosure and transparency. For this reason, all company directors and officers are required to disclose and get clearance for any attempted trades of company securities. These trades must be made within three days of the receipt of clearance. In addition, companies operate with a strict time when insiders can legally trade company securities called the “window period.” This period opens on the second day after the company’s earnings figures are made public and extends for 20 trading days [1] During this period, directors and officers must still get company clearance to make trades and any individual who does possess information unknown to the public remains unable to trade until this information is made public and a new “window period” opens. Any trading done by an insider with material nonpublic information at any time, or any trade done which violates the guidelines detailed above is illegal.

Consequences of Illegal Insider Trading

The Free Market Argument

It may seem trading with the use of nonpublic information is a victimless crime. Some prominent economists over time have adopted this position. Nobel Laureate Milton Friedman famously said all insider trading should be legal. Friedman argued this form of trading increases market efficiency. Free markets achieve best results without government interference. As insiders trade based on private information, price fluctuations inform market participants as to which securities to purchase [3]. To illustrate Friedman’s point, if insiders know the company has performed well, they will buy more of the stock to make a profit. As they buy more of the stock the price increases signal to the market the company has done well. In this case the market for and price of securities act as efficient information messengers. As such, Friedman argues not only should insider trading be legalized but encouraged. Friedman’s thinking may hold true in terms of (theoretical) efficiency. Yet, several concerns about allowing insider trading persist, and regulations remain stringent. 

Fairness and Trust

Even if the increase in efficiency is as large as Friedman proposes, insider trading comes with negative consequences that outweigh this benefit. An increase in efficiency likely comes with a substantial decrease in fairness. A trader without insider information must work harder and take more risk to make a profit compared to an insider. An insider does not need to closely research market trends or do preparatory work that traditionally comes with security trading. This means insider trading allows individuals who are already likely in privileged positions, as insiders, to make money in the market with greater ease than the average investor. Allowing this trading disrupts the fairness of the market. 

Utilitarian economics holds that in certain contexts fairness can be sacrificed for efficiency, especially if the increase in efficiency leads to better outcomes for everyone. This proposition is untrue in the case of insider trading. People recognize unfairness. An acknowledgement of fairness in markets encourages investment. A reason why U.S. securities markets are active and largely dependable is a perception markets are fair [4]. A complete lack of fairness and the perception of unfairness potentially harms markets and consequently, the economy. There is significant agreement perceived unfairness contributed to the market crash of 1929 and the Great Depression thereafter. For this reason, the first anti insider trading legislation was put in place in 1933 to ensure a crash of this proportion would not happen in the future [4]. Preventing insider trading prevents erosion of trust and maintains the integrity of markets. 

Prevention of Illegal Insider Trading 

The 1934 Act

Insider trading was first expressly prohibited in the U.S. by the Securities Act of 1933 following the 1929 stock market crash. This was quickly followed by the Securities Exchange Act of 1934 which, crucially, establishes the SEC. The 1934 Act also addresses insider trading in Sections 10(b) and 16(b)[4]. Section 16(b) directly prevents insider trading by regulating trading done by corporate insiders; here meaning directors, officers, and company employees having more than a 10% stake. Section 16(b) prohibits these insiders from making profits realized in less than six months from trading company stock. Section 10(b) prevents insider trading in a more indirect manner, making it illegal to engage in manipulation or contravention of the newly implemented SEC’s regulations in the purchase or sale of securities. These regulations include rule 10b-5 which states, among much else, that it is illegal for an individual engaging in the trade of a security to omit a material fact necessary to make all statements made by the trader not misleading. This regulation formally prohibits trading that does not disclose insider information. 

Insider Trading Before the 1934 Act

Instances of insider trading had been ruled illegal even before the 1933 and 1934 Acts were passed into law. In 1909 the case Strong v. Repide was appealed to the U.S. Supreme Court. In this case the Supreme Court upheld that Repide, a director of Philippine Sugar Estates Development Company, knew the company’s value would soon rise due to new contracts. Repide bought stock from an outsider without disclosing this information, and even took steps to hide his status as a company insider. When the profit was realized and the outsider became aware of what occurred, he sued Repide for fraud. The Supreme Court found Repide did indeed engage in fraud, thus marking the first instance of such a decision in the U.S. [5]. Today, it remains the courts which are tasked with making the decision whether an individual has committed a violation of insider trading regulations. Cases which breach section 16(b) or other explicit regulations proceed fairly straightforwardly. In these cases, the court must prove an insider did indeed make a trade which violates any of these regulations. They must also prove the presence of scienter, or that the offending party acted with fraudulent intent in a culpable state of mind [6]. The cases brought due to violations of rule 10b-5 continue to evolve. These cases cover more now than in the past including company employees who were fired and retained information, and others who do not have any relationship or fiduciary duty to the company. Many of these new cases have arisen due to a new interpretation of laws referred to as misappropriation theory. 

