Insider Trading: Legal and Ethical

Insider Trading: Legal and Ethical Issues

Illegal insider trading can be defined as buying or selling stocks based on information that has not yet been made public in order to make a substantial profit or avoid a significant loss. According to Time magazine writer, Randy James, insider trading has been around for some time. A man by the name of William Duer, a former Assistant Treasury Secretary used government information to make bets on the country's debt in the 1700's. James says that the first crackdown on illegal insider trading happened in the early 1900's when the United States Supreme Court ruled that a Philippine businessman committed fraud by buying stocks in his company and profiting and not sharing the information. Many believe that the stock market crash of 1929 was due in part to illegal insider trading. It wasn't until then that Congress passed laws to limit insider trading.

It is important to note that there is a difference between insider trading and illegal insider trading. When most people hear the term 'insider trading' they automatically assume that it is illegal. This isn't the case. Insider trading can be legal when members of a corporation buy and sell stock in their own company while abiding by the rules and regulations which govern the trading. When trading is done in this manner, it is for the betterment of the corporation and not so that any one individual or individuals will make a large profit or avoid any losses. Insider trading becomes illegal when confidential information that is not known to the public is used to make a decision on whether to buy or sell stock for profit or to avoid a loss. This is considered illegal insider trading because it creates an unfair market by not giving all players a chance to buy or sell in order to profit or avoid loss. What is unfair about it is that all investors do not have equal access to the confidential information.

All parties investing in the stock market should have an equal and fair advantage to profit while minimizing losses.

II. LEGAL ISSUES

Some may use the excuse that sharing private information is something we all do in our daily lives and it is true. However, when it comes to the stock market and trading, sharing and withholding private information is a serious matter because it has the capability to affect the entire economy. It is said that during the stock market crash of 1929, insiders would run the price of stocks higher than they actually were, announce the news to the public causing many to buy the stocks and then they themselves would sell. Illegal insider trading wasn't the only cause of the crash, but it played a part in it. The crash of 1929 and the following depression are a few of the reasons why the Securities Exchange Act of 1934 was established. There are many sections to this Act, but the sections dealing with insider trading (although it isn't called this specifically) basically states that a person must refrain from trading if private information isn't disclosed to the public and it also imposed reporting requirements among other things on those persons within a firm buying or selling stocks.

The law is structured so that there is a clear distinction between what is considered legal insider trading and what is considered illegal insider trading. We need these laws in order to avoid another stock market crash like the one in 1929. Also, the laws are needed in order to create a fair market for investors. Some say that insider trading should not be considered illegal because we live in a capitalistic society and the ability to get ahead by insider trading falls within the accepted definition of capitalism. Some proponents of insider trading say that not allowing it takes away wealth from outsiders and gives it to the shareholders.

There are varying views on whether or not certain types of insider trading should be considered illegal. This is the reason for such acts as the Securities Exchange Act of 1934, the Insider Trading Sanctions Act, and the Sarbanes-Oxley Act. The Securities Exchange Act of 1934 was created to govern securities transactions as well as to protect the public from illegal insider trading. During the time that this act was established, the stock market crash had happened a few years before and the country was in a depression. The Securities and Exchange Commission (SEC) was created from this act. Companies must file reports with the SEC in order to provide information to the public so that informed investing decision can be made. In recent years, the SEC has been enforcing section 15(f) of the Securities Exchange Act of 1934. Section 15(f) of the act requires that dealers, brokers, and advisers maintain and enforce procedures designed to prevent the misuse of nonpublic information. Since the early 1990's, the SEC has come down heavily on firms with no established procedures for the prevention of misuse of information. Some corporations have had to pay millions of dollars in fines and some of the senior officers of these firms have come under attack.

The Insider Trading Sanctions Act was implemented in 1984. This act outline the criminal and civil penalties imposed on individuals who traded stocks and bonds based on information not made available to the public. This act was implemented to further discourage insiders from using private trading information for their personal gain. This act allowed the Securities and Exchange Commission to impose harsh penalties on illegal insider trading by imposing triple damages on anyone profiting off of nonpublic information. Before the Insider Trading Sanctions Act was passed, the penalty for this offense was that the offender was required to return illegally obtained profits.

