Expert FAQ: Why Insider Trading Hurts Us, and How We Can Fix It

IT

by Susan Lyon

What is Insider Trading?

Insider trading occurs when someone – the ‘insider’ – uses information that has not been made public yet to trade a company’s stock or other securities, such as bonds and stock options.  The insider can be anyone from a major shareholder to a CEO or company director.  Insider trading is illegal because a corporate insider is supposed to represent the interests of the shareholders as opposed to his own interests.

The United States has severe penalties for illegal insider trading cases, but this does not mean all cases are caught.  How bad is the problem, and what can be done to fix it?

Despite Costs to Society, Some Trading Based on Inside Information Can Be Legal

One thing that insider trading does is keep the wealth among insiders at the top, making it very difficult for everyday investors to profit as getting exclusive information is very costly, usually illegal, and relies on an individual being in a powerful position.  Other arguments against insider trading are that it negatively affects economic growth and increases the price of a security.

That said, legal insider trading is pretty common and this what makes it so hard to punish those involved in illegal insider trading. There is a thin line between the two types of insider trading. Most of the time, CEOs and other company officers have lines in their contract that governs their trading. Even if they do come across nonpublic information, they can still profit from trades outlined in their original plan.

The problem is that tracking insider trading is like finding a needle in a haystack. It is like the case of the NCAA investigating illegal benefits procured by an athlete during his college career.  Often, the biggest names are scrutinized extensively while others go unseen and unheard.

Private Sector: A hedge fund gone awry & a McKinsey CEO Sentenced

Galleon Group founder Raj Rajaratnam is serving an 11-year prison term in Ayer, Massachusetts and on October 24, his close friend Rajat Gupta was also sentenced to a two-year sentence having provided Rajaratnam with illegal tips while serving on the board of Goldman Sachs. Here is a prime case of insider trading: industry bigwigs hobnobbing and making millions of dollars from illegal tips in the process.

Greed is what has motivated the two men to make insider trades; they were rolling wealth. Insider trading like other white collar crimes stems from participants having an insatiable nature. Rajaratnam has banked on insider information since the beginning of his career at Chase and then as an analyst at Needham. He often boasted about having insiders at firms such as Intel and other Silicon Valley success stories.  Both men have suffered a fall from grace that is in league with some of the Greek tragedies.

Public Sector: Members of Congress, too

Any insider trades that Members of Congress do is legal and this prompted Congressman Spencer Bachus to take advantage of news of an imminent financial crisis. It was Hank Paulson and Ben Bernanke that made the presentation to members of Congress. John Boehner and Senator Dick Durbin cashed in on the nonpublic information too.

Famous economists make the case for insider trading

Nobel laureate Milton Friedman argues that insider trading actually benefits investors and makes markets information efficient. Investors often follow the insiders lead as it has quite a high success rate. It should come as no surprise that when executives bought into a stock, it outperformed the market by 8.9% over the next year. CEOs and CFOs have access to crucial information that everyday investors can only dream of.

This is why investors tend to follow the insiders lead. Fortunately, it has gotten easier to gather insider trade data. Yahoo! Finance is a great source and it conveniently has an ‘Insiders’ section that lets you browse recent trades list. Another place investors can look for trading data is the SEC EDGAR Database.

Will it work to penalize harshly?

Defenders of inside traders like Microsoft founder Bill Gates and former UN Secretary General Kofi Annan in the Rajat Gupta case always argue about the good turn done by the offenders to the community. ‘Everyone’s doing it’ and ‘let’s get ahead no matter what happens’ are the rationale for partaking in insider trading. As the world’s most successful democracy, the United States has done the right thing to punish this white-collar crime harshly. CEOs and top management in America are paid high levels of executive compensation when compared to other countries and they must preserve shareholder interests.

Nonetheless, insider trading remains one of the most litigious matters on Wall Street.

Expert Opinions: What More Can Be Done to Curb Insider Trading?

We turn to the professional and academic experts to hear what reforms they think would work best.

