Insider Trading Has Two Distinct

Insider trading has two distinct effects on the financial sector. The first is a purely economic effect while the second is an indirect effect that, while harder to measure, in all likelihood, has a more serious overall effect. The first effect is that insider trading (which is also known as "informed trading") reduces the liquidity of a marketplace or a market sector (Fishe & Robe, 2002). Liquidity can be understood as a function in large measure the result of the degree of asymmetry that exists in the marketplace in which information is dispersed along legal lines. When the degree of asymmetry shifts because of insider trading, therefore, the liquidity of the market will almost necessarily also shift.

The less measurable but potentially even more important effect of insider trading is that it breeds a level of distrust in the marketplace and in business in general that would not otherwise exist. Businesses, including especially the financial sector, rely on a certain level of trust in each other and from their customers. Without this level of trust, business cannot be conducted. The more illegal and unethical behavior there is the less trust there is, which makes it hard for even the honest brokers to do business.

Introduction

For people who do not actively participate in the financial markets (or do so only in indirect ways such as through their 401ks), the topic of insider trading might seem to be sufficiently distant and arcane not to be relevant to those of us leading ordinary financial lives. However, the effects of insider trading, even on a relatively low level, insider trading does have a widespread effect on the financial sector, which in turn affects the rest of the business world, and so everyone who interacts with the business world, which comprises all of us.

There are, as noted above, both technical effects of insider trading, constituted primarily of reduced liquidity and the resultant consequences that follow from that, and an overall reduction in the trust that people have in business and in businesses. This can have dire consequences, because economic activity depends in largest measure on trust. Certainly governmental regulations are important and helpful, but there can never be sufficient regulations and regulators to ensure that every businessperson is acting honestly.

Business, like other realms of human activity, cannot be conducted unless there is a basic degree of trust between and among the parties who are participating. No reasonable person believes that any activity in which there are a large number of individuals participating -- and especially in which there is a great deal of money to be made -- will be free from unethical material. But while some unethical material is to be expected, the presence of unethical behavior beyond a certain point is highly disruptive.

This paper examines the phenomenon of insider trading, establishing what it is, how widespread it may be, attempts to prevent it, and the consequences that occur when it cannot be prevented. While illegal activities take place in all nations in terms of how business is conducted (for where there is money there will always be a certain amount of unethical behavior), this paper focuses solely on the issue of illegal behavior in the United States and the specific federal laws and regulations that make it illegal.

Literature Review

Insider trading is the trading of the securities of a corporation, which include stock, bonds, and stock options, by individuals who have, or who might have, information about the company's financial health and especially future changes in the company that may have a significant impact on the values of the company's securities. This does not mean that company "insiders" -- including managers, members of boards of directors, major shareholders, and employees cannot trade in the company's securities. Insider trading is also used to apply to the practice of the use of non-publicly available information by the public when it has been passed on to them by someone with a direct relationship with the company.

Rather, federal law requires that when individuals with information about a company that is not available to the general public, they do so in a manner that is not based on their potential special knowledge. (A tricky legal standard.) When insiders (as legally constituted) do make legal trades regarding their own company, they must make their trades public knowledge within a few days of having finalized the transaction.

The legal background for the prohibition of insider trading stems from common law traditions (both English and Spanish common law, which have been incorporated in state law depending on geography and colonial history) as well as U.S. court decisions. At the root of both common law and judicial bases for the prohibition of insider trading is the larger legal concept of fraud: The public is seen to be defrauded by certain traders having an unfair advantage. While on one level, this is a clear enough standard and legal concept. It remains a complicated one in actuality given that what constitutes insider knowledge that can be used as a basis for securities trading and what constitutes insider knowledge that cannot be used as a basis for securities trading can be seen to shade together into an amorphous gray zone (Ma & Sun, 1998).

The specific legal prohibitions against insider trading (as opposed to the larger legal issue of fraud, which is an ancient one) go back a century to the 1909 U.S. Supreme Court case Strong v Repide, 213 U.S. 419. The case involved the sale of land, a sale that benefited individuals who had specific "insider" knowledge about the future value of the land. (The word "insider" had then no legal meaning, of course.)

The Court noted in its conclusion the key distinction between information that was publicly available and information that was held only by insiders, even if that information might be suspected by the public:

It is undeniable that, during all this time, the subject of the sale of the friar lands was frequently mooted and its probabilities publicly discussed in a general way. Such discussion was founded upon rumors and gossip as to the condition of the negotiations. The public press referred to it not infrequently, but the actual state of the negotiations, the actual probabilities of the sale being consummated, and the particular position of power and influence which the defendant occupied in such negotiations prior to the time of the purchase of plaintiff's stock were not accurately known by plaintiff's agent or by anyone else outside those interested in the matter as negotiators. (U.S. 427).

While the nature of securities trading has become vastly more complex in the interviewing century, the basic legal and ethical principles have not changed (Harris, 2003, p. 593).

