Insider Trading Risk Assessment Insider

Insider Trading Risk Assessment

Insider trading is a term that most individuals have heard and generally view it as an illegal conduct. In practice, the term usually is inclusive of both legal and illegal conduct. The legal conduct is for corporate executives like officers, directors, and employees to buy and sell stock in their own companies. At the same time, when corporate insiders buy or sell their own organization securities, they have an obligation to report their trades to the SEC. (Insider Trading)

Identify the risks to individuals and/or organizations.

Recent disclosures due to fault practices that took place at Enron and WorldCom have put the conduct of concerned individuals under a microscope. They have led also to the passage of the Sarbanes-Oxley Act of 2002, which has made sweeping changes to the U.S. financial reporting system and limitations on services that a CPA may offer to audit clients. Partners and staff of audit organizations now face tough decisions while managing the insider trading risk that is found within their freedom to buy and sell securities. This is now a responsibility that necessitates a meticulous reply in the present, post-Enron, Sarbanes-Oxley Act era. Many of the large accounting firms now have retained internal legal task forces to consider insider trading issues, and all of the accounting firms have to be aware of new insider trading risks. (Ivancevich; Jones; Keaveney, 2002)

In general, the legal view is that insider trading prevails while a person has "material, nonpublic information" regarding a security or its issuer and buys or sells that security. The SEC has specified that an individual with such inside information has to move away from trading in the securities of the company or correctly reveal what he or she knows even before buying or selling them. Those who violate these rules are subject to civil penalties of about three times the illegal profits which are being gained or losses prevented by the insider trading in addition to criminal penalties. Criminal penalties for individuals may mean a fine of as about $5 million, prison as long as 20 years or even both. Courts have also allowed injured private parties to sue for the purpose of damages. (Ivancevich; Jones; Keaveney, 2002) Thus the penalties or risks are now pretty severe.

2. Analyze the risks.

For all practical purposes insider trading is extraordinarily difficult to prove. The concerned direct act of buying or selling securities is a truly legal activity and insider trading occurs due to what is in the mind of the trader. Only that makes this legal activity of buying or selling shares a restricted act of insider trading. Direct evidence of insider trading is hardly ever available. There are no smoking guns or physical evidence available which can be scientifically related to a perpetrator of insider trading. It is only when the insider trader confesses his knowledge in certain legally admissible form that the crime can be proved; otherwise, evidence is almost completely circumstantial. Investigations of cases and the proof presented to fact-finders is a difficult matter and similar to putting together pieces of a puzzle. It requires examining inherently innocuous events like meetings in restaurants, telephone calls, relations between people, trading patterns, etc. And then deriving reasonable inferences on the basis of the timing and surrounding situations of the events to provide the conclusion that the defendant bought or sold stock with the advantage of inside information which was being wrongfully received. (Speech by SEC Staff: Insider Trading - AU.S. Perspective) Thus the risks are very difficult to assess at most of the times.

a. Discuss impact, probability, and timeframe

In September 1998, the Ninth Circuit Court of Appeals held in the case of United States v. Smith that when there is a criminal insider trading case, the government has to prove that even a defendant who is a traditional insider usually used material, which was nonpublic information in taking the decision to trade. This rejected the SEC's position and the position of the Second Circuit which was expressed in an earlier decision where it was held that it was enough for the government to show that the defendant was possessing information at the time he traded. That would have been easier to prove. Again, the Eleventh Circuit Court of Appeals reached the same decision in SEC v. Adler, which was a civil case, but alleviated the difficulties of proof encouraged by the standard.

It used a rule providing that even though use is a necessary element of Rule 10b-5 insider trading violation, at the same time, when an insider trades in the matter of possession of material nonpublic information, then a reasonable inference evolves that such information was being made use of by the insider in trading. The burden then transfers to the trader to provide arguments against the inference through showing evidence that there was no direct link between the knowledge and the trade. Such an inference is not usually available in the criminal background, and there the burden rests on the government to prove every element of the offense beyond a reasonable point of doubt. (Speech by SEC Staff: Insider Trading - AU.S. Perspective) Thus all factors of impact, probability and time frame depend on the case.

b. Classify risks and prioritize them.

