When persons deal in financial products having prior knowledge of price sensitive information which is not in the public domain, such trades are termed as Insider Dealing. These trades seem to a non participant, legally and morally incorrect as understood in colloquial understandings as a matter of ethics. However, if the moral high ground is set aside then the desirability of prohibiting insider dealing is debatable and remains unresolved.
Basically there are two schools of thought regarding insider dealing. One school debates the unfairness of such trades, while the other argues the economic efficiency generated by such trades. These divergent views are a subject of intense debate which this paper highlights. For the sake of clarity it is necessary to demarcate an insider who is responsible for insider trading. Insiders are persons regularly involved with the activities of the firm i.e. owners, directors and management, as also it’s lawyers, accountants and all other functionaries who routinely have information about the firm which is not in the public domain.
Besides the conventional insider trading, it can manifest itself in various forms. Two such forms involve brokers who decipher information derived from orders placed by clients, and resort to client precedence or front running. When the time priority is manipulated by brokers against client orders it is termed as client precedence, wherein the broker places orders on his own account before initiating his client’s order, thereby accruing maximum price advantage and executing his clients order at a comprised price. While in front-running, a broker on receiving a large client order, trades just before execution of the order expecting movement of price when the large order goes through. Another dealing in front-running is the broker on receipt of a large order takes a positions opposite to that of the client without informing him to square the trade off market at a profit. In spite of all the legal provisions that have been put in place to curb insider dealing, it is still questionable if such curbs are enough to protect outside investors.
Insider dealing was first taken cognizance of by the US. Courts promulgated the disclose or abstain rule and misappropriation theory under section 10(b) SEA 1934 thereby leading to rule 10b-5. Under powers of Exchange Act Section 14(e), Securities and Exchange Commission (SEC) enacted rule 14e-3 concerning tender offers. This research paper mainly deals with the policy debate on the prohibition of insider dealing and its effective implementation in different evolved markets.
Insiders in a general sense are people who during the course of their interaction within the company acquire information which is not available to outsiders. Insiders are also categorized in two types i.e. Primary insiders and Secondary insiders. (Article 2(1), Market Abuse Directive)
Though insider dealing is projected as an offence under Market Abuse Directive, but the
directive treats most cases as an objective offence; thereby opening the debate that insider trading is economically efficient.
This research paper first tries to explain the scope and definition of insider dealing and in the second part it explains the Continent wise approach to insider dealing in which it tries to compare the approach of certain jurisdictions. Further, in the third part it tries to reason out whether or not it should be prohibited. This paper discusses the policy debate on the prohibition mainly in the second and third part. Consequently, it seeks the effectiveness and alternatives to insider trading regulations concluding by analyzing the complete paper and the opinion as to whether its prohibition is in the interest of all parties concerned.
2) Scope and definition of Insider Dealing
The scope of insider dealing varies from country to country. In the US both the Securities Exchange Commission and the federal government have taken cognizance of insider dealing and have taken steps to curb this. Most countries now treat it as an offence and have put in place legislation to curb it with serious infringement penalties. Insider dealing is considered as a social taboo because of its immoral nature. However, it is not fathomable to comprehend if it would be comprehensively possible to curb this offence.
Defining the offence itself varies from country to country. Citing the example of US, US law makers have not given any fixed definition of insider dealing. Hence rules invoked against insider dealing make no mention of the word ‘Insider’ or ‘Insider Trading’ and inside information is defined as ‘material non public information’. Whereas Article 1(1) of Market Abuse Directive of the EU goes on to articulate ‘inside information’ precisely as any information of a specific nature, which has not been made public concerning directly or indirectly to all issuers of financial instruments, which if released to the public is likely to significantly impact the value of the concerned financial instrument or related derivative financial instruments.
Further Article 2 (1) lays down what constitutes insider dealing. Article 3(a) and 4 deals with primary or secondary insiders disclosing information to a third person subject to such information being passed on in the normal course of discharge of duties or as per Article 3(b) and 4 primary or secondary insiders recommending / inducing a person to deal in or dispose such inside information will be treated as insider dealings.
3) CONTINENT WISE APPROACH TO INSIDER DEALING
3.1) US PERSPECTIVE
As per theories, the US has been the first to proscribe insider dealing. The collapse of the United States stock market in 1929, led to the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934 by the Congress. S.16(b) and s.10(b) of the 1934 Act tried to deal in all possible ways with the issue of insider trading. Wherein s.16(b) disallowed corporate people in the know to make short term profits from their own corporation stocks, however, an exception was in place for extraordinary circumstances. Application of this law was to safeguard insider trading by people most likely in the know of restricted information e.g. Directors / corporation honchos holding in excess of 10% of the stocks.