Misappropriation Theory

Misappropriation theory applies to outsiders who come into possession of insider information. If these individuals use the insider information for personal gain when they otherwise should not, they are said to have misappropriated this information and are liable in an insider trading case [4]. In these cases, proof of scienter is again required. The use of misappropriation theory has greatly increased the number of individuals who could potentially become liable for breaching insider trading regulations. 

Tips and Market Surveillance

With the increase in potential cases there are more insider trading investigations. Insider trading cases arise in two ways. First, through informants, and second, through market surveillance. Informants include anonymous callers, market professionals, disgruntled employees, and company competitors who provide the SEC with tips about suspected breaches of regulations [6]. The SEC vets each tip received for accuracy, determining if there exists a violation of regulations. If the tip is credible a formal investigation is opened which looks for substantial evidence of a breach of regulation or an instance of misappropriation. The presence of such evidence or suspicious activity result in a case being brought against the accused party. 

The other main source of insider trading cases are market surveillance measures, including surveillance done by the SEC and Self Regulatory Organizations (SROs). The SEC monitors trading both through an automated program and by hand reviewing periodicals, looking for trades made before large fluctuations in company value, and any suspicious activity by insiders. When instances are flagged as suspicious by the SEC they are assigned case numbers and formally investigated in the same manner as credible tips [6]. 

An SRO refers to a body required by law to impose and uphold regulations on its own accord. The SEC requires all securities exchanges register themselves and establish their own bylaws that align with SEC guidelines. SROs must establish standards to prevent fraud and market manipulation to promote “just and equitable principles of trade,” and discipline exchange members who violate SRO regulations or federal securities law [7]. As such, many SROs will investigate suspicious instances that occur within their own exchanges. If an investigation reaches a critical point where the SRO believes wrongdoing likely occurred, they may fine the perpetrator or provide a report of their findings to the SEC, depending on regulations and severity of the alleged infraction. The SEC continues the investigation building on the information provided by the SROs [6].

Preet Bharara (left) U.S. Attorney for the Southern District of New York, successfully prosecuted Raj Rajaratnam (right) billionaire founder of Galleon Group for insider trading in 2011. Rajaratnam served 7 ½ years for insider trading.

Ethics Assessment of Insider Trading 

First, consider legal insider trading that follows all regulations put in place by the U.S. government. This type of trading encompasses trades made by company insiders without the use of nonpublic information where the insider discloses the planned trade with their company and complies with the regulated window period. Inspecting these trades, it is clear they comply with U.S. law, and they do not represent an action which violates a code of ethics. Legal insider trading simply equates to individuals who happen to be insiders engaging in trading of that firm’s securities. In these cases, there are no elements of fraud, misappropriation, or misconduct.

Illegal insider trading includes trades done by company officials not adhering to the window period or other regulations, trades made by insiders with the use of private information, and a range of cases of individuals misappropriating insider information. Most of these cases include instances of actions such as fraud or lying, problematic in many ethical systems. 

Utilitarian Analysis of Illegal Insider Trading

In classical utilitarian ethics, actions that maximize total utility are considered the best action. Utility is the term that refers to the measure of benefit given by consuming a good or service or in this case that arises as the consequence of an action [8]. As such, ethical actions are those where the outcomes maximize benefit or limit harm overall. When considering illegal insider trading through a utilitarian lens, a quick glance may lead to the conclusion that it’s an ethical act because illegal insider trading is a victimless crime. The insider profits without negatively impacting the profits or the satisfaction of other traders. Additionally, Milton Friedman argues efficiency increases with unregulated insider trading. This increased efficiency has potential to benefit more people to a greater extent than are harmed by the decrease in fairness. The funds usually used for prevention measures could be used in ways that further increase overall utility. Yet, consider, one of the main reasons for insider trading regulations is to ensure fairness in securities markets. Insider trading undermines fairness. If markets are perceived as unfair, decreased participation in trading can harm the economy as in the Great Depression [4], when 25 percent of the workforce was unemployed [9]. This outcome is surely a large negative and does not lead to the greatest total utility possible. 