  • Professor Jin Xu, Assistant Professor of Finance with Purdue’s Krannert School of Management, lays out why regulating insider trading is not as easy as it sounds, and the best practices in shaping corporate governance incentives moving forward:

“There is still not enough certainty whether insider trading needs to be restricted. On the one hand, informed trading by insiders makes profits against uninformed outside investors. On the other hand, information transfer from insiders to outsiders through insider trading increases market liquidity. Furthermore, allowing insider trading may have implications on the incentives of corporate insiders (including executive officers).  For example, my recent paper joint with David Denis at the University of Pittsburg finds that, cross countries, stricter insider trading regulations are associated with higher equity incentives given to corporate top executives. This result suggests that insider trading has important incentive effects on executives.

Now assume that insider trading is completely evil and we should get rid of it. The regulations in place include the original Securities Exchange Act of 1934 (in particular Section 16) and a series of amendments attempting to strengthen the insider trading rules. Today there are the short-swing profit rule, the insider-filing rule, and trading restrictions during pension blackout periods and so forth, where offenders can face criminal sentences. The regulators are watching such activities much more closely than twenty years ago as evident from the increasing number of insider trading cases brought up and convicted according to news media.

Have we done enough to curb insider trading? No one can tell. But insiders are certainly much more cautious today in that profits have to be really large for insiders to be willing to cross the line and that they have to do this in much more secret ways.  So how do we fix the system? Prohibiting all trading by corporate insiders is not optimal. Perhaps we should try our best to restrict informed insider trading, i.e. that which is based on private information. Then identifying and proving certain transactions are “informed” is a daunting task and we almost have to rely on the regulators’ diligence in prosecution and possibly, advanced digital tracking system to detect “abnormal” trading patterns.”

  • Professor Robert Prentice, Chair of the Department of Business, Government and Society at UT Austin’s McCombs School of Business, argues that limited government resources need to be harnessed to implement Dodd-Frank and investigate the subprime mortgage crisis:

“Because insider trading is a pervasive problem that undermines the integrity of the U.S. capital markets, hurts people’s confidence in those markets, and thereby raises the costs of capital and retards economic growth, one may confidently conclude that we are not doing enough to curb insider trading.  However, DOJ and the SEC, which recently have been more active in punishing insider trading than ever before, also face many other very important priorities that they must tackle with limited resources.

Personally, if I ran the SEC I would choose the current level of enforcement for insider trading and devote any additional resources to other priorities, such as implementing Dodd-Frank’s demanding but potentially useful provisions and bringing to justice more culprits (especially the higher level ones) behind the subprime mortgage debacle.”

  • Thomas Balcom, Founder of 1650 Wealth Management, presents one very simple fix for a very intricate problem:

 “The solution to curbing insider trading is simple: Prevent insiders from selling or buying stock in their company to once a quarter or 4 times a year. This would cause executives to signal their bullishness or bearishness on their company very clearly to investors.”

  • Andrew Schrage, Co-Owner of Money Crashers Personal Finance, recognizes the need for additional political action to secure financial security:

One measure recently taken to curb insider trading is the Stop Trading on Congressional Knowledge (STOCK) Act, which was passed by Congress and approved by President Obama in April 2012. It restricts members of Congress from using “any nonpublic information derived from the individual’s position…or gained from performance of the individual’s duties, for personal benefit.” Politicians are also required to report any purchase or sale of a security over $1,000 within 45 days. It includes a variety of other restrictions aimed and limiting insider trading in Washington, D.C.  The Federal Government has also become much more adept in the recent past at prosecuting insider trading cases. The U.S. attorney’s office for New York’s southern district has achieved guilty verdicts in its last eight cases.

That said, more needs to be done.  Public companies need to reduce the number of employees who are privy to so-called “material” information. They must also ensure that the people who do have access to this information clearly understand what insider trading consists of.  Another idea recently put forth to limit insider trading is to simply reduce the size of our Federal Government.  The fewer people who have access to this information, the less risk there is of insider trading.  The U.S. Government also needs to address the issue on a global scale. The fact of the matter is that insider trading is tolerated in many countries around the world.

Increase federal sentencing guidelines is also a possibility, but this will only be effective if judges use them to their fullest extent. Many judges in the recent past have issued stiff monetary fines for insider trading, but the associated prison terms were relatively lax.”