However, s.16(b) of Securities Exchange Act 1934 only restricts the insider trading on inside information, if he resorts to counter trades in the preceding six months or intends to make such trades in the future within the next six months. This stipulation of six months is seemingly inadequate and the period can be considered for enhancement to resolve this. This given period of six months acts as a major hurdle in the effectiveness of this rule as the insider can wait for six months in order to trade.
Also Rule 10b-5 which was brought in by the SEC under sec 10 of the 1934 Securities Exchange Act, set a requirement for the insiders with a fiduciary duty towards those with whom they would trade, to abstain from trading incase they had access to material information which had not been made public. The Congress and SEC have been very strict in the enforcement of Rule 10b-5 especially since 1980’s. The Congress allowed the SEC to increase the civil penalty by three times for the violators of Rule 10b-5 in 1984 by passing the Insider Trading Sanctions Act. It became common to send the culprits behind the bars after 1980’s. In 1988, the penalties touched the peak when the Insider Trading and Securities Fraud Enforcement Act announced $ 1 million as the maximum criminal penalty and an imprisonment of ten years.
However, due to the complexities involved with regard to insider trading, proving violations in insider trading under Rule 10b-5 (SEA 1934) is very difficult. The onus of conclusively showing that pertinent and non public information was used in trade by the insider lies with the SEC. To compound matters Rule 10b-5 puts no restriction on the corporate insider armed with pertinent inside information to defer trade or not to trade at all, putting the corporate insider in a relevantly better position than an outsider not having the relevant information. But as is the duty of all regulators SEC continues to pursue cases.
In spite of these rules, the insiders have not yet been completely hindered from making profits. This shows that there is something lacking in these rules. Moreover, in order to be punished under rule 10b-5 it is necessary that the information meets the standards of materiality in a strict sense. The main reason for rule 10b-5 not being effective enough is the materiality criteria. The meaning of materiality might differ circumstantially and may be different for different people. Moreover, it is possible that insiders trade on information which is not material but is not in the public domain and is enough to make profits.
Besides this the issues of disinformation also required to be largely curbed. Section 10(b) pegs the “material misstatement” clause which due to misinformation by office bearers of the firm may be directly responsible in affecting the stock prices of other companies. Section 10(b) holds people accountable to civil liability, who spread misinformation about one firm and make profit from the resultant variation in prices from other firms.
There are mainly three theories under which insider dealing is considered illegal. The first rule i.e., the disclose or abstain rule in which it was decided in the SEC v. Texas Gulf Sulphur Co. , that if a person had access to information which was not available to the general public, then he had two options. First is, revealing that information incase he wished to make use of it, or
second, refrain from trading in the securities of that company. However, this policy was later discarded by the Supreme Court of US, in the Chiarella v. United States and Dirks v. SEC in which it held that the liability of a person would arise only subject to an obligation to reveal ahead of trading. This rule unlike the rule in Texas Gulf Sulphur Co. brought about a vital change by enhancing the ambit of the offence from only insiders to certain outsiders who owed a fiduciary duty to the issuer. However, this also had its own limitations as the outsider would only be liable if, he obtained information which was not public, from the issuer and the issuer expects confidentiality from the person to whom the information is disclosed. The rule also gave rise to tippee liability, however, this also has it’s own limitations, i.e., the liability of a tippee only arises when there is a breach on the part of the tipper of a fiduciary duty due to revelation of information and the tippee has knowledge or there is basis for him to have knowledge of this fact.
This decision of involving involved outsiders within the ambit of insider trading, dilutes the opportunities to identify the insiders as well as makes it difficult to pinpoint the involved outsiders.
As a reaction by the SEC to the Chiarella case, came rule 14e-3. It proscribed the letting out of secret information related to tender offer by insiders of the bidder and target companies to any person who is capable of trading on that information thereby infringing the rule.
However, this rule also has its limitation. Research has shown that though under rule 14e-3 a person is proscribed from using information that is not in the public domain, which may be accessed by a person initiating a business deal with a firm from purchasing stock of such a firm with whom he has entered into an agreement. However, this does not disqualify or hamper a person from trading in stocks of subsidiaries of the firm whose information is not in the public domain. This implies that the information that is under wraps of dealing with a firm though disallows purchasing stocks from that firm does not prohibit a person from purchasing stocks of other firms in the same industry. This is despite the fact that it may be evident to predict the outcome of the impact of the dealings of the firm with whom an agreement has been entered into. Therefore, the logic that supports Rule 14e-3 may support the logic reaching out to the stocks dealt with within the same industry. Hence, an insider working in the same industry might have knowledge of other firms, but as per this rule there is nothing to prohibit them from trading on the stocks of those other firms.
