Regulation of Insider Trading

Abstract

Insider trading has over the last 30 years become an increasingly well regulated form of financial securities crime. The Australian insider trading regime is based upon the principles of ensuring fairness and efficiency within the share market. A vocal group of advocates of deregulation have consistently argued that insider trading should be de criminalized as the practice actually improves the efficiency of equity markets and is a victimless crime. However this paper argues that the larger public interest is maintained by an effort to restrict insider trading. Insider trading damages confidence in the transparency and efficiency of stock market transactions. Such confidence is the basis upon which equity market are built and allows them to most efficiently allocate resources. Whilst the current Australian insider trading regime has had modest success the principles upon which it is based are sound and suitable for further action and development.

Introduction

Traditionally insider trading has been seen as a harmless victimless crime committed by the economic elites of society. The practice has largely been beyond the reach of the law and prosecutions have been rare. As such the normative framework within insider trading has been accepted has to be changed in addition to stricter legislation and enforcement mechanisms. As long as insider trading is ill defined and socially acceptable it will remain a part of the financial services industry.

The argument that insider trading reflects prices more accurately in an open market does not hold true as, such transactions are zero sum in nature, the insider gaining at the expense of the outsider. This attacks the principle of fairness and ultimately confidence upon which markets must operate. Furthermore confidence in the absence of insider trading from a market place acts as an incentive for active information gathering and provides a level playing field for small and large investors. Further development of both common law principles and legislative provisions is needed to broaden the scope of the insider trading regime and provide greater clarity to traders of the constraints within which they must operate. However enforcement of insider trading will always be difficult it is needed for the purposes of perception and maintaining confidence levels within the market.

Principles and Processes within Stock Markets

Stock markets are based upon a fundamental relationship between risk and reward. In a stock market investors take risks with their capital betting as to whether events will or will not occur.[1] There is a relationship between risk and return in that the investor weighs up the probability of a return on investment, seeking a higher return if the likelihood of that return will be small.[2] In this way investors can choose safe investments which will pay them less, or high risk investment which pay more. Investors can spread risk by investing in a range of instruments rather than just one. It is a zero sum game in which the gains which accrue to the insider trader have to come out of the losses which are incurred from other traders who trade without inside information

The capitalist economy which distributes scarce resources through the creation of a price mechanism is dependent on information which can generate accurate prices and distribute resources more efficiently.[3] Favourable information about a company will make it easier to compete for finance making it convenient and cheaper to raise capital.[4] A secondary market then emerges in which investors can trade in the stocks of companies in which they invested. Company strategies are often dictated by the anticipated likely effect of any new strategy or project on the share price, thus indirectly allocating resource use within companies. It is for this reason, efficient resource allocation, that it is generally accepted as a principle that correct and transparent information flows are required for the smooth functioning of a stock market. Investor’s money should flow to companies which will make best use of that money and not wasted in companies which will not make a profit.[5] The method of ensuring an adequate flow of information is the requirement that companies disclose relevant information.

The Role and Nature of Inside Information in the Stock Market

Insider trading is generally the preserve of the rich and powerful, as it is they who hold positions of economic power which give them access to information which is not in the public domain.[6] The act of insider trading does not generally exclude perpetrators from the realms of high society which they inhabit.[7] According to the classical school of criminal law, human beings have a free will and commit crimes when perceived benefits outweigh perceived costs. Conduct is the result of a rational choice based upon a cost-benefit analysis of rewards and punishments.[8] As such the decision to engage in insider trading is essentially economic in nature. The perceived benefits include a growth in wealth, social status, and career prospects and the avoidance of financial losses. Whilst the perceived costs may be the transgression of personal ethics, laws, social norms and punishments which may result.[9] Insider trading is a breach of confidence of the public in company office bearers, and is considered to be taking unfair advantage of general public investors.[10]

Contrary to the view that insider trading distorts markets and damages investor confidence, some argue that insider trading is beneficial as the trading of insiders transmits the real value of the share to its market price. Assuming the action of the uninformed investor is fixed, an insider selling on information of future losses will bring down the share price, whilst an insider trading on information of future gains will increase the share price.  Henry Manne’s 1966 landmark work “Insider Trading and the Stock Market” questions whether insider trading is actually harmful to society.[11] Manne contends that insiders who trade on non public information are only shifting the price of the security to its true value.[12] Manne further argues that insider trading should be viewed as just another means of executive compensation, allowing executives to profit from information created through the entrepreneurial process.[13] However an opposing view is that tolerance of insider trading can equally give an incentive for managers to take decisions which are adverse to a company’s interests in order to gain from short term stock price falls.

