Insider trading refers to the illegal buying or selling of securities based on undisclosed material nonpublic information. Some argue for its legalization, claiming it provides valuable market insights, and that current laws unjustly harm innocent individuals, despite the offense itself causing little damage. However, opponents maintain that insider trading is unfair, as it discourages regular market participation and hinders companies' capital raising. It is important to note that trading based on undisclosed material nonpublic information is strictly prohibited.
There is an ongoing debate in the financial community regarding the impact of insider trading on markets. Insider trading is not limited to company management, directors, and employees - outside investors, brokers, and fund managers can also violate insider trading laws if they obtain nonpublic information.
Theses to Support Insider Trading
Insider trading proponents argue that it facilitates the inclusion of nonpublic information in a security price, contributing to market efficiency. When insiders and individuals with access to nonpublic information engage in buying or selling shares of a company, the resulting price movement conveys valuable information to other investors. This enables both current and prospective investors to make informed decisions based on price fluctuations. Prospective investors have the opportunity to buy at more favorable prices, while current investors can sell at advantageous prices.
Postponing the Inevitable
Supporters of insider trading claim that banning it causes delays and investor mistakes due to the influence of material information on security prices. Restrictions on accessing or indirectly acquiring information can lead to errors. Enforcing insider trading laws may imprison innocent people and deter talented individuals. It is argued that pursuing insider trading cases diverts resources from more serious crimes. Therefore, if you encounter undisclosed material information, refrain from making investment decisions or sharing it.
Theses Against Insider Trading
Insider trading opponents argue that when only a few individuals trade based on undisclosed material information, it creates a perception of unfairness in the markets. This perception can erode confidence in the financial system, leading retail investors to avoid participating in what they perceive as rigged markets. Insiders with nonpublic information can avoid losses and profit from gains, eliminating the risks faced by investors without such information. As public trust in the markets diminishes, firms would face challenges in raising funds. Eventually, there may be a scarcity of external participants. At that stage, insider trading could essentially eliminate itself.
The Case Against Insider Trading
Insider trading is often criticized because it deprives investors without access to nonpublic information of the opportunity to make fully informed investment decisions. If material nonpublic information were to become widely known before insider trading occurred, it would lead to fairer and more accurately priced securities.
Consider a situation where a company is about to launch a new product that is expected to significantly boost its revenue. An insider with knowledge of this information can take advantage of it by purchasing the company's stock before the public announcement. This can result in significant profits for the insider through buying call options, while those who traded without the benefit of that information would not have made the same decisions.
By prohibiting insider trading, investors without access to nonpublic information are protected from potential unfair advantages and can have more confidence in the fairness and integrity of the financial markets. Fair and transparent markets are crucial for maintaining trust and attracting a diverse range of investors.
Insider Trading Laws
Insider trading laws have evolved to prohibit certain types of trading. Directors can legally trade shares if they disclose their activity to the SEC and make it public. Previously, insider trading laws did not apply to members of Congress. In response to lawmakers using nonpublic information for personal gain during the 2008 crisis, the STOCK Act was passed in 2012. It made insider trading by members of Congress illegal.
Michael Milken’s Insider Trading Accusations
During the 1980s, Michael Milken, known as the Junk Bond King, was accused of insider trading. He was an expert in trading junk bonds and helped create the market for below-investment-grade debt while at Drexel Burnham Lambert. Milken allegedly used confidential information about junk bond deals to buy stocks of targeted companies before takeovers were announced, leading to him benefiting from the subsequent rise in stock prices. Milken pleaded guilty to securities fraud, paid a $600 million fine, served a two-year prison sentence, and received a lifetime ban from the securities industry.
Insider trading, a controversial practice, has both proponents and critics. Opponents argue that it creates an unfair advantage for individuals with nonpublic information, while advocates claim that it helps reduce risks and improve market efficiency. However, regardless of differing viewpoints, it is essential to recognize that insider trading is currently illegal. Perpetrators can face severe consequences, including hefty fines and imprisonment.