Chief Justice Burger used the idea of misappropriation to give a theory based on insider dealing liability. This theory was brought into practice by the Supreme Court in the case of O’Hagan v US , it was clarified in this case that misappropriation theory is a part of Rule 10(b)-5, the criteria for which are, the employment of a misleading device, violation of a fiduciary responsibility, using of important, non pubic information in order to trade on a security, and the defendant’s determination.
While deciding on the case, the first and foremost argument given by the Court was the protection of investor confidence which would be possible by proscribing insider dealing.
The second argument as quoted in the Court’s words was
“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.”
It is evident from the above facts that even though the rules against insider trading have not been as effective as they should have been, but the approach of the US towards it has been very strict. It has been considered a serious offence in the US and 1980 onwards a more stringent approach has been adopted.
The US though looks at insider trading through a broader perspective, and civil penalties can be imposed by the SEC, hence, unlike the EU, the standards of proving the offence are not very
high. However, it is the concept of fiduciary duty which makes it difficult to completely control insider dealing.
3.2) EU PERSPECTIVE
The first to make extensive progress in order to prohibit insider dealing outside the United States was the European Community Directive which was adopted on November 13, 1989, known as the EC Directive. Scandals of 1980’s in Europe that involved the Guinness Brewing Group, made it highly important to prohibit insider trading throughout Europe. The Directive has been greatly influenced by the US Laws. The 2003 Directive came after the 1989 Directive. Unlike the US law, the 2003 Directive clearly defines “insider” and “insider dealing”.
The 2003 Directive not only defines the insiders but also those who use illegal means to attain information. As to taking cognizance of the offence, the Directive adopts a flexible approach, by allowing insider trading to be punished either as a crime or civil wrong or even both.
However, the member states have had their own political and cultural issues and it took time to get the legislation in writing.
However, the basic difference between the United States prohibition of insider trading and prohibition under the EC directive is that in order to be liable under the EC directive, the insider dealer does not need to have been in violation of a fiduciary duty. Moreover, the standards of proving the crime are much higher in UK due to the criteria of “precise nature”.
However, there may be drawbacks in the legislation, but the strictness in the rules against this particular offence proves that the approach of both these countries has been positive enough to lessen or completely prohibit this offence.
3.3) ASIAN PERSPECTIVE
Since India is the largest democracy in the world, this research paper considers it relevant to discuss the state of insider dealing with regard to India. Insider trading in India was unchecked till 1970. That is to say after the founding of the Bombay Stock Exchange in 1875, insider trading remained unchecked for almost 100 years. The ill effects of insider trading became apparent with time. Several committees made recommendations in order to control this practice. Ultimately, the Securities and Exchange Board of India (SEBI) Regulations 1992 managed to restrain insider dealing to an extent. The liability of a person if convicted under this offence arises under s.24 and s. 15G of the SEBI Act 1992. The laws on insider trading had been made more stringent during February 2002. The definition of insiders was broadened.
However, at present in a country like India in which there are too many loopholes in the statute it is very difficult to curb this offence. But the initiative taken itself is in the right direction and shows the positive will of the state to curb insider trading.
Malaysia gave the investors an upper hand by allowing them privately to take action against the insider dealers.
Japanese law seeks intrusive clarity and has laid down specifics that may be triggers for initiation of insider trading, e.g. allotment of securities by the management, capital reduction, stock splits, changes in dividend distribution, mergers, dissolutions, changes in marketing strategies, natural calamities, damages to the corporation, sales or purchase of the whole or part
of the business, changes in the shareholding pattern, actual profit or loss, events listed by the Cabinet Ordinance or changes in the assets or business strategies which effect future investment decisions involving the management. The impact of these information and permutation- combination of these inside information may vary. The Japanese law appears to be more meticulous and clear about what it actually wants to include in the offence.
This paper traverses across various regions and in its study deduces that different countries have enacted different laws and also have different takes in enforcement of the insider trading laws. But most seem to agree that there is a requirement to curb this practice as, in the foreseeable future it would be ultimately good for the economy.
