Insider Trading By Jennifer Miller Instructor Margie Andrist Business Ethics The purpose of this paper is to review the phenomenon of illegal insider trading in the United States financial securities markets. The analysis section of this paper (a) defines illegal insider trading, (b) explains the enforcement of laws and regulations concerning illegal insider trading, (c) review the pattern of illegal insider trading from 1996 through 2005, and (d) compares the problem of illegal insider trading in the United States with the problem in other countries. Consider this: “Imagine a boardroom of corporate executives, along with their lawyers, accountants, and investment bankers, plotting to take over a public company. The date is set; an announcement is due within weeks. Meeting adjourned, many of them phone their brokers and load up on the stock of the target company. When the takeover is announced, the share price zooms up and the lucky ‘investors’ dump their holdings for millions in profits. ” First things first – insider trading is perfectly legal. Officers and directors who owe a fiduciary duty to stockholders have just as much right to trade a security as the next investor. But the crucial distinction between legal and illegal insider trading lies in intent. As a result, two theories of insider trading liability have evolved over the past three decades through judicial and administrative interpretation: the classical theory and the misappropriation theory. The classical theory is the type of illegal activity one usually thinks of when the words “insider trading” are mentioned. What is insider trading? According to Section 10(b) of the Securities Exchange Act of 1934, it is “any manipulative or deceptive device in connection with the purchase or sale of any security. ” This ruling served as a deterrent for the early part of this century before the stock market became such a vital part of our lives. But as the 1960’s arrived and illegal insider activity began to pick up, courts were handcuffed by this vague definition. So judicial members were forced to interpret “on the fly” since Congress never gave a concrete definition. There is a difference between insider trading and illegal insider trading. One of the major difficulties in dealing with the problem of insider-trading appears involves defining the practice. Some writers define insider trading as trading by a stockholder of a corporation who is also an officer or key executive. Other parties include professional traders as insiders, as opposed to the investing public. Legally, however, and insider is someone who has knowledge of facts that are relevant to the valuation of a publicly-traded company. The individual with such knowledge need not be a member of the company in question, nor is it necessary for the person to own stock in the company in question. It is legal for persons with knowledge of facts that are relevant to the valuation of a company to trade in the stock of that company if the information to which the person has knowledge also is available to the public. Insider trading becomes and illegal act when the trading is performed by persons who have knowledge the access to which is restricted to a narrow group of company insiders or to others to whom such information has been made available. For years, the Securities and Exchange Commission (SEC) applied a “strict constructionist view” of what was considered to be insider-trading. The following example illustrates this view of insider-trading: “… an airplane passenger who saw a factory in flames while aloft and rushed to the phone to short sell the stock when the plane landed violated … the … anti-fraud prohibition on which the SEC bases insider-trading prosecutions” (Muzea 19). For decades, the SEC operated within the context of the preceding illustration. Following rulings by the United States Supreme Court, and because of other incidents, the strict constructionist view was discarded by the SEC. Today, the SEC pursues insider trading charges if an investor (a) profits from a transaction based on nonpublic information, and (b) either (1) breaches a duty to a company, shareholder, or someone else to whom the investor had a fiduciary responsibility, or (b) receives the nonpublic information from someone who violated such a trust. Thus, under current regulations, insider-trading may be attributed to someone not directly affiliated with he firm issuing the stock or with an investment house. It may not be attributed to an individual who profits from nonpublic information, but who has no fiduciary responsibilities, and who does not act in concert with another person who does have such responsibilities. The securities industry itself attempts to regulate insider-trading through self-policing procedures. The industry’s procedures range from computer tracking of all trades to the maintenance of compliance departments at brokerages to strict codes of ethics. The computer tracking works relatively well; however, the codes of ethics and the compliance departments are less effective. A key element in the SEC’s effort to control illegal insider trading is the requirement for listed companies to disclose relevant information in their financial reports. The principal objective of the disclosure of financial information is to enable the users of such information to have the opportunity and the capability of making better investment decisions. The purpose is to “assure the public availability in an efficient and reasonable manner on a timely basis of reliable and relevant information”. The assumption is that, if investors are provided sufficient, reliable information, they will be able to protect themselves. In actuality, the requirement of disclosure is, in itself, a form of protection. Disclosure required by most regulatory authorities in developed economies may be classified into two categories: (a) disclosure related to operations in the securities markets; and (b) disclosure required by publicly held companies subject to the jurisdiction of the regulatory authority. Disclosure related to the direct operations of securities markets concerns the relationships of security brokers and representatives to the corporate entities issuing the securities traded. Disclosure required by publicly held corporations subject to the jurisdiction of the regulatory authority includes almost all of what is generally considered to be the public disclosure requirements for corporations. These disclosure requirements include information pertaining to, “(a) the relationship between the management of a corporation and its auditors; (b) the nature of relationships between a corporation and any of its shareholders; (c) institutional investment relationships; (d) proxy requirements; (e) board and committee composition; (f) compensation for the board of directors; and (g) management compensation” (Securities Exchange Act of 1934 Title 12). Shareholder rights and proxy disclosure requirements resulted from the belief that the management of a public corporation can effectively frustrate shareholders’ efforts to participate in the management of public corporations. Financial disclosure is required because financial statements and the disclosure of other information relevant to these statements are central to the securities investment process. The motives for a failure to disclose financial information are numerous. Basically, however, there exists a desire to create an appearance of financial stability and prosperity, where such conditions do not exist, or where the situation is such that those conditions may not exist in the near future. Behind the basic reason for a failure to disclose financial information are diverse motives. These motives include a desire to maintain the market price of a company’s stock; the creation of an image of profitability, as a means of favorably influencing current, and/or potential lenders; and to satisfy management greed and ego. Another motive is a desire to either maintain or create a demand for a company’s stock, so that management can dump the stock, before any adverse information about the company surfaces. In addition to requiring disclosure of relevant information, the SEC also introduced the so-called “Plain English” rule to improve the understandability of disclosed information. The Plain English Rule is Rule 421 of the SEC regulations. Sections (b) and (d) of Rule 421 are referred to as “Rule 421(b)” and “Rule 421(d)”. The rules require that disclosures be clear, concise, and understandable. The Plain English requirements direct the use of four general writing techniques and list four writing styles that must not be used. Information must be presented in clear, concise sections, paragraphs, and sentences. Whenever possible, use short explanatory sentences and bullet lists. Descriptive headings and sub-headings are to be used. Disclosure is to avoid frequent reliance on glossaries or defined terms. A glossary is to be used only if it facilitates understanding of the disclosure. Disclosures are directed to avoid the use of legal and highly technical business terminology. Disclosures must not be in the form of legalistic or overly complex presentations that make the substance of the disclosure difficult to understand. Disclosures must not use vague boilerplate explanations that are readily subject to differing interpretations. Disclosures must not include complex information copied directly from legal documents without any clear and concise explanation of the provision of what the information actually means. Repetitive disclosure of facts that increases the size of the document, but which do not enhance the quality of the information provided must not be included in disclosures. Figure 1, which may be found on page 9 of this paper, shows the frequency of SEC prosecutions for illegal insider trading from 1996 through 2005 in comparison with SEC prosecutions for all securities violations. As the data reflected in Figure 1 indicate, the pattern of insider trading violations and total securities violations are similar, although the frequency of insider trading violations is more volatile. Over the 10-year period, insider trading violations represented from seven-percent to 12 percent of total prosecutions for securities violations. The data for Figure 1 were obtained from SEC Annual Performance and Accountability Reports. Figure 2, which also may be found on page 9 of this paper, compares the severity of the illegal insider trading problem in 16 countries, as measured by the Insider Trading Index. The value of the Insider Trading Index can range from 1. 0-to-7. 0. The lower the index-value, the less severe is the illegal insider trading problem (World Economic Forum 781). As the data presented in Figure 2 indicate, most developed economies and rapidly developing economies have index values in the 2. 5-to-3. 5 range. The index value for the United States is 2. . Seven countries have lower index value among those countries reflected in Figure 2. This paper presented the findings of a review of illegal insider trading in the United States. The review found that illegal insider trading accounted for seven-percent to 10 percent of all prosecutions for securities violations by the SEC over the past several years. The review also found that the severity of illegal insider trading in the United States is slightly lower than the median on a global basis. In conclusion, knowledge is power in today’s business world. And where power goes, manipulation can’t be far behind. Not a day goes by without talk of a new merger, acquisition, or IPO – that is why illegal insider trading has become an ongoing problem. Just remember one thing. Greed follows opportunity, and as money continues to pour into the market, illegal insider trading will continue to grow. When faced with a situation where you may be exposed to illegal insider trading, use the golden rule – “If a lead sounds too good to be true, it probably is. ” References 1. Alkhafaji, A. F. (1990). Restructuring American corporations: causes, effects, and implications. New York, NY: Quorum Books. 2. Baltic III, C. V. (1990). The next Step in insider trading regulation: international cooperative efforts in the global securities market, in law and policy in international business. Westport, CT: Quorum Books. 3. Manley II, W. W. (2000). Critical issues in business conduct. New York, NY: Quorum Books. 4. Muzea, G. (2004). The Vital few vs. the trivial many: invest with the insiders, not the masses. Hoboken, NJ: John Wiley and Sons Publishing. 5. Seyhun, H. N. (1998). Investment in intelligence from insider trading. Boston, MA: MIT Press. 6. Spencer, M. P. (1995). Corporate misconduct: the legal, societal, and management issues. Westport, CT: Quorum Books.
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