Advocates of the deregulation of insider trading claim that in a sense insider trading is another type of disclosure, discreet disclosure in which information is filtered into the share price through insider trades which usually create less fluctuation in share prices than public disclosures do. This ironically makes the stock market a less risky proposition for public investors. Insider trading is claimed by some to be a property right of those who possess the information and its transaction should left to those possessing the property to do with it what they please. This is related to the notion that inside information is just another form of management compensation. It is simply a way of allowing managers to share in the value which they produce.

In some ways the practice of insider trading may arise out of the inadequacy of information released though conventional corporate channels. Incomplete or scarce information about publicly listed companies may offer an incentive to insider trading. For example the information released by banks in Japan may not give an adequate picture of the financial health of the bank forcing uninformed investors into alternative ways of information gathering.[14] This may give bank officials incentives to indulge in insider trading.

The need for regulation of insider trading

There has been a trend toward increasing litigation in the area of insider trading and a broadening of classes of persons considered liable to prosecution within the ambit of insider trading. It is sometimes said that insider trading is a victimless crime. However the very nature of the process of insider trading does produce victims. When an insider purchases stock based on non public information, the insider will have more of that stock at the time of public issue, whilst someone else will have less, and as a result is worse off because of the insider trade.[15] When an insider sells shares, the insider will have less of the stock at the time of public disclosure, someone else will have more and be worse off as a result.[16] Insider trading does have specific yet anonymous victims.[17] As stocks are generic products, that is all have the same features, any defect, in this case incomplete information affects all victims equally. Assuming the number of shares to be constant, the trade of shares with incomplete information will always benefit the inside trader whether he buys or sells.  However it is difficult to identify the victim or quantify the harm as this would mean identifying the price in the absence of the insider trade and how the public would have reacted to such a price.[18]

Enforcement of insider trading laws in developed countries which have strong legal infrastructure increases price informativeness.[19] Stricter enforcement of insider trading laws reverses a crowding out effect in which outsiders see a disincentive to gathering information in an environment in which they perceive insiders are trading on non public information. Enforcement of insider trading laws also leads to greater firm specific return variation.[20] This essentially means that better enforcement of insider trading laws leads to lower costs of information accumulation, more informed trading, and more informative stock prices.[21] This results is lower levels of risk for the uninformed investor.

The harms created by insider trading and measures for prevention

Insider Trading is thought to be a crime on the basis that it is an unfair practice which distorts markets. Insider Trading gives an unfair advantage to the possessor of restricted information while leaving other investors in a state of ignorance. It is assumed that all investors should have equality of access to information in a transparent environment. Those trading without insider information are essentially trading a stock at the wrong price which does not reflect the value linked to the restricted information.[22] This damages investor confidence upon which all markets are based.

Insider trading can distort normal flows of information upon which financial markets depend. For example corporate announcements should dictate price movements of shares, however in environments where insider trading is taken as the norm, markets may not react to corporate announcements if they feel that these pieces of information have already been incorporated into the share price through some form of insider trading.[23]

Enforcement of insider trading law is difficult and some would say impossible. Whilst detection of insider trading will always be difficult in stock market trades, insider information is often used in the decision not to transact. Not transacting in the event of insider information is not illegal. A clear definition of the offence is required as is the consistent application of the law for adequate deterrence. It must be clear to the potential offender that they are committing an illegal act when engaging in insider trading. The directive of the European Community is a model in this sense, in that it prohibits trading whilst possessing material non-public knowledge.[24] Due to the general societal tolerance of insider trading it must always be incorporated into the criminal law and be administered as a criminal offence. It is necessary to clarify what state of mind is necessary to prove insider trading, a low level of mens rea will widen the scope of the offence.[25] The use of insider information whilst not trading could also be brought into the ambit of the law.

Insider trading has been regulated in Australia for over 30 years, yet conviction rates remain minimal. Insider trading in Australia is regulated under the Corporations Act 2001 Division 3 Part 7.10. The key terms for defining insider trading under the Corporations Act are “readily observable matter”, “persons who commonly invest” and ‘reasonable period” none of which are adequately defined, making successful prosecution extremely difficult.[26] The principles of market fairness and market efficiency are the principles upon which the Australian insider trading regime is based. At the moment there are only on average two successful prosecutions of insider trading per year in Australia.[27]

Insider Trading and Open Market Share repurchases

Insider trading differs from other types of fraud in a number of ways. Full disclosure to the party on the other side of the trade may breach other duties.[28] Open market share repurchases are generally less subject to anti fraud provisions than insider trading. Share repurchases are the means by which long term investors use corporate information for speculative purposes when insider trading laws are enforced.[29] The use of such corporate information increases the incidence of adverse selection losses to short term shareholders which distorts the incentive to invest in the most productive companies.[30]

Share repurchase programs are not as tightly regulated in most countries as insider trading has come to be.  Companies repurchase stock in response to undervaluation which they perceive will yield them abnormally high returns.[31] Corporate managers use open market buy back schemes to indirectly buy themselves stock at a low price.[32] Managers also increase stock prices by announcing repurchases which they will not actually implement allowing them to sell share on the market at an inflated price. This process essentially transfers wealth from public investors back to company managements through price manipulation. This type of manipulation is known as informed trading or false signalling. With increased regulation of insider trading informed trading and false signalling have become increasingly common ways for management to manipulate markets based on non public information and deceptive transaction behaviour.

Conclusion

Insider Trading is not a victimless crime as it has been supposed to be. The practice of insider trading shakes the foundations upon which equity markets function- investor confidence, and upon which the capitalist system operates- efficient allocation of resources. The Australian insider trading regime has not been very successful in prosecuting perpetrators of the crime due to the vagueness of key provisions in the concerned legislation. Open market share repurchases have become an alternative avenue for stock market manipulation in the wake of increasing scrutiny of traditional methods of insider trading. Despite this the further tightening of regulation of insider trading must continue to create the impression of fairness and efficiency in Australian and global equity markets.

Bibliography

1. Ayres, Ian and Bankman, Joe. ‘Substitutes for Insider Trading’ (2001) 54 Stanford Law Review 235

Bokhary, Kemal. ‘Insider Dealing- Identifying and Tackling it’ (1984) 14 Hong Kong Law Journal 11

Buffa, Andrea and Nicodano, Giovanna. ‘Should Insider Trading be prohibited when share repurchases are allowed?’ (2008) 12 Review of Finance 735

Cheng, Kiang. ‘Insider Trading and Voluntary Disclosures’ (2006) 44 Journal of Accounting Research 815

Fernandes, Nuno and Ferreira, Miguel. ‘Insider Trading Laws and Stock Price Informativeness’ (2009) 22 The Review of Financial Studies 1845

Fried, Jesse. ‘Open market repurchases: signalling or managerial opportunism?’ (2001) 2 Theoretical Inquiries in Law 865

Fried, Jesse. ‘Insider Signalling and Insider Trading with Repurchase Tender Offers’  (2000) 67 University of Chicago Law Review 421

Fried, Jesse. ‘Informed Trading and False Signalling with Open Market Repurchases’ (2005) 93 California Law Review 1323

Malone, Emily. ‘Insider Trading: Why to commit the crime from a legal and psychological perspective’ (2003) 12 Journal of Law and Policy 327

McGee, Robert. ‘Applying Ethics to Insider Trading’ (2008) 77 Journal of Business Ethics 205

McVea, Harry. ‘What’s wrong with insider dealing?’ (1995) 15 Legal Studies 390.