4) SHOULD INSIDER DEALING BE PROHIBITED
The question “Should insider dealing be prohibited?” is of primary importance and also the main subject of this research paper. There are advocates supporting both, prohibition and deregulation of insider trading. Since the fountainhead of majority of laws is the US law, this research paper primarily discusses the US law, though insider trading is neither defined including all parameters nor are there clear regulations by the federal rules. The most prominent argument against insider dealing mentions the unfairness of it ethically which may resultantly frighten away investors who contribute to the liquidity of the stock market. But in the absence of a clear definition of insider trading, enforcement of the regulations becomes a difficult task.
Moreover, the majority rule says that there is no such responsibility for the corporate insiders towards the shareholders. In the case of Carpenter v. Danforth which is among one of the initial cases to deal with insider trading, it was held by the appellate division that the director’s duty which was owed to the corporation was not owed to the shareholders by reason of his holding shares.
This research paper giving all due respect to the decision of the court argues that while conceding the fundamental duty of the directors towards the corporation also has to be accountable to the share holders who are in effect owners of the corporation. Shareholders will enhance/ continue their investments only if the corporation dealings are transparent and their investments bring them higher returns.
A point of view supporting insider trading justifies that it is acknowledged as a type of compensation for the corporate sector work force which can be kept at a subdued salary thereby benefiting the shareholders eventually. On the company value enhancement, academicians profess that it encourages innovations, due to the sheer quantum of rewards to be reaped, from creating products which add value and result in steep increment in the stock. However, strong the argument is, it does not explain the unfair act of keeping the general public from material corporate information and reaping the financial gains on their own at the shareholder’s cost. It also does not justify the issue of insiders getting into dicey business for quick profits. Besides, due to acute competition there is no check on the managerial compensation, there by profits from insider trading augment the high managerial compensation rather than substitute lower compensations as envisioned.
The compensation argument is one of the most common arguments which the proponents of insider dealing argue, however, they tend to forget the fact that, not only is insider dealing an ethically wrong instrument to compensate the management but the management is usually given higher salaries on the basis of their skills, experience and performance, the judgment for which is, in principle, made by the shareholders. If measures such as insider dealing are used to compensate the management, the shareholders inevitably lose to the insiders of a firm because of lack of the information, which, these insiders use to great advantage of their own.
Moreover, this cannot be a valid argument in support of insider dealing because the insider not only includes the management and executives but other secondary insiders such as lawyers, accountants as well, for whom this cannot be a valid justification.
The fact that insider trading lacks a legal definition in place and the reliance by Americans on numerous anti-fraud provisions gives a base to the proponents of insider dealing to argue on the ground that regulating insider dealing might prove to be unfair to those traders who do not indulge in insider trading in it’s strict sense but their dealings are such that are borderline on insider trading. However, this is not of much importance. The reason being that it is necessary to prove the intention of fraud.
Critics of stringent insider trading regulations point out that securities analyst play a major role in assessment of companies and this would stifle their basis of analysis because of the absence of inputs from the company officials. However, the empirical evidence shows that the analysts in the United States make their assessments within the ambit of permitted law. Moreover, in a country like the US which has been highly cautious after the fall of ENRON, and the Sarbanes-Oxley Act which came in response to the Enron case, it is very difficult for the securities analyst to make any unfair or fake assessments.
There are also arguments on the basis that there is no sufferer of the so-called crime, “insider trading” and moreover, it would be highly expensive to impose restrictions on insider trading. To enforce the restrictions against an offence like this is highly expensive as well as time consuming and whether directly or indirectly the cost is borne by the shareholders ultimately.
The parity of information is yet another reason given by the proponents for prohibiting insider dealing. However, the US Supreme Court rejected this argument contending that a truly efficient market is one in which the information possessed by all investors is not equal. Moreover, the Court argued that a different level of possession of information encourages the investors to be more competitive and do more research thereby, improving market efficiency.
With all due respect to the Supreme Court this research paper argues that competitiveness in the market place brings out the best and is a source of greater efficiency, but this is only true when the competition is healthy. In insider dealing, a person is privy to information by virtue of his being in that particular position. The question of research, competency and efficiency do not arise here because it amounts to possession of relevant information that might negate research about the future prospects of the company.
Legal, financial and institutional data researched across 33 countries show that if insider trading laws are strictly implemented in the stock markets, such markets have greater liquidity and the ownership of equity is dispersed making the stock prices more transparent.
