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Insider trading

Insider trading

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Insider trading is the trading of a corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...

's stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

 or other securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...

 (e.g. bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

s or stock options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...

) by individuals with potential access to non-public information about the company. In most countries, trading by corporate insiders such as officers, key employees, directors, and large shareholders may be legal, if this trading is done in a way that does not take advantage of non-public information. However, the term is frequently used to refer to a practice in which an insider or a related party trades based on material
Materiality (law)
Materiality is a legal term which can have different meanings, depending on context. When speaking of facts, the term generally means a fact which is "significant to the issue or matter at hand".-In the law of evidence:...

 non-public information obtained during the performance of the insider's duties at the corporation, or otherwise in breach of a fiduciary or other relationship of trust and confidence or where the non-public information was misappropriated from the company.

In the United States and several other jurisdictions, trading conducted by corporate officers, key employees, directors, or significant shareholders (in the U.S., defined as beneficial owners of ten percent or more of the firm's equity securities) must be reported to the regulator or publicly disclosed, usually within a few business days of the trade. Many investors follow the summaries of these insider trades in the hope that mimicking these trades will be profitable. While "legal" insider trading cannot be based on material non-public information, some investors believe corporate insiders nonetheless may have better insights into the health of a corporation (broadly speaking) and that their trades otherwise convey important information (e.g., about the pending retirement of an important officer selling shares, greater commitment to the corporation by officers purchasing shares, etc.)

Illegal insider trading is believed to raise the cost of capital for securities issuers, thus decreasing overall economic growth.

However, it is relatively easy for insiders to capture insider-trading like gains through the use of transactions known as "open market repurchases." Such transactions are legal and generally encouraged by regulators through safeharbours against insider trading liability.

Legal insider trading


Legal trades by insiders are common, as employees of publicly traded
Public company
This is not the same as a Government-owned corporation.A public company or publicly traded company is a limited liability company that offers its securities for sale to the general public, typically through a stock exchange, or through market makers operating in over the counter markets...

 corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...

s often have stock or stock options. These trades are made public in the United States through Securities and Exchange Commission filing
SEC filing
An SEC filing is a financial statement or other formal document submitted to the U.S. Securities and Exchange Commission . Public companies, certain insiders, and broker-dealers are required to make regular SEC filings. Investors and financial professionals rely on these filings for information...

s, mainly Form 4
Form 4
Form 4 is a United States SEC filing that relates to insider trading. Every director, officer or owner of more than ten percent of a class of equity securities registered under Section 12 of the Securities Exchange Act of 1934 must file with the United States Securities and Exchange Commission a...

. Prior to 2001, U.S. law restricted trading such that insiders mainly traded during windows when their inside information was public, such as soon after earnings releases. SEC Rule 10b5-1
SEC Rule 10b5-1
SEC Rule 10b5-1 is a regulation by the United States Securities and Exchange Commission in 2000. The SEC states that Rule 10b5-1 was enacted in order to resolve an over the definition of insider trading, which is prohibited by SEC Rule 10b-5....

 clarified that the prohibition against insider trading does not require proof that an insider actually used material nonpublic information when conducting a trade; possession of such information alone is sufficient to violate the provision, and the SEC would infer that an insider in possession of material nonpublic information used this information when conducting a trade. However, SEC Rule 10b5-1 also created for insiders an affirmative defense
Affirmative defense
A defendant offers an affirmative defense when responding to a plaintiff's claim in common law jurisdictions, or, more familiarly, in criminal law. Essentially, the defendant affirms that the condition is occurring or has occurred but offers a defense that bars, or prevents, the plaintiff's claim. ...

 if the insider can demonstrate that the trades conducted on behalf of the insider were conducted as part of a pre-existing contract
Contract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...

 or written binding plan for trading in the future. For example, if an insider expects to retire after a specific period of time and, as part of his or her retirement planning, the insider has adopted a written binding plan to sell a specific amount of the company's stock every month for two years and later comes into possession of material nonpublic information about the company, trades based on the original plan might not constitute prohibited insider trading.

