This essay has been submitted by a law student. This is not an example of the work written by our professional essay writers.
Published: Fri, 02 Feb 2018
Insider Trading: Legality & Morality
Insider trading is the practice of mainly “insiders” such as directors, managers, or employees of a certain company, trading on shares of that company for which they have confidential material, i.e. information not openly available to the public. Their main goal is to seek monetary gains, or other benefits. They are called insiders since they are able to get that confidential information about their company, gaining advantages through information about imminent mergers, by purchasing shares of that company before the news of the merger becomes public. This usually results in the increase of the share’s price, after which the insider sells the total shares purchased, making a quick profit. In terms of rate of return, USA studies have shown that businesses based on insider trading obtain a rate that is on an average 3% points more than the average of all stocks (Chakraverty, McConnell, 1999). Insider trading has been historically widespread in the stock market, and even in all types of economic, political, and social life. For example, a father can share what is named as “private” information with his daughter about a job opportunity in her field of work, and she is able to quickly get the job since she is quick on the scene (O’Hara, 2001).
So the question remains, should insider trading be legal or illegal in the stock market? If it was to be legal, is it then considered moral or immoral as a practice? If it has been made illegal in the stock market, then why is it still legal in other areas of our social life? This paper will discuss the legality and morality of insider trading, stating numerous arguments and counter arguments for and against insider trading.
History & Legality
Before the 1970s, insider trading was considered perfectly legal in almost every nation in the world, but the USA somehow had been the main nation to indirectly legislate against it as a practice in the stock markets. The Securities and Exchange Act of 1934 outlawed “fraud” in the buying and selling of securities (O’Hara, 2001). According to Karni (1992), Fraud is done when an agent “misinterprets the information she has at her disposal so as to persuade another individual or principal to choose a course of action he would not have chosen had he been properly informed”. As we can see that insider trading is not even stated in this Act, but supporters of its illegality claim that the legislation indirectly contains it by trying to prohibit the “employment of manipulative and deceptive practices” (Herzel and Katz, 1987). The Act also tries to guarantee a “fair and honest market that is one that would reflect an evaluation of securities in the light of all available and pertinent data” (Section 10b-5 of the Act; Betis et al. 1998). This specific section states that a person must reveal inside information, or avoid from trading. So indirectly, this Act banned insider trading by demanding that insiders reallocate profits gained through buying and selling shares within a six-month period (O’Hara, 2001). It is also illegal to use private information to gain benefits (Section 10b of Act), and imposed certain reporting necessities on insiders buying and selling securities in the firm (Section 16b).
United States legislation has led the way to insider trading and only gradually has legislation been presented in other nations such as the UK and Japan, who generally followed the US example in the 1970s through the 1990s (DeMarzo et al. 1998). The European Union directs such legislation in the member nations, even though much of the legislation passed has not been sufficiently controlled. Australia on the other hand, has legislation similar to the United States, and more lately legislation has been under way in parts of Asia (O’Hara, 2001). But still to this day, most nations do not forbid or regulate insider-trading practices.
Court decisions have influenced much of the force of insider trading legislation, which in some cases, contradictory decisions were made. US courts for example have based their decisions on the idea that those engaging in insider trading have illegally used such information. First, such information is said to be illegally used, since insider traders break a financial, or “fiduciary duty” which argues that officers of a company have a duty to protect the interests of shareholders. Second, many cases have been indicted for the practice of “misappropriating” information from a company. The “misappropriation” theory has been applied since 1982. Both fiduciary duty and misappropriation are said to include abusing non-public information, breaking a duty occurring from a relationship of trust, and using that information in a securities transaction. According to Ten (1997), fiduciary duty involves corporate insiders having a “duty to shareholders”, whereas misappropriation is defined as stealing important proprietary information from a company.
Vicente (1999) says that legislation made insider traders change their performance in order to escape from it. Rather than taking advantage of serious information and making profits close to the time of the events, they trade on inside pieces of information that are less significant but more numerous, and regularly quite a long time before the critical event, such as bankruptcy. Bettis et al. (1998) validate this finding through research that shows insiders using information to engage in four types of unfair advantage. So if the private information is good news, they can gain by purchasing more stocks or shares, or by holding the stock that was going to be sold. But if the information is bad news, they benefit by selling stock to “ignorant” traders or refraining from purchasing stock that otherwise would have been bought (Bettis et al., 1998).
Arguments and cases for insider trading
According to O’Hara, the case for insider trading in a philosophical, justice and efficiency view of the workings of capitalism and financial institutions. The philosophy comes from the right of individuals to have an ultimate range of unshackled activity, to attain property, to trade, to buy and sell labor power, and to become rich or poor. Brown (1986) says that freedom in the attaining of property and in human association are rights that the states must not harmfully affect uncles they are directly hurting or damaging others. Brown’s view is similar to Nozick’s view of justice, which is based on the notional of natural freedom, where people have certain negative rights, which are rights against other people meddling forcefully in their affairs and the right to property acquisition and increase (McGee, 1988). Such rights can never be justifiably violated.