According to Carlton and Fischel, one of the benefits of insider trading is that it allows the stock prices to find its own legitimate level due to the inputs and settle to the firm’s proper value earliest. However, insiders do not trade for the benefit of others. While on the other hand insider trading stigma may curb insiders their initiative to release relevant information in the market resulting the stock prices not having factored in the information and being less informative.(Kraakman, 1991). Also insider trading may act as a deterrent by reducing incentives to outside informed traders from researching and finding out relevant information about the firm thereby making the stock less informative. by: (1) Possibility of sabotage by insiders (Morck, Yeung, and Yu, 2000); or by (2) Stemming the flow of stock information after reducing competitors. (Fishman and Hagerty, 1992)
Though insider trading, if allowed to go on unchecked will lead to a different set of problems and open an avenue for higher cost of doing business. When insiders trade it is invertible that brokers and other market makers consistently lose money, to cover this additional cost they enhance their bid-ask value. This way they cover the higher cost and shift the onus of this enhanced cost to investors outside whom they deal with, resulting in creating “insider trading tax.” Enhanced ownership may be a direct fall out of insider trading even if such trades are considered beneficial. Due to the large holdings it can be assumed that monitoring is professionally carried out and better (see, e.g., Bhide, 1993). With these large holdings (undiversified) the vulnerability factor is required to be offset through compensation. One such means is by allowing insider trading (Bhide, 1993; Demsetz, 1986). Enhanced valuation through insider trading encourages investors to hold large blocks of shares, however if insider trading is legally forbidden it is likely to discourage investors investing in large blocks of shares. (Bhide, 1993; Demsetz, 1986). Various countries have different perspectives of pattern of share holdings, wherein countries promoting widespread equity ownership have put in place necessary regulations to prohibit insider trading.
Insider trading regulations are not totally independent. They are influenced by various regulations among which is included the pattern of equity ownership.
Research has further shown that if there are no regulations for insider trading then the small shareholders are at loss, as the large investors such as the institutional investors who have better resources and are by all means more powerful, join hands with the controlling authorities of the company in order to safeguard their interests.
Some academicians argue that it is true that the insider dealers make striking profits from the inside information that they have access to, however, it is believed that these insiders are able to make these profits because of the information they have and not because of any kind of deception. However this argument cannot be given credit as having access to information by virtue of being in a particular position and using it for the same transaction in which the other shareholders also participate, without disclosing that information to them, is itself a form of deception.
Moreover, regulations are to deter insiders from trading stocks of their own company but the regulations are silent about such trading of stocks of other companies. Though the actual beneficiary of the insider dealing regulations are not clear. Small shareholders and general public do not greatly benefit from these regulations but it is usually the institutional investors, brokers, security analysts, floor traders. Moreover the regulators i.e. SEC gets more visibility and power which is accompanied with prestige and a larger budget. (Bainbridge 2002).
The arguments as those given above by the proponents of insider trading are not consistent. Insider trading has to be regulated, this must have a rationale, only because there is nothing to stop the offenders from trading on the stock of other companies does not mean that the insiders should not be prohibited from trading on the stocks of their companies, the information of which they have easy access to on a quid pro quid basis. Moreover, even if the beneficiaries of the regulations are institutional investor or brokers it stands to reason. This is what makes the market efficient and competitive in its true sense, as these large investors may have more access to resources and may be more powerful but benefit purely on the basis of their research. Providing a level playing field to market professionals, small share holders and insiders by regulating insider trading will check volatility in the market.
Academicians Scott (1980), Herzel and Katz(1987), point out that insiders use information belonging to their organization for their personal gain.
Researchers have contested that insiders benefit at the expense of outsiders when inside information is the basis of initiating a trade, but outsiders trading their shares would have initiated the trades anyway and would have traded at a worse price (Manne 1970). That is to say if an insider is selling stock, he is doing so as his inside information informs him that the stock prices are likely to fall. As a consequence of selling pressure the stock prices fall, however a buyer of the stock in the market picks up the stock at a lower price consequent to the fall, thereby getting a better price for the stock he had set out to buy. As is evident that someone in the market has to bear the burden of the loss due to the insider trading, but such losses are generally spread out across buyers and sellers and cannot be easily traced. (Wang and Steinberg 1996 ). But insiders selling resulting in marginal fall in prices, goads the buyers on the margin to buy who actually loose, as well as the stock holders who sold at a lower price or persons who could not sell as there was no demand. In the instant case it is argued that transfer of wealth takes place from an outsider to an insider, the stock prices falling down erodes the valuation of the company thereby raising the cost of capital (Mendelson 1969). Insider trading rarely affects long term investors as opposed to short term speculators as the trades had been calculated and initiated for the long term projected value. (Manne 1966).