Illegal insider trading


Rules against insider trading on material non-public information exist in most jurisdictions around the world, though the details and the efforts to enforce them vary considerably. Sections 16(b) and 10(b) of the Securities Exchange Act of 1934 directly and indirectly address insider trading. Congress enacted this act after the stock market crash of 1929. The United States is generally viewed as having the strictest laws against illegal insider trading, and makes the most serious efforts to enforce them.

Definition of "insider"


In the United States and Germany, for mandatory reporting purposes, corporate insiders are defined as a company's officers, directors and any beneficial owners of more than ten percent of a class of the company's equity securities. Trades made by these types of insiders in the company's own stock, based on material non-public information, are considered to be fraudulent since the insiders are violating the fiduciary duty that they owe to the shareholders. The corporate insider, simply by accepting employment, has undertaken a legal obligation to the shareholders to put the shareholders' interests before their own, in matters related to the corporation. When the insider buys or sells based upon company owned information, he is violating his obligation to the shareholders.

For example, illegal insider trading would occur if the chief executive officer
Chief executive officer
A chief executive officer , managing director , Executive Director for non-profit organizations, or chief executive is the highest-ranking corporate officer or administrator in charge of total management of an organization...

 of Company A learned (prior to a public announcement) that Company A will be taken over, and bought shares in Company A knowing that the share price would likely rise.

In the United States and many other jurisdictions, however, "insiders" are not just limited to corporate officials and major shareholders where illegal insider trading is concerned, but can include any individual who trades shares based on material non-public information in violation of some duty of trust. This duty may be imputed; for example, in many jurisdictions, in cases of where a corporate insider "tips" a friend about non-public information likely to have an effect on the company's share price, the duty the corporate insider owes the company is now imputed to the friend and the friend violates a duty to the company if he or she trades on the basis of this information.

Liability for insider trading


Liability for insider trading violations cannot be avoided by passing on the information in an "I scratch your back, you scratch mine" or quid pro quo
Quid pro quo
Quid pro quo most often means a more-or-less equal exchange or substitution of goods or services. English speakers often use the term to mean "a favour for a favour" and the phrases with almost identical meaning include: "give and take", "tit for tat", "this for that", and "you scratch my back,...

 arrangement, as long as the person receiving the information knew or should have known that the information was company property. It should be noted that when allegations of a potential inside deal occur, all parties that may have been involved are at risk of being found guilty.

For example, if Company A's CEO did not trade on the undisclosed takeover
Takeover
In business, a takeover is the purchase of one company by another . In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to the acquisition of a private company.- Friendly takeovers :Before a bidder makes an offer for another...

 news, but instead passed the information on to his brother-in-law who traded on it, illegal insider trading would still have occurred.

Misappropriation theory


A newer view of insider trading, the "misappropriation
Misappropriation
In law, misappropriation is the intentional, illegal use of the property or funds of another person for one's own use or other unauthorized purpose, particularly by a public official, a trustee of a trust, an executor or administrator of a dead person's estate or by any person with a responsibility...

 theory," is now part of US law. It states that anyone who misappropriates (steals) information from their employer and trades on that information in any stock (not just the employer's stock) is guilty of insider trading.

For example, if a journalist who worked for Company B learned about the takeover of Company A while performing his work duties, and bought stock in Company A, illegal insider trading might still have occurred. Even though the journalist did not violate a fiduciary duty to Company A's shareholders, he might have violated a fiduciary duty to Company B's shareholders (assuming the newspaper had a policy of not allowing reporters to trade on stories they were covering).

Proof of responsibility


Proving that someone has been responsible for a trade can be difficult, because traders may try to hide behind nominees, offshore companies, and other proxies. Nevertheless, the U.S. Securities and Exchange Commission prosecutes over 50 cases each year, with many being settled administratively out of court. In order for a case against insider trading can stand up in court, it must not only infer the trading of information but also have the plus factor. The plus factor is one approach to prove responsibility and is the additional facts implying guilt or deception and to detect this, the government put into consideration six key pieces of evidence: parties access to the information, their relationship to one another, the timing of the contract involved, the timing of their trades, trade patterns, and any attempt to hide their relationship. The SEC and several stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...

s actively monitor trading, looking for suspicious activity.