Miller, Stewart et al. ‘Insider Trading and the valuation of international strategic alliances in emerging stock markets’ (2008) 39 Journal of International Business Studies 102

Moore, Jennifer. ‘What is really unethical about insider trading?’ (1990) 9 Journal of Business Ethics 171

North, Gill. ‘The Australia Insider Trading Regime: Workable or Hopelessly Complex’ (2009) 27 Company and Securities Law Journal 310

Padilla, Alexandre. ‘How do we think about insider trading-An Economist’s perspective on the insider trading debate and its impact’ (2008) 4 Journal of Law, Economics and Policy 239

Painter, Richard. ‘Insider Trading and the Stock Market 30 years later’ (1999) 50 Case Western Reserve Law Review 305

Roulstone, Darren. ‘The Relationship between insider trading restrictions and executive compensation’ (2003) 41 Journal of Accounting Research 525

Shimizu, Katsutoshi. ‘Is the information produced in the stock market useful for depositors?’ (2009) 6 Finance Research Letters 34

Wang, William. ‘Stock market insider trading: victims, violators and remedies- including an analogy to fraud in the sale of a used car with a generic defect’  (2000) 45 Villanova Law Review 27

Werhane, Patricia. ‘The indefensibility of Insider Trading’ (1991) 10 Journal of Business Ethics729

[1] Richard Painter. ‘Insider Trading and the stock market 30 years later’ (1999) 50 Case Western Reserve Law Review 305, 307.

[2] Ibid 307.

[3] Harry McVea. ‘What’s wrong with insider dealing’ (1995) 15 Legal Studies390, 393.

[4] Ibid 393.

[5] Ibid 393.

[6] Emily Malone. ‘Insider Trading: Why to commit the crime from a legal and psychological perspective’ (2003) 12 Journal of Law and Policy 327, 329.

[7] Ibid 332.

[8] Ibid 332.

[9] Ibid 333.

[10] Kemal Bokhary. ‘Insider Dealing- Identifying and Tackling it’ (1984) 14 Hong Kong Law Journal 11,12.

[11] Alexandre Padilla. ‘How do we think about insider trading-An Economist’s perspective on the insider trading debate and its impact’ (2008) 4 Journal of Law, Economics and Policy 239,241.

[12] Ibid 242.

[13] Ibid 243.

[14] Katsutoshi Shimizu. ‘Is the information produced in the stock market useful for depositors?’ (2009) 6 Finance Research Letters 34, 35.

[15] William Wang. ‘Stock market insider trading: victims, violators and remedies- including an analogy to fraud in the sale of a used car with a generic defect’  (2000) 45 Villanova Law Review 27, 29.

[16] Ibid 29.

[17] Ibid 37.

[18] Ibid 64.

[19] Nuno Fernandes and Miguel Ferreira. ‘Insider Trading Laws and Stock Price Informativeness’ (2009) 22 The Review of Financial Studies 1845, 1845.

[20] Ibid 1847.

[21] Ibid 1847.

[22] Emily Malone. ‘Insider Trading: Why to commit the crime from a legal and psychological perspective’ (2003) 12 Journal of Law and Policy 327, 338.

[23] Stewart Miller et al. ‘Insider Trading and the valuation of international strategic alliances in emerging stock markets’ (2008) 39 Journal of International Business Studies 102, 103.

[24] Emily Malone. ‘Insider Trading: Why to commit the crime from a legal and psychological perspective’ (2003) 12 Journal of Law and Policy 327, 366.

[25] Ibid 366.

[26] Gill North. ‘The Australia Insider Trading Regime: Workable or Hopelessly Complex’ (2009) 27 Company and Securities Law Journal 310, 315.

[27] Ibid 323.

[28] William Wang. ‘Stock market insider trading: victims, violators and remedies- including an analogy to fraud in the sale of a used car with a generic defect’ (2000) 45 Villanova Law Review 27, 65.

[29] Andrea Buffa and Giovanna Nicodano. ‘Should Insider Trading be prohibited when share repurchases are allowed?’ (2008) 12 Review of Finance 735, 735.

[30] Ibid 735.

[31] Ibid 737.

[32] Jesse Fried. ‘Informed Trading and False Signalling with Open Market Repurchases’ (2005) 93 California Law Review 1323, 1326.