These rights provide a foundation for backing up the actions of the entrepreneur who always seeks to be attentive to any intact gains from trade, discovery, alertness, or action. Thus “the proper scope of government is to protect life, liberty and property, and any act by government which goes beyond this scope results in injustice because it must necessarily use the coercion to take from some to give to others” (McGee, 1988). Manne (1966) set out the clearest case for insider trading. The entrepreneur is that individual who does things otherwise in economic life, and encounters established commercial and industrial practices. He also tends to encourage impulsive change in the system of economic organization. Moreover, the entrepreneur according to Schumpter, provides the ideas and creative element for development and change. His self made profit is a surplus above costs originating from disturbing recognized lines of business, creating a new market and carrying out new patterns. So this activity according to Schumpter is different from that of shareholders since the latter provides the money, while the entrepreneur offers the ideas and knows how to put changes in practice. So the surplus value created from the entrepreneur cannot last, since other competitors will finally “destroy” it by copying the new good, method or market.
There are great advantages of insider trading over other systems of benefits for innovators (O’Hara, 2001). Salaries and pensions are said to be fairly secure and predictable. Insider trading rewards are the right type of compensation package for risk taking and driving new ideas and practices, according to Manne, since they relate to material information about certain developments in the company, such as a new product, market, or source of raw material. The actual challenge is to establish the corporate and managerial structure so that this inside info is directed to innovators instead of free riders. But on the other hand, it is essential to provide a suitable legal system to hearten such insider practices.
Insider trading laws (Udpa, 1996) affect the freedom of business, diminish innovation, reduce macro and micro efficiency, and almost always represent a cost to shareholders. Moreover, insider trading reduces uncertainty by increasing the amount of information available, and by that lowering the variance of abnormal returns upon release of annual reports. It is often repeated in the literature that insider trading is a victimless crime that helps to motivate entrepreneurial activity and the efficiency of the market.
Arguments and cases against insider trading
There are four main ethical arguments against insider trading:
Asymmetry of information
Unequal access to information
Contravention of property rights in information
Being counter to fiduciary duty
We’ll be now presenting each argument alone, along with their respective counter arguments that have originated as a result.
Taking first asymmetry of information, it states that insider trading is unfair since the two parties to a transaction do not have equal information. So according to this view, both parties should have the same material information about the conditions that are essential for this transaction. This argument however, seems to create a problem, from the view of historical notions of fairness under capitalism, because this argument would certainly argue against most transactions made in the capitalist market. Thus there will always be traders who have superior information about the transaction or product due to superior technical skills or knowledge, and more experience. So the asymmetrical distribution of information cannot be used as a serious argument to attack insider trading, taking into account the historically predominant and ethical institutions of business.
The second argument is that the information is not available to the shareholder to ascertain the suitability of buying and selling securities in the marketplace. This argument is more concerned that this information should be public in the sense that hard work on the part of potential dealers in the market will be able to extract it. This phase of fairness concentrates on the information being open to everybody given sufficient hard work into the marketplace and the economy in general (Koslowski, 1995). This particular argument has been critiqued by many especially Moore (1990), who says that the information they have would be traded in a market and that information would be available to anyone who wanted to buy it, if insider trading was legal. Moore doubts that the knowledge of insiders is in principle different from the knowledge that plumbers have over people who are not plumbers (for example), especially given the difficulty of the different situations that arise over plumbing in different contexts. Dennert (1991) believes that access to information is not absolute but relative, depending on the degree to which they are insiders or outsiders. Whereas Kay (1988) believes that the illegalization of insider trading simply redistributes power from insiders to market professionals, while the “ignorant traders” stay weak as before.
The third argument opposing insider trading is that it disobeys property rights in information. Advocates of this view argue that inside information is a type of property, and that dealing in this information is an abuse of property rights. The misappropriation theory of property rights can pertain to corporate insiders, but was presented into legal theory mainly to decrease the level to which corporate outsiders have an advantage from inside information. Manne (1966) and McGee (1988) argue that the person who invented the product, discovered the source of raw material or promoted a form of corporate reorganization, should have property rights over the information. Moore (1990) proposes that the misappropriation theory can also be applied to corporate insiders but that information cannot be broken in this way if the shareholders allow insiders to use such information. So in order to moderate the violation of property rights, Moore suggests that either the shareholders could directly seek to allow insider trading, or a company could have a plan supporting it by certain conditions, and thus informing actual shareholders of this fact.
The fourth argument is that of fiduciary duty. This theory theorizes the notion that insiders have a long-standing ethical duty to enhance the interests of shareholders. According to Boatright (1997), fiduciary duty “is a duty of a person in a position of trust to act in the interests of another person without gaining any material benefit, except with the knowledge and consent of that other party”. Moore (1990) makes this argument the only real case against insider trading. Manne (1966) argues that insiders who trade in privileged information usually do so in a way that supports the interests of shareholders, and therefore there is no conflict with fiduciary duty. Other supporters of insider trading such as Dennert (1991), argue that there is little evidence of the “lack of confidence” ever happening in mature capitalist economies as a direct result of insider trading, and is more likely to happen in emerging economies. But this is probably due to the power of “mafier capitalists” rather than insider trading as such.
The current state of knowledge about insider trading does not provide a strong case against the practice beyond reasonable doubt (O’Hara, 2001). Arguments in favor of insider trading are well developed, and authors such as Manne produced extensive study to support it on many grounds. At the same time, many ethical arguments against insider trading are problematical, and many of them are dismissed on the basis of the standard ethical workings of capitalism. Moreover, legislation in the USA changed the nature of the practice, but hasn’t affected its occurrence significantly. Much examination is still required about insider trading in other areas instead of financial markets in order to treat the fact in a general fashion, and comprehend it more systematically.
Cite This Essay
To export a reference to this article please select a referencing style below: