Market Abuse and Insider Trading

Definition, History, & the Lingering Debate Over Insider Information

Nov 5, 2009

Americans have been battling inside trading for over a century, but many don't know its exact meaning, or that the question of its legality is not an open and shut case.

"Arthur Cutillo and the Inside Traders" may sound like a popular new music group, but it's actually the newest scam uncovered in the marketplace. The newest corruption scandal on Wall Street is the fourteen people arrested for a $20 million insider trading scheme. While this amount may seem to be pocket change when the national GDP is nearly 14 billion, the prosecution of insider trading is always fierce, and frequently ends in jail time for all participants.

In the current market situation, it may seem that playing for any advantage on Wall Street would be acceptable, yet in the United States, insider trading has been one of the most prosecuted crimes to occur in the market place. Despite the frequency of insider trading, the actual meaning and issues involved are not always thoroughly discussed.

What is Insider Trading?

Insider trading occurs when a person who has unfair information trades stocks on the stock exchange for their benefit. The issue is far more complex than just that, however. The definition of what an “insider” is has changed from time to time. However, the usual definition is an individual with information not publicly released.

This inside information, when not released to the public, is used by inside traders to influence their decisions before public reaction takes place, thereby giving them an edge in making the best deals, whether to buy or to sell. In the current economy, most insider trading has involved the selling of stocks rather than the buying of stocks, but both are equally illegal in many countries.

Insider information can take any forms. One can be a member of a company and have stock in the company, and find out that your company is going publicly bankrupt the next day. Or, quite the opposite, if a business were to be buying out a major competitor, knowing that information before it was publicly announced would also be insider information. Paying someone to be an informant from a company is also insider info.

The History of Insider Trading Legislation in the U.S.

America has been a pioneer in criminalizing insider trading. By the end of the first decade of the 20th century, laws were already in place that banned company owners from buying out businesses that they knew were about to skyrocket in price. When the Great Depression hit, more laws were passed to ensure that insider trading wouldn’t be allowed. Such legislation led to the creation of the regulatory committee NASD, the future founders of NASDAQ.

The heat really was put on insider trading with ITSFEA, or The Insider Trading and Securities Fraud Enforcement Act in 1988. An act made three years prior had determined that inside traders could pay fines up to three times the amount gained from the illegal trading, along with five to ten years of incarceration, but ITSFEA offered money to whistle-blowers.

Why is Insider Trading Bad?

The argument made by advocates of banning insider trading is that it is entirely unfair. If insider trading is legal, then those with the most stocks and those in high-ranking positions in the company have the most money to gain, and have very little loss so long as they stay on the pulse of insider information.

However, stock holders outside the circle of major decision makers for the company, the majority of people with stock, are left hanging out to dry. Insider trading ultimately leans towards the wealthy, and in that sense is a aggressive money policy against middle and lower-class shareholders.

Director Linda Chatman Thomsen argued before congress in 2006 that “Our laws against insider trading play an essential role in protecting our securities markets and in promoting investor confidence in the integrity of those markets. Rigorous enforcement of our current statutory and regulatory prohibitions on insider trading is an important part of the Commission's mission.”

Some, however, view insider trading as a sound idea for the economy. The Japanese had no law against insider trading until the eighties, and many economists argue that it should be legalized. Some have argued that such control over the stock market is too much government regulation in the stock market, and is ultimately harmful to capitalism.

Economists such as Henry Mann, for example, argue that the legislation has not stopped insider trading from happening, and that legalizing it is a sensible solution to the improper regulation that ultimately hurts the market. He also claims that if insider trading is allowed, it will allow stocks to show its actual worth, rather than have the price tempered by waiting for the information to go public.

Insider Trading Policies Under Obama and Bush Jr.

Is the best solution to legalize insider trading or to keep it reigned in? While economists disagree, it is likely that the stiff fines and penalties will remain in place for some time to come, as the second Bush administration and a more conservative congress felt no need to alter the current statutes, and the present administration has argued for more regulation rather than less.

The copyright of the article Market Abuse and Insider Trading in Law, Crime & Justice is owned by Frank Yeats. Permission to republish Market Abuse and Insider Trading in print or online must be granted by the author in writing.