Trading on information in general


Not all trading on information is illegal inside trading, however. For example: if, while dining at a restaurant, you hear the CEO of Company A at the next table telling the CFO that the company's profits will be higher than expected, and then you buy the stock, you are not guilty of insider trading unless there was some closer connection between you, the company, or the company officers. However, information about a tender offer
Tender offer
Tender offer is a corporate finance term denoting a type of takeover bid. The tender offer is a public, open offer or invitation by a prospective acquirer to all stockholders of a publicly traded corporation to tender their stock for sale at a specified price during a specified time, subject to...

 (usually regarding a merger or acquisition) is held to a higher standard. If this type of information is obtained (directly or indirectly) and there is reason to believe it is non-public, there is a duty to disclose it or abstain from trading.

Tracking insider trades


Since insiders are required to report their trades, others often track these traders, and there is a school of investing which follows the lead of insiders. This is of course subject to the risk that an insider is making a buy specifically to increase investor confidence, or making a sell for reasons unrelated to the health of the company (e.g. a desire to diversify or pay a personal expense).

Insider trading vs. insider information


In the industry of investing, there is a difference between insider trading and insider information. For example, there was information released about Continental and United Airlines merging in late 2009. At the turn of the year, it was believed that the merger was going to fall through and that the two companies were not going to act upon the merger. By summer of 2010 and the final signing of the legal details (a), the deal went through officially. The acquisition of the added resources, capital, and infrastructure for the two companies would easily drive up the stock price of the new “company” under UAL on the New York Stock Exchange. With this done, insider traders could have acted back when there were rumors assuming the price would have gone up. However, insider informants “said” that the merger fell through and nothing was going to happen. This creates gossip in the trading world and information that an insider can be giving out to friends and family may not be completely accurate since they do not know the full story.

Generally, insider traders act upon information that they believe to be true that is not available to the public giving them the upper hand in making profits. Insider informants pass along information in the form of gossip and do not personally buy or sell stock based on projections. Whether or not either party is acting illegally is solely in the hands of the SEC.

American insider trading law


The United States has been the leading country in prohibiting insider trading made on the basis of material non-public information. Thomas Newkirk and Melissa Robertson of the U.S. Securities and Exchange Commission (SEC) summarize the development of U.S. insider trading laws. Insider trading has a base offense level of 8, which puts it in Zone A under the U.S. Sentencing Guidelines. This means that first-time offenders are eligible to receive probation rather than incarceration.

Members of the U.S. Congress are not exempt from the laws that ban insider trading, however, they generally do not have a confidential or fiduciary relationship with the source of the information they receive and accordingly, do not meet the definition of an "insider".

Common law


U.S. insider trading prohibitions are based on English and American common law prohibitions against fraud. In 1909, well before the Securities Exchange Act was passed, the United States Supreme Court ruled that a corporate director who bought that company’s stock when he knew it was about to jump up in price committed fraud by buying while not disclosing his inside information.

Section 15 of the Securities Act of 1933
Securities Act of 1933
Congress enacted the Securities Act of 1933 , in the aftermath of the stock market crash of 1929 and during the ensuing Great Depression...

 contained prohibitions of fraud in the sale of securities which were greatly strengthened by the Securities Exchange Act of 1934
Securities Exchange Act of 1934
The Securities Exchange Act of 1934 , , codified at et seq., is a law governing the secondary trading of securities in the United States of America. It was a sweeping piece of legislation...

.

Section 16(b) of the Securities Exchange Act of 1934
Securities Exchange Act of 1934
The Securities Exchange Act of 1934 , , codified at et seq., is a law governing the secondary trading of securities in the United States of America. It was a sweeping piece of legislation...

 prohibits short-swing profits (from any purchases and sales within any six month period) made by corporate directors, officers, or stockholders owning more than 10% of a firm’s shares. Under Section 10(b) of the 1934 Act, SEC Rule 10b-5
SEC Rule 10b-5
SEC Rule 10b-5, codified at 17 C.F.R. § 240.10b-5, is one of the most important rules promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10 of the Securities Exchange Act of 1934...

, prohibits fraud related to securities trading.

The Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 provide for penalties for illegal insider trading to be as high as three times the profit gained or the loss avoided from the illegal trading.

SEC regulations


SEC regulation FD ("Fair Disclosure") requires that if a company intentionally discloses material non-public information to one person, it must simultaneously disclose that information to the public at large. In the case of an unintentional disclosure of material non-public information to one person, the company must make a public disclosure "promptly."

Insider trading, or similar practices, are also regulated by the SEC under its rules on takeovers and tender offer
Tender offer
Tender offer is a corporate finance term denoting a type of takeover bid. The tender offer is a public, open offer or invitation by a prospective acquirer to all stockholders of a publicly traded corporation to tender their stock for sale at a specified price during a specified time, subject to...

s under the Williams Act
Williams Act
The Williams Act refers to amendments to the Securities Exchange Act of 1934 enacted in 1968 regarding tender offers. The legislation was proposed by Senator Harrison A. Williams of New Jersey....

.

Court decisions


Much of the development of insider trading law has resulted from court decisions.

In SEC v. Texas Gulf Sulphur Co. (1966), a federal circuit court stated that anyone in possession of inside information must either disclose the information or refrain from trading.

In 1909, the Supreme Court of the United States
Supreme Court of the United States
The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...

 ruled in Strong v. Repide that a director upon whose action the value of the shares depends cannot avail of his knowledge of what his own action will be to acquire shares from those whom he intentionally keeps in ignorance of his expected action and the resulting value of the shares. Even though in general, ordinary relations between directors and shareholders in a business corporation are not of such a fiduciary nature as to make it the duty of a director to disclose to a shareholder the general knowledge which he may possess regarding the value of the shares of the company before he purchases any from a shareholder, yet there are cases where, by reason of the special facts, such duty exists.

In 1984, the Supreme Court of the United States
Supreme Court of the United States
The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...

 ruled in the case of Dirks v. SEC that tippees (receivers of second-hand information) are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information and the tipper received any personal benefit from the disclosure. (Since Dirks disclosed the information in order to expose a fraud, rather than for personal gain, nobody was liable for insider trading violations in his case.)

The Dirks case also defined the concept of "constructive insiders," who are lawyers, investment bankers and others who receive confidential information from a corporation while providing services to the corporation. Constructive insiders are also liable for insider trading violations if the corporation expects the information to remain confidential, since they acquire the fiduciary duties of the true insider.

In United States v. Carpenter (1986) the U.S. Supreme Court cited an earlier ruling while unanimously upholding mail and wire fraud convictions for a defendant who received his information from a journalist rather than from the company itself. The journalist R. Foster Winans
R. Foster Winans
R. Foster Winans is a former columnist for The Wall Street Journal who co-wrote the "Heard on the Street Column" from 1982 to 1984 and was convicted of insider trading and mail fraud. He was indicted by then-U.S...

 was also convicted, on the grounds that he had misappropriated information belonging to his employer, the Wall Street Journal. In that widely publicized case, Winans traded in advance of "Heard on the Street" columns appearing in the Journal.

The court ruled in Carpenter: "It is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principal for any profits derived therefrom."

However, in upholding the securities fraud (insider trading) convictions, the justices were evenly split.

In 1997 the U.S. Supreme Court adopted the misappropriation theory of insider trading in United States v. O'Hagan, 521 U.S. 642, 655 (1997). O'Hagan was a partner in a law firm representing Grand Metropolitan
Diageo
Diageo plc is a global alcoholic beverages company headquartered in London, United Kingdom. It is the world's largest producer of spirits and a major producer of beer and wine....

, while it was considering a tender offer for Pillsbury Co. O'Hagan used this inside information by buying call options on Pillsbury stock, resulting in profits of over $4 million. O'Hagan claimed that neither he nor his firm owed a fiduciary duty to Pillsbury, so that he did not commit fraud by purchasing Pillsbury options.

The Court rejected O'Hagan's arguments and upheld his conviction.

The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information.

The Court specifically recognized that a corporation’s information is its property:
"A company's confidential information...qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty...constitutes fraud akin to embezzlement – the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another."