Some academicians such as Manove (1989) have argued that due to insider trading selling pressure, the stock prices may be depressed thereby depreciating the value of the firm. But Manne 1996 points out agency problem may be actually reduced due to insider trading. Also Harold Demsetz concluded that shareholders who hold large chunks of controlling stocks instead of diversified portfolios need to be compensated for the risk, this can be taken care of by allowing them access to valuable trading information. Bhattacharya further argues that outsiders also may benefit from insider trading. Though, even if law ensures a level playing field and information is available to all participants, it is not necessary that they arrive at the same conclusion after analysis. In all probability different analysts would arrive at different conclusions and trades initiated will be as per varied opinions of the best analysis of the information available.
Analysis and interpretation is directly proportional to the competence of the analyzer, however analysis is secondary. Firstly it is mandatory to follow the source of information. Information per say cannot be the same with all interested parties as market players compete and research credible information and have to at times wade through misinformation. However, this source of information seeking and analysis takes an unfair preponderance if the information is available to a select few to act upon, by virtue of their position giving them easy access to important information, denied to others.
Manager’s incentives compensating them through insider trading can hurt the corporate performance, as in the zeal to garner insider trading profits through substantial price swings, managers may engage in risky projects and expose the company to undue risk. Insider trading also tends to make managers complacent not exercising themselves to their full potential as they are able to generate profits even faced with bad news. Besides these managers exploit inside information by hoarding and trading this information before revealing it, thereby interfering with the natural flow of information within the firm which may be counter productive.
As a natural consequence the innovators who create valuable information are the ones who actually profit from the information and this can go unchecked as it is not possible to ensure otherwise. The real innovators of the firm would prefer to hoard information to enable them to monopolize on the insider trading profits, but the fact that this is discouraged, would possibly allow other insiders to take advantage of this without any contribution from them. The inability to hold back information by the true innovators of the firm to take maximum advantage of insider trading, acts as a deterrent as it ultimately reduces their initiative, as their advantage from insider trading is diluted , thereby ultimately adversely affecting corporate performance due to lack of incentive. Conversely curbing free flow of information within the firm and having access by a select few could jeopardize organizational efficiency of the firm
The problem of free riding is age old. However, this research paper suggests that there should be a body in place to decide on certain information which can be kept confidential by the innovators, just like certain official information which cannot be made public, other than that there should be an equal distribution of information to one and all.
5) Effectiveness of insider dealing regulations
According to one academician “enforcement by any means of insider trading restrictions is a bankrupt idea because enforcement attempts are to curb an incurable element of human nature.”
So far there is no established empirical research as to the effectiveness of insider trading regulations. However, the importance of regulating insider trading is evident from the fact that 87 countries out of the 103 countries which had stock markets by the end of 1998 had established laws against insider trading (Bhattacharya and Daouk 2002).
Academicians suggest that sometimes where government regulations are not very effective, there can be private negotiations between the company and the employees as to whether insider trading should be permitted or proscribed. Though these regulations are perplexing. Technology has also been one of the reasons for increase in insider dealing. With the advent of the internet, insider trading has become easier and possibly another category called ‘hackers’ can be added on to the list of insiders. However, Securities Exchange Commission of United States (SEC), has been clear about this and stated, “liability provisions of the federal securities laws apply equally to electronic and paper-based media.”
Though with technological advancement, online trading is the order of the day and insider trading may be simplified, it must be realized that tracing such trades has also become simpler for the regulators to enforce the laws of the land.
The first to study the effect of regulations on insider trading was Jaffe. His study was based on three case laws. He has observed the effect of their decisions on the amount of insider trading. The three cases on which he makes his observation are Cady, Roberts 1961; Texas Gulf Sulphur condemnation, 1961; and the decision of Texas Gulf Sulphur in 1966. Jaffe’s observation based
on the decision of these cases showed that it was difficult to bring to a close that there was any impact of insider trading regulation on the quantum of trade or the profits accrued.
However, other academicians pointed out that during the period of these three cases SEC was not serious and its main objective was not insider trading. It has been researched by Dooley (1980) that in the period from 1966-1980, the numbers of cases brought by the SEC were very few, most of which resorted to out of court settlement. However, strict enforcement of insider trading regulations in 1980’s, coupled with sanctions resulted in behavioral changes in insider outlook to insider trading.
Haddock and Macey (1987) mention the progress made by SEC From January 1982 to August 1986 wherein seventy nine 10b-5 cases were processed averaging 17.2 cases which was more than a six times escalation. Cases against corporate insiders rose from 49 percent to 80 percent in the 1980s which generally tells us the period from which impact of the regulatory changes started taking effect and consequently trading behavioral changes of insiders started to show effect.
It has been observed that there has been good progress with time as regards the effectiveness of insider trading regulations and also insider trading behavioral changes have started to bear fruit.
However, the difficulty in proving the offence in order to enforce the law is evident from an apt statement made by the SEC staff “Insider Trading is an extraordinary crime to prove. The underlying act of buying or selling securities is, of course, perfectly legal activity. It is only what is in the mind of the trader that can make his legal activity a prohibited act of insider trading.” (SEC 1998).
Insider Trading Sanctions Act (ITSA) in 1984 strengthened the hands of the SEC by allowing a steep increase in the penalties for infringement of securities laws including Rule 10b-5. This in effect has shown a decline in insider trading before impending tender offers, merger bids as well as earning announcements.
This research paper observes that, as more and more research tackles this issue of insider trade, the laws can be fine tuned and loopholes plugged as new facets will come to the fore and existing laws can be amended as well as new laws promulgated to curb insider trading as much as reasonably possible.
Arturo Bris correctly summarizes the effect of insider trading laws stating that if the laws of a country are ineffective or not enforced it would be prudent to not have laws at all. The assumption is that laws not enforced allow the insider trader to secure greater profits if he chooses to disregard the law. This higher profit is consequential to the fact that in countries where laws against insider trading exist, less people are inclined to initiate a trade on inside information but wait for public announcements, so the few who choose to break the law are recipients of higher profits. Hence it is evident that profitability from insider trading is enhanced, which is a direct result of countries not enforcing their laws of insider trading whereby instead of curbing insider trading they are at risk of allowing it to go unchecked. Moreover, the fact that those who choose to break the law are absolutely prepared to get into dicey business and receive large profits has been quite evident from the insider dealing scandals that took place following Ivan Boesky and Dennis Levine.
However, it is a known fact that there is nothing to stop those who do not believe in the law. But for small investors whose only support is the law, it is very necessary to have regulations in order to prevent their confidence from being shattered.
Research shows that one of the countries which rarely implements its laws against insider dealing is India and the laws are merely a piece of legislation. Arturo Bris in his work has proved that the profitability from insider trading is high in India and there is hardly any deterrence by penalty. However, on the other hand, US profits from insider trading are subdued. The reason is not only their enforcement of insider trading laws, but also their broadminded markets, transparency and the fact that financial information spreads speedily in the US.
On the other hand, evidence shows that though Britain has tough criminal prohibitions of insider trading they are not as effective as US. Since in the UK the cases are largely civil actions and the defendants seek to settle without going to trial, as mostly big scandals are dealt in criminal prosecutions. Under the Japanese law, only officers of the listed company and shareholders having 10 % or more shares of the company are covered. Maximum penalty imposable by the courts is return of the trading profits to the share holders and that too has been imposed once.
All these suggest that effectiveness of these regulations depends from country to country based on their will of enforcement and the outlook with regards to the degree of severity of this offence in that country as well as the influence of other factors, i.e. social, economic, political or cultural.
6) ALTERNATIVES TO INSIDER TRADING REGULATIONS
It is evident that laws pertaining to insider dealing are grossly inadequate but mostly act as a deterrent. Detection of offence and offenders indulging in it is also a complex process. Strict imposition of regulations to curb insider dealing besides being impractical would also not prove to be cost effective. Moreover, the makers of law are unsure of the fact that whether it is such a big offence, or to quote simply, even if it is an offence at all, other than the ‘immorality and unfairness factor”. It is true that business should be on the basis of fair principles, but it is also true that the market is not only about “morality”. It is about making use of the right information at the right time. However, having an unfair informational advantage over other market participants by virtue of being primary or secondary insiders does not give a level playing field to all participants but is also against the business ethics. Hence, this research paper suggests that there should be a mid way so as to curb insider dealing while keeping in mind other factors.
Wittman, Carlton and Fischel, attach great importance to Coase’s analysis that, benefits of insider trading depends on the value attached to the information is more valuable to the manager of the firm or the investors of the firm. The maximum valuing user should have the property right of the information which is required to be worked out by both parties to ensure maximum value is accrued out of the information available. If the analogy of banning insider trading is justified it can be assumed that property right of information in the hands of the firm’s investors will benefit both the firm’s insiders and investors. However, the allocation of property right in information, to the maximum valuing user is not a physical negotiation process between insiders and investors. Investors need to be aware of the likelihood of insider trading and if a maximum value allocation is reached then both the managers’ compensation as well as the share prices will be higher.
This research paper suggests that there should be an autonomous monitoring agency to monitor the transactions of insiders. The members of the agency should be independent nominees of the investors. For the sake of transparency, a modality should be worked out wherein insiders are required to declare their financial gains pertaining to trades from their own and their associated firms. This would be a confidence building measure for investors knowing fully well that their representatives are monitoring insider transactions. However, it is easier said than done, hence, the paper recognizes the requirement of a detailed feasibility of implementing has to be worked out.
Professor Brudney reflects on the principle that dictates the disclosure or refrain rule. He summarizes that, if, information parity is not available to all parties regardless of their source, such transactions must not be permitted. The principle given by Professor Brudney is a good way to prohibit the insiders from trading on insider information, as it gives clear limitation to using this information by a select few.
If implemented “Pre trading Disclosure” rule under which a corporate insider makes public his order to the broker before he places such order, is a cost effective way to rationalize profits of corporate insider trading. The information being in the public domain all parties including dealers, market makers, public investors would have the information to weigh this against other parameters available with them and arrive at a price they are willing to buy or sell. This will restrict corporate insider’s capability as a group to reap gains from insider trading, also this pre-disclosure will give the desired results at a nominal cost to the Government.
Insider trading is an act indulged in by select knowledgeable few for higher profits. As the participation by investors in the stock markets is with the aim of garnering higher returns, insider dealing will always have supporters as well as critics. However, for the sake of propriety and giving a level playing field to all participants, as well as stability against volatility in the stock market, it is necessary to regulate greed. A stock market will be vibrant and act as a barometer of the health of the economy only if the participation is all-encompassing. This is only possible if there is investor confidence in the market across the investor spectrum.
As has been observed in this research paper, the main grounds of prohibiting insider dealing are based on the fact that it is immoral and unfair. Policies relating to prohibition of insider dealing have been a subject of debate since long. The academicians on either extremes of the debate have given their opinions on the subject of prohibiting insider dealings. However, this research paper deduces, if insider dealing is left completely unregulated it would be against business ethics and
unfair to the small shareholders, who seen as a group bring in substantial wealth, investing their savings for higher returns.
In discussing the ills of insider dealing as is derived in various research , it is deduced that stock markets thrive with participation from all quarters, from the smallest individual investors to large investors, whose combined buying and selling activities create the demand and supply of stocks which ultimately drives the stock market and determines the price of stocks. An act of insider trading on inside information results in higher profits for the insider at the cost of outsiders. Insider dealing if prevalent and unchecked discourages and frightens away small investors / outsiders, which is against the grain of a healthy stock market.
Justifications by supporters of insider trading mention that, the inside information would be public at some point of time or that insider trading makes the market more efficient as the price of the information gets built in the stock price thereby reflecting its true value or that inside
information in the hands of large investors caters for better monitoring of the firm, is no good. This paper opines that proper checks and regulations to curb insider dealing, results in confidence building for all traders, it encourages research by professionals and large investors to dig for information thereby exposing short-comings in the firms, contributing to greater efficiency. It also provides a level playing field to all investors thereby encouraging hectic trade in the stocks and in matured stock markets like the US, ensures transparency and speedy flow of financial information across the markets.
However, it would be naïve to suggest that the insider dealing regulations promulgated in different countries are not influenced by the political, social and economic environment, consequently influencing their effectiveness. Hence the degree of strictness of implementation varies from country to country. But to have laws promulgated and not to implement them efficiently puts the uninformed outside trader in a no win situation, suggesting that it is better in these cases not to have laws at all. Though not having laws will force the small investors out of the markets, as laws however weakly enforced are their only protection.
This paper concludes on the ‘policy debate on prohibition of insider dealing’ based on the various extracts of research by academicians, that prohibiting insider dealing has a definite ring of justice, ethics and market maturity.
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List of cases
Carpenter v.Danforth 19 Abb. Pr. 225 (N.Y. Sup. Ct. 1865), rev’d, 52 Barb. 581 N.Y. App. Div. 1868.
Chiarella v. United States 445 US 222 (1980).
O’Hagan v. US 521 US 642 (1997).
SEC v. Stevens 91 Civ. 1869 (S.D.N.Y. March 19, 1991), Litig. Rel. No. 12813.
SEC v. Texas Gulf Sulphur Co. 401 F 2d 833