The risks come from that of the dealings that the person who was accused has with the organization and whose stock he or she has been accused of dealing in trading in an illegal manner. Thus assigning significant priorities in general are quite impossible.

c. Discuss financial reporting, operational, and compliance risks.

The point is the same as above. Financial reporting takes place at best every quarter and there may be certain internal reports at greater faster intervals, but those would be again made available to that of the senior executives of the company. Their official trades cannot be considered as being criminal. (Insider Trading) The operational and compliance risks for such a trade is already being fixed according to the regular operation routines of the company. If an outsider follows the movements of that of the company, the individual cannot be accused of insider trading if it can be shown that the insider dealt in a large amount of shares. Even if that were so, the question still is bound to remain as to the reason for his attaining such a large amount of shares. For the small quantities of shares, it will often be considered as not being worth pursuing.

3. How can proven risk assessment methods be applied to insider trading to improve the decision making process?

Conventional risk assessment methods can be applied towards acquiring information that is made available to everybody, and insider trading does not occur with regard to general information that is being made available to everybody. Therefore the chances of applying the various risk assessment methods are considered to be quite difficult, and there have been several efforts only for studying the various possibilities of gains from that of insider trading only with regard to certain general information. In the study it was being found that higher types of dividend paying firms have lower levels of insider gains in comparison to low dividend paying firms and this result is found to be consistent with that of 'free cash flow theory' and 'institutional monitoring theory' for the purpose of dividend payments. Another important finding from the study was in relation to the payment of dividends which was not in itself a significant determining factor in the case of insider gains and the required amount of information asymmetry for the purpose of insider purchase transactions. This means that however there is no real difference which is being caused via high or low dividends and the only difference is being caused by dividends or virtually no dividends. (Khang; Dolly King, 2001) This is a situation that is also guessed at by the market and often there are market movements based on assumptions, so whether insider trading occurs with resultant gains or not, it is rather difficult to prove anyway.

4. Discuss the importance of information sharing to develop risk assessment models. What types of information would enhance the model if you could procure it?

The question of information sharing is often tied up to the question of privacy, and this point would make it difficult to enforce any amount of information sharing. There are certain laws about information that have to be passed on by companies to shareholders, but changing those laws would require a lot of changes involving many groups connected with industry. What would be permitted or not are not known, and till that is known, it would be a waste of time to discus the matter. However, the developments in information technology have made it possible for companies to collect, compile, analyze and deliver data around the world much faster and cheaply than before. At the same time, these technological advances have also brought new challenges to companies for protection of information privacy. (Privacy Policy Primer)

This may not be involved with passing on information to them, yet it may lead to charges that some of them have been misguided at a later date. However, it would be safer to follow general policies that are being followed even now. This means that one should pass on published information to shareholders on the Internet as it would be simpler and less expensive to send. This may include information about quarterly results, monthly turnover, changes of directors, appointment of new sales agents, general trends of markets at certain times, etc. The question would still remain as to how many shareholders would be competent enough to use this information and the passing on of information may result for the clients as an exercise of garbage in, garbage out.

5. Discuss the legal boundaries, including privacy issues. What exceptions if any exist to allow for the use of such data? If they do not exist, how would you counter the privacy advocates concerns?

Some experts believe that privacy concerns will ultimately reduce the growth of the Internet generally and electronic commerce. As it is, different countries consider privacy issues variedly, but this is for the privacy of individuals. In the U.S. companies have largely been allowed to self-regulate. In Europe on the other hand, protection of consumer privacy is the topic of wide legislation, and that includes a comprehensive Data Protection Directive that took its form in 1998. In November 2000, the Commerce Department prepared a safe harbor program for U.S. companies trying to acquire personal information from that of the European organizations. The basic need of the program is that companies do have a privacy policy addressing certain listed principles inclusive of "access; choice; notice; security; transfers to third parties; and data integrity and enforcement." (Privacy Policy Primer) Studies have revealed while an enhancing number of U.S. companies have developed privacy policies, enforcement of these policies has been found at best. (Privacy Policy Primer) The question here is of privacy of individuals in general. Regarding share trading risks and privacy, it is not clear as to what issues may come up.