In 2000, the SEC enacted Rule 10b5-1
SEC Rule 10b5-1
SEC Rule 10b5-1 is a regulation by the United States Securities and Exchange Commission in 2000. The SEC states that Rule 10b5-1 was enacted in order to resolve an over the definition of insider trading, which is prohibited by SEC Rule 10b-5....

, which defined trading "on the basis of" inside information as any time a person trades while aware of material nonpublic information so that it is no defense for one to say that she would have made the trade anyway. This rule also created an affirmative defense
Affirmative defense
A defendant offers an affirmative defense when responding to a plaintiff's claim in common law jurisdictions, or, more familiarly, in criminal law. Essentially, the defendant affirms that the condition is occurring or has occurred but offers a defense that bars, or prevents, the plaintiff's claim. ...

 for pre-planned trades.

Insider trading by members of Congress


Members of Congress
United States Congress
The United States Congress is the bicameral legislature of the federal government of the United States, consisting of the Senate and the House of Representatives. The Congress meets in the United States Capitol in Washington, D.C....

 are exempted from insider trading laws and thus can act on information they are bound to gain in the course of their congressional activities, although house rules may consider it unethical. A 2004 study found that stock sales and purchases by Senators outperformed the market by 12.3% per year. Peter Schweizer
Peter Schweizer
Peter Schweizer is a conservative author and a research fellow at Stanford University's Hoover Institution.Schweizer's book Do as I Say : Profiles in Liberal Hypocrisy received praise from conservative political pundits including Bill O'Reilly. Schweizer's book Reagan's War was the basis of the...

 points out several examples of insider trading by members of Congress, including action taken by Spencer Bachus
Spencer Bachus
Spencer Thomas Bachus III is the U.S. Representative for , serving since 1993. He is a member of the Republican Party and the senior member of the Alabama U. S. House delegation...

 following a private, behind-the-doors meeting on the evening of September 18, 2008 when Hank Paulson and Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....

 informed members of Congress about the imminent financial crisis, Bachus then shorted stocks the next morning and cashed in his profits within a week.

Security analysis and insider trading


Security analysts
Security analysis
Security analysis is the analysis of tradeable financial instruments called securities. These can be classified into debt securities, equities, or some hybrid of the two. More broadly, futures contracts and tradeable credit derivatives are sometimes included...

 gather and compile information, talk to corporate officers and other insiders, and issue recommendations to traders. Thus their activities may easily cross legal lines if they are not especially careful. The CFA Institute
CFA Institute
CFA Institute is headquartered in the United States of America at Charlottesville, Virginia, with offices in Hong Kong and London. Formerly known as the Association for Investment Management and Research , CFA Institute awards the Chartered Financial Analyst designation...

 in its code of ethics states that analysts should make every effort to make all reports available to all the broker's clients on a timely basis. Analysts should never report material nonpublic information, except in an effort to make that information available to the general public. Nevertheless, analysts' reports may contain a variety of information that is "pieced together" without violating insider trading laws, under the mosaic theory
Mosaic theory
Mosaic theory, also referred to more colloquially as the scuttlebutt method by Philip Fisher in his seminal work Common Stocks and Uncommon Profits, in finance is the method used in security analysis to gather information about a corporation. Mosaic theory involves collecting information from...

. This information may include non-material nonpublic information as well as material public information, which may increase in value when properly compiled and documented.

In May 2007, a bill entitled the "Stop Trading on Congressional Knowledge Act, or STOCK Act" was introduced that would hold congressional and federal employees liable for stock trades they made using information they gained through their jobs and also regulate analysts or "Political Intelligence" firms that research government activities. The bill has not passed.

Arguments for legalizing insider trading


Some economists and legal scholars (e.g. Henry Manne
Henry Manne
Henry Manne is an American writer and academic, considered a founder of the Law and economics discipline. He is Professor Emeritus of the George Mason University....

, Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

, Thomas Sowell
Thomas Sowell
Thomas Sowell is an American economist, social theorist, political philosopher, and author. A National Humanities Medal winner, he advocates laissez-faire economics and writes from a libertarian perspective...

, Daniel Fischel
Daniel Fischel
Daniel R. Fischel is the emeritus Lee and Brena Freeman Professor of Law and Business and former Dean of University of Chicago Law School, and a co-founder of Lexecon...

, Frank H. Easterbrook
Frank H. Easterbrook
Frank Hoover Easterbrook is the Chief Judge of the United States Court of Appeals for the Seventh Circuit. He has been Chief Judge since November 2006, and has been a judge on the court since 1985...

) argue that laws making insider trading illegal should be revoked. They claim that insider trading based on material nonpublic information benefits investors, in general, by more quickly introducing new information into the market.

Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

, laureate of the Nobel Memorial Prize in Economics, said: "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that." Friedman did not believe that the trader should be required to make his trade known to the public, because the buying or selling pressure itself is information for the market.

Other critics argue that insider trading is a victimless act: A willing buyer and a willing seller agree to trade property which the seller rightfully owns, with no prior contract (according to this view) having been made between the parties to refrain from trading if there is asymmetric information. The Atlantic has described the process as "arguably the closest thing that modern finance has to a victimless crime".

Legalization advocates also question why "trading" where one party has more information than the other is legal in other markets, such as real estate
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...

, but not in the stock market. For example, if a geologist
Geology
Geology is the science comprising the study of solid Earth, the rocks of which it is composed, and the processes by which it evolves. Geology gives insight into the history of the Earth, as it provides the primary evidence for plate tectonics, the evolutionary history of life, and past climates...

 knows there is a high likelihood of the discovery of petroleum
Petroleum
Petroleum or crude oil is a naturally occurring, flammable liquid consisting of a complex mixture of hydrocarbons of various molecular weights and other liquid organic compounds, that are found in geologic formations beneath the Earth's surface. Petroleum is recovered mostly through oil drilling...

 under Farmer Smith's land, he may be entitled to make Smith an offer for the land, and buy it, without first telling Farmer Smith of the geological data. Nevertheless, circumstances can occur when the geologist would be committing fraud
Fraud
In criminal law, a fraud is an intentional deception made for personal gain or to damage another individual; the related adjective is fraudulent. The specific legal definition varies by legal jurisdiction. Fraud is a crime, and also a civil law violation...

 if, because he owes a duty to the farmer, he did not disclose the information; e.g., if he had been hired by Farmer Smith to assess the geology of the farm.

Advocates of legalization make free speech arguments. Punishment for communicating about a development pertinent to the next day's stock price might seem to be an act of censorship. If the information being conveyed is proprietary information and the corporate insider has contracted to not expose it, he has no more right to communicate it than he would to tell others about the company's confidential new product designs, formulas, or bank account passwords.

There are very limited laws against "insider trading" in the commodities markets, if, for no other reason, than that the concept of an "insider" is not immediately analogous to commodities themselves (e.g., corn, wheat, steel, etc.).
However, analogous activities such as front running
Front running
Front running is the illegal practice of a stock broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers...

 are illegal under U.S. commodity and futures trading laws. For example, a commodity broker
Commodity broker
A commodity broker is a firm or individual who executes orders to buy or sell commodity contracts on behalf of clients and charges them a commission. A firm or individual who trades for his own account is called a trader. Commodity contracts include futures, options, and similar financial...

 can be charged with fraud if he or she receives a large purchase order from a client (one likely to affect the price of that commodity) and then purchases that commodity before executing the client's order in order to benefit from the anticipated price increase.

Legal differences among jurisdictions


The US and the UK vary in the way the law is interpreted and applied with regard to insider trading.

In the UK, the relevant laws are the Criminal Justice Act 1993
Criminal Justice Act 1993
The Criminal Justice Act 1993 is a United Kingdom Act of Parliament that set out new rules regarding drug trafficking, proceeds and profit of crime, financing of terrorism and insider dealing.-External links:**...

 Part V Schedule 1 and the Financial Services and Markets Act 2000
Financial Services and Markets Act 2000
The Financial Services and Markets Act 2000 is an Act of the Parliament of the United Kingdom that created the Financial Services Authority as a regulator for insurance, investment business and banking.-Outline:...

, which defines an offence of Market Abuse. It is also illegal to fail to trade based on inside information (whereas without the inside information the trade would have taken place). The principle is that it is illegal to trade on the basis of market-sensitive information that is not generally known. No relationship to the issuer of the security is required; all that is required is that the guilty party traded (or caused trading) whilst having inside information.