Rules Based System

In deontology, morality is contained in the act itself and not based on the consequences of an action. Deontological ethics bases the morality of an action on a duty one has, an obligation, to follow the moral rules. In religion generally, a higher power establishes the moral rules [10]. An example of moral rules can be seen in the Ten Commandments in the Judeo-Christian tradition. These Commandments were passed from God and contain rules such as “Thou shalt not kill”. In contrast, in secular deontology, advanced by Immanuel Kant, moral laws derive from human reason. Regardless of origin, one is obligated to obey moral rules regardless of circumstances or outcomes [10]. 

Evaluating illegal insider trading by the standards of a rules-based system, the actions taken represent breaches of moral rules. As shown by the 1909 court case Strong vs Repide, illegal insider trading involves lying and theft. Instances of theft or lying are not permitted for any reason. Even if the theft or lying benefits someone, this action still is unethical. There are several provoking thought experiments on this subject, and addressed by Kant directly in his essay On the Supposed Right to Lie from Benevolent Motives. Lying in insider trading cases comes in a few different forms. In traditional cases, either a company official committed fraud to circumvent regulations, or an insider used nonpublic information in a trade based on fraudulent information. In cases brought under misappropriation theory, individuals engaged in a trade without disclosing information, thus deceiving the other party. This type of deception breaks established moral rules in the markets. 

Fairness

Commutative justice often applies to transactions, in business and finance. This form of justice is concerned with fairness in all exchanges between individuals or groups. There must not be swindling or price gouging, and both parties should not attempt to take advantage of the other. To ensure fairness, full disclosure and transparency between parties are necessary [11]. Evaluating illegal insider trading on these principles, the act violates the principles of commutative justice. The insider acts with information not available to the public and the counterparty. The transactions which take place are fundamentally unfair due to an asymmetry of information. 

Works Cited

  1. “Insider Trading Policy.” Sec.Gov, 11 Nov. 2015,    www.sec.gov/Archives/edgar/data/1164964/000101968715004168/globalfuture_8k-ex9904.htm
  2. Nyantung Beny, Laura. “Insider Trading Laws and Stock Markets Around the World: An Empirical Contribution to the Theoretical Law and Economics Debate” Umich Law Repository., 2007, https://repository.law.umich.edu/cgi/viewcontent.cgi?article=1053&context=articles
  3. Coleman, Robyn. “Insider Trading as a Precursor to Modern Business Ethics .” University of Arkansas Scholarworks, 2021, https://scholarworks.uark.edu/cgi/viewcontent.cgi?article=1071&context=finnuht
  4. Newkirk, Thomas. “Speech by SEC Staff: Insider Trading – a U.S. Perspective.” SEC Speech: Insider Trading – U.S. Perspective (T. Newkirk, M. Robertson), 19 Oct. 1998, www.sec.gov/news/speech/speecharchive/1998/spch221.htm#FOOTNOTE_7
  5. 213 U.S. 419. Strong v. Repide. 1909, https://supreme.justia.com/cases/federal/us/213/419/
  6. Foster, Hilton. “Insider Trading Investigations.” Insider Wing Investigations, www.sec.gov/about/offices/oia/oia_enforce/foster.pdf
  7. “Self Regulatory Organization.” Legal Information Institute, www.law.cornell.edu/wex/self_regulatory_organization
  8. “Utilitarianism.” Seven Pillars Institute, 2 Jan. 2018, https://sevenpillarsinstitute.org/glossary/utilitarianism/
  9. Shipley, Jonathan. “Tag Archives: Great Depression Hunger.” Living New Deal, 18 Feb. 2021, https://livingnewdeal.org/tag/great-depression-hunger/
  10. “Deontology.” Seven Pillars Institute, 2 Jan. 2018, https://sevenpillarsinstitute.org/glossary/deontology/
  11. Tan Bhala, Kara. “The Philosophical Foundations of Financial Ethics” in Russo, Costanza A., Lastra, Rosa M, and Blair, William (eds), Research Handbook on Law and Ethics in Banking and Finance, by Edward Elgar Publishing, Cheltenham, UK, 2019 https://www.elgaronline.com/display/edcoll/9781784716530/9781784716530.00009.xml