January 30, 2012 | In: General

Why Is Insider Trading Illegal?

“The more numerous the laws, the more corrupt the government.” – Gaius Cornelius Tacitu, Roman Senator

Well, first let me start by saying that the title of this post is wrong, insider trading is not illegal. Executives in any company can buy or sell shares in their company anytime they want, there is no law whatsoever barring them from doing this. In fact, Yahoo Finance has a special page listing the insider traders for every company (insider transactions are public by law).

Now there is some kind of insider trading that is illegal. Illegal insider trading happens when an insider relies on non-public information in order to make a trade. For example, let’s say that you are an executive at RIM who’s aware of a top-secret-yet-imminent deal between Microsoft and RIM in order to promote Windows 8 on RIM’s products. Clearly, this will make RIMM’s price skyrocket. Now, if you buy RIM’s shares based on your knowledge of this matter, then this is illegal.

Now here’s another example… Let’s say that you a secretary working at RIM (I’m just giving RIM as an example, it can be any company) and you were asked by your superior (who is the CFO) to prepare the most important document that a company releases to the public: its quarterly results (including the guidance). While preparing the document, you realize that RIM’s future is bright (contrary to investors’ belief). Of course, this is top secret information and it’s not public. If you buy RIMM shares based on this information, then this is considered illegal.

A third example would be if someone steals a confidential report from RIM. Even if that person does not work in RIM, then all his trades based on the information he acquired from that report would be considered illegal. Arguably, it’ll be very hard to catch the person if there is no proof of the theft.

Now, let’s get back to the main title of the post, why is insider trading illegal?

Well, let’s imagine that it’s not illegal for a moment. Let’s say that you are an insider, and that you know that something good or bad is going to happen to your company, so your purchase/sell shares in your company accordingly. That would be unfair to the market in general as it gives you a clear advantage. Now let’s imagine another, even worse scenario. As a top executive in a company, you can make all the wrong decisions to make your company’s stock drop and benefit from shorting it. Now that is even much more unethical than just buying/selling shares based on the information you (and no nobody else) know. That is considered to be market manipulation, and it’s very, very illegal.

When was insider trading made illegal?

Again, let me re-iterate the fact that only the insider trading that is based on non-public information is illegal. Now, that kind of insider trading was stated to be illegal by the SEC in 1934, right after the great depression ended. There was a huge backlash against listed companies back then (many investors were saying that there was a lot of unfair insider trading happening at these companies) and the SEC reacted by regulating insider trading the following way:

  • All insider trades should be made public.
  • Insider trades based on confidential (non-public) information are illegal.

Now, the big question is, how to catch illegal insider trading?

Well, there are many ways for the SEC to spot illegal insider trades (which will call for further investigation/audit of these trades), here are some:

  • An insider buys many shares/call options shortly before the earnings, and the company’s stock skyrockets when the earnings are released (because of good earnings and good guidance).
  • An insider sells many shares/buys put options shortly before bad earnings are released to the public.
  • An insider makes several trades, some losing, and some making money before the earnings, where the ones making money will (much) more than make up for the loss of those losing money.
  • Someone close to an insider performs any of the above transactions.

Of course, there are many other ways to spot illegal insider trades, but the above are the most basic ones.

I’m currently trying to imagine a stock market without regulation on insider trading. If that stock market is in this current economy, then all insiders would be shorting stocks and all companies will intentionally bleed money. Ah, the greed of man!

This article (as well as all other articles on this website) is an intellectual property and copyright of Fadi El-Eter and can only appear on fadi.el-eter.com.

Comment Form