Japan enacted its first law against insider trading in 1988. Roderick Seeman says: "Even today many Japanese do not understand why this is illegal. Indeed, previously it was regarded as common sense to make a profit from your knowledge."

In accordance with EU Directives, Malta
Malta
Malta , officially known as the Republic of Malta , is a Southern European country consisting of an archipelago situated in the centre of the Mediterranean, south of Sicily, east of Tunisia and north of Libya, with Gibraltar to the west and Alexandria to the east.Malta covers just over in...

 enacted the Financial Markets Abuse Act in 2002, which effectively replaced the Insider Dealing and Market Abuse Act of 1994.

The "Objectives and Principles of Securities Regulation" published by the International Organization of Securities Commissions
International Organization of Securities Commissions
The International Organization of Securities Commissions is an association of organisations that regulate the world’s securities and futures markets....

 (IOSCO) in 1998 and updated in 2003 states that the three objectives of good securities market regulation are (1) investor protection, (2) ensuring that markets are fair, efficient and transparent, and (3) reducing systemic risk
Systemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...

. The discussion of these "Core Principles" state that "investor protection" in this context means "Investors should be protected from misleading, manipulative or fraudulent practices, including
insider trading, front running
Front running
Front running is the illegal practice of a stock broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers...

 or trading ahead of customers and the misuse of client assets." More than 85 percent of the world's securities and commodities market regulators are members of IOSCO and have signed on to these Core Principles.

The World Bank
World Bank
The World Bank is an international financial institution that provides loans to developing countries for capital programmes.The World Bank's official goal is the reduction of poverty...

 and International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

 now use the IOSCO Core Principles in reviewing the financial health of different country's regulatory systems as part of these organization's financial sector assessment program, so laws against insider trading based on non-public information are now expected by the international community. Enforcement of insider trading laws varies widely from country to country, but the vast majority of jurisdictions now outlaw the practice, at least in principle.

Larry Harris claims that differences in the effectiveness with which countries restrict insider trading help to explain the differences in executive compensation
Executive compensation
Executive pay is financial compensation received by an officer of a firm, often as a mixture of salary, bonuses, shares of and/or call options on the company stock, etc. Over the past three decades, executive pay has risen dramatically beyond the rising levels of an average worker's wage...

 among those countries. The U.S., for example, has much higher CEO salaries than do Japan or Germany, where insider trading is less effectively restrained.

See also

  • Abuse of information
  • Efficient market hypothesis
    Efficient market hypothesis
    In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...

  • ImClone stock trading case
    ImClone stock trading case
    A U.S. Securities and Exchange Commission and U.S. Attorney probe of trading in the shares of ImClone Systems resulted in a widely publicized criminal case, which resulted in prison terms for media celebrity Martha Stewart, ImClone chief executive officer Samuel D...

  • Private Securities Litigation Reform Act
    Private Securities Litigation Reform Act
    The United States Private Securities Litigation Reform Act of 1995, Pub. L. 104-67, 109 Stat. 737 implemented several substantive changes affecting certain cases brought under the federal securities laws, including changes related to pleading, discovery, liability, class representation, and...

  • Raj Rajaratnam
    Raj Rajaratnam
    Raj Rajaratnam is an American former hedge fund manager and founder of the Galleon Group, a New York-based hedge fund management firm. On October 16, 2009, he was arrested by the FBI on allegations of insider trading, which also caused the Galleon Group to close. He stood trial in U.S. v...

  • Rene Rivkin
    Rene Rivkin
    Rene Rivkin was an Australian entrepreneur, investor, investment adviser, and stockbroker. He was a well-known stockbroker in Australia for many years until his death in 2005.-Early life:...

  • Securities fraud
    Securities fraud
    Securities fraud, also known as stock fraud and investment fraud, is a practice that induces investors to make purchase or sale decisions on the basis of false information, frequently resulting in losses, in violation of the securities laws....

  • Securities Regulation in the United States
    Securities regulation in the United States
    Securities regulation in the United States is the field of U.S. law that covers various aspects of transactions and other dealings with securities...


External links



General information

Articles and opinions

Data on insider trading