It is possible that illegal insider trading was rampant before the passage of this act because the penalties were not stiff. If offenders did not face the possibility of any jail time and only had to return the illegal profits, then the incentive for insider trading could have still been a strong one. There was always the chance that they would not be caught and if they were, the penalty wasn't extremely disruptive to their lives. Studies have shown that for many of the years after the Insider Trading Sanction Act was passed illegal insider trading did not slow down. This means that the act did not have a significant effect on insider trading.

The Sarbanes-Oxley Act is named after the two men that created it -- Senator Paul Sarbanes and Representative Michael Oxley. The act was created in 2002 after a series of public accounting scandals with companies such as Enron, Tyco and WorldCom. The SEC administers this act which was implemented to protect investors from fraudulent accounting activities. The act requires certain records to be stored and it determines the length of time that they are stored. Records included are not only financial, but electronic records as well. This act also protects employees who blow the whistle, or report them for corporate fraud. The whistle blowing provision in the Sarbanes-Oxley Act will charge any retaliatory acts against the whistle blower as a felony.

To take some of the stress off of the employee reporting the accounting fraud of a corporation, many companies have set up anonymous procedures for this to happen. Some corporations in the European Union are not in favor of the anonymous procedures and prefer that the identity of the whistle blower remain confidential instead of anonymous. They say this is the preferred method because it aids in better data collection.

While there may be some validity to this, there is the possibility that an employee wishing to report fraud may be reluctant for fear of retaliation. Also, as most know there is really no such thing as confidentiality in these days. Even if an employee with a legitimate purpose to access the file does not mention anything to his coworkers, that same person could discuss the issue with family members and friends and thus, the gossip starts. The world we live in is smaller than we think because of how easily and quickly information can be shared. As a result, something meant to be confidential could become public knowledge within a matter of days.

III. ETHICAL ISSUES

Both the employer and the employee have a fiduciary duty concerning illegal insider trading. Employees are bound by SEC regulations to maintain and enforce rules regarding illegal insider trading. The employer must act in the best interest of the employee and if the employee knows that something is awry, he should act within the best interest of the company by reporting the offense. An officer of a corporation may be in a position where he is around friends who own stock in the company. The officer may know that there is about to be a merger, but he is not a liberty to discuss this with his friends no matter how hard they may press him on it. Even if he hints around in a non-direct way that his friends should sell their stock without coming out and saying it, he may be guilty of insider trading because the information on the merger has not yet been made known to the public.

This is unethical and what the corporate officer should steer the conversation in a different direction and if his friends insist on continuing to ask questions he should firmly, but politely tell them he is not allowed to discuss personal company information with them.

Likewise, an employee has a certain amount of fiduciary responsibility if he knows that there are fraudulent practices happening at the corporation. If the employee knows that there is insider trading or if he knows that the accounting practices the corporation is using are dishonest, then he has an obligation to report what he knows. Some employees, especially if they do not hold high positions within the corporation, may think it is okay to look the other way and not say anything. But, as we saw in the case of Enron, the misconduct of a few can be devastating for the entire corporation.

IV. NOTABLE INSIDER TRADING CASES

Martha Stewart

Most of us are somewhat familiar with Martha Stewart and the fact that she was sent to prison to serve time on charges of insider trading. However, many are still unsure of what exactly constitutes illegal insider trading. Some may think it is just sharing private information which is something that all of us do at some time or another in our daily lives. They make think, "What is the big deal?" But they think this because they are not fully aware of the consequences illegal insider trading can have on all investors.

Martha Stewart found out in 2001 from the CEO's assistant of ImClone that the FDA would not be approving its application for a cancer drug. It was suggested that she sell her shares of stock in this company because they were about to fall and she did. When this action was discovered, Stewart lied about it and was even discovered erasing the message that the assistant left for her telling her to sell her stock. She ended up paying a hefty fine more than three times the amount of what she avoided losing by selling her shares of stock in ImClone. But, Stewart was being prosecuted because she lied about knowing anything that would cause her to sell her stock right before the price fell.

There are some legal experts who feel that Stewart's attorney should shoulder some of the blame for allowing her to perjure herself. The evidence against her was clear that she in fact sold the stock after receiving the message and she also was seen by her assistant erasing the message. Her attorney knew this and should have advised her to come clean on what she did. If she had been advised in this manner, it is highly likely that she would have avoided prison time and would have only been fined.