Insider Trading: Understanding Securities Law
While insider trading is one of the most well-known instances of a violation of securities law, it is by no means the only way in which finance and law intersect. Let’s first begin by getting a grip on insider trading, as a starting point to gain a deeper understanding of the world of security law.
Insider trading is defined by the S.E.C, or the Securities and Exchange Commision, a United States governmental agency which was created after the Great Depression to protect investors and keep financial markets fair by enforcing law against market manipulation, as “...buying or selling a security, in breach of fiduciary duty or other relationship of trust and confidence, while in possession of material, non-public information of the security.” There are certain nuances associated with such a definition. For example, non-public information refers to information that the public cannot access in a legal way, i.e earnings before release, information about loans, or knowledge about mergers, sales, or acquisitions before being publically available. These definitions and the specifics of insider trading are all expressed in the S.E.C.’s Rule 10b-5 Prohibition on Insider Trading. Also, an insider is more specifically expanded on in Rule 10b-5, as someone who is “an officer, director, 10% stockholder, and anyone who possesses inside information.” Rule 10b-5 is also crucial to understanding insider trading in other ways. More specifically, it prohibits “tipping,” or the providing of non-public information to anyone who is a third-party.
However, all of this does not mean that company insiders cannot trade in company stock. However, they must report the timing and details of the trades in the appropriate Forms 3, 4, or 5, or a combination of the three.
Now, let’s move on to an example of insider trading. By far the highest ever insider trading fine in history was paid by SAC Capital at $1.8 billion. To know how insider trading fines are appropriately distributed, we must first understand that the S.E.C. primarily considers how much profit the firm or individual was able to make, and in this case it was a record $275 million in profit for SAC Capital. Additionally, the portfolio manager who was convicted as an individual for insider trading, Mathew Martoma, was sentenced to 9 years in prison and was forced to forfeit his $10 million bonus.
My personal take on insider trading? I think that insider trading being illegal is positive for society, and there are a few nuanced reasons for this. Certain advocates for insider trading claim that the legalization of it would create more efficient markets and that it is a victimless crime. However, there are some clear counterpoints to these views: firstly, even if there was an increase in efficiency, the unintended consequences of it would be the loss of faith in governmental reports (i.e governmental employees could be incentivized to change governmental data to profit,) and secondly, insider trading is not in fact a victimless crime as the victim is the buyer of the stock who suffers a loss or the losing out on potential profit. Imagine your grandparents’ pension fund existing in a world where insider trading was legal. Every time they buy or sell shares, they would have to accept that there is a substantial risk that they would face losses or lose out on profits. The other possible types of victims are ordinary investors who would be even more discouraged to participate in the market as they would believe it would be rigged from the start. Such a side-effect would be even more amplified in the derivatives (more specifically options or credit default swaps) market or other zero-sum financial markets, where the losses would be even more substantial. For these specific reasons, insider trading has a detrimental effect on the global financial system, and having it outlawed results in good for society.