There is, in addition to the legal and ethical arguments, an economic one to be made as well in terms of how insider trading affects the efficiency of the marketplace. There is an allied argument that the most efficient market is the most just one, in that a market in which there is perfect competition (which some schools of economics would argue is the most efficient one) because it rewards talent and effort, which are available to all.

According to the economic model, although perfect competition is rarely or never achieved, because of the significant advantages of a perfectly competitive world, it is still a goal towards which one should strive. Actions which result in a more perfectly competitive world should be encouraged; actions which lead to a less perfectly competitive world should be discouraged.

Insider trading, with its inherently unequal information, clearly is counter to perfect competition. The preferred outcome, according to the economic model, is that the inside information be made publicly available so that all market participants have access to it. Barring that, market participants should have access to the same information. Thus, insider trading is not permissible in a perfectly competitive economic model.(Sayler, n.d.)

The degree to which one finds this to be a reasonable model depends in large measure upon one's beliefs about the market in general.

It should be noted that there are economists who believe that insider trading is at worst a sort of victimless financial crime and, in fact, can arguably be viewed as beneficial to the functioning of the financial markets. This group of economists -- primarily Milton Friedman but also his fellow travelers such as Thomas Sowell and Henry Manne -- argue that insider trading is generally beneficial throughout the financial markets because insiders are in possession of the newest information about the company. This economic argument is summarized in the following letter to The Economist:

Amid the increasing frequency of insider trading phenomena, an alternative approach should be considered. Rather than simply forbidding trading on insider information, why not legalise this so called 'market abuse', and use it to improve the flow of information to the market?

As mentioned in the article, the Nobel Prize-winning economist Milton Friedman himself noted that "You want more insider trading, not less." Friedman argued that it will give people most likely to have knowledge about deficiencies of the company an incentive to make such deficiencies known. In other words, trading based on private information might benefit investors, as it stimulates a quicker absorption of new information into the markets, making them more efficient.

It is clear that insider trading continues despite vigorous enforcement of the existing regulations. This is because of the difficulties in detecting and prosecuting it. Further regulations will only add unnecessary complexity to market participants and eventually bind the already limited resources of enforcement agencies, which could be used more usefully. (Letters to the editor, 2007)

This novel (and presumably accurate) information will be beneficial because, these economists argue, markets are most efficient when there is the highest possible amount of information in circulation. The majority of economists, however, believe that insider trading is detrimental to the most efficient functioning of the marketplace -- as well as being detrimental to the most ethical functioning of the market.

Analysis and Discussion

Money, we are frequently reminded, is the root of all evil. That's certainly an exaggeration: Money can inspire people to act well, and certainly there are other sources of evil. But the lure of money can indeed lead people down dark psychological and cultural pathways, and one of the surest ways in which people can be diverted from such pathways is through sanctions. Regulations and laws against insider trading, as currently in place in the United States today, reduce the incentive of people to profit from particular types of knowledge when there is a social consensus that such actions are essentially unfair (Smith, 1997, p. 74).

While there are a number of studies that have demonstrated that insider trading reduces the profitability of financial markets at least to some extent over a period of time, this fact is not the most important reason that insider trading is wrong. Insider trading is illegal, and -- in a broader sense -- is a form of cheating. Anyone who has ever been the victim of cheating understands the anger that such victimhood brings, and understands how hard it is to regain trust in a situation or person who has done the cheating.

Preston and Post's model of corporate citizenship offers another lens through which to address the effects of insider trading. Their model posits that at the highest level of organization companies do concern themselves with corporate citizenship. Marsden (2000) defined corporate citizenship as a concern on the part of company leaders about the effect of the company's actions on the whole of society. A company that is indeed concerned with its corporate citizenship will be especially severe about penalties to individuals who engage in insider trading because -- even when such trading does not adversely affect the company itself, insider trading does cause damage to the market as a whole.

One important aspect of any analysis of the effects of insider trading must be a stakeholder analysis, because the (potential) risks and rewards of insider trading vary significantly among different stakeholder groups. Part of this differential arises from the differential risks faced by different stakeholder groups, but even more important in terms of assessing how significantly different types of stakeholders will be affected is the degree of moral peril that they believe that they will be exposed to because of such actions.

Jones (1991) argues that a range of activities and the actions that individuals are likely to make in those circumstances can be analyzed by the "moral intensity" of the situation for those individuals. The more intensely an individual feels that the situation contains a moral element, the more likely it will be that that individual considers the moral context and moral consequences of the moral elements of the situation when deciding how to act.

Different actions involved in insider trading have moral intensity, although they center on acting on information in an improper way, that is, making a profit in a way that harms others directly or indirectly. How likely one is to do this is affected by personality types, experience with the company as well as in the business world as a whole, how much authority and power one has in an organization, and larger issues such as cultural and social values in the realm outside of the boardroom (Loe, Ferrell, & Mansfield, 2000).

Carroll argues that ethics screening instruments must be designed both to filter out unethical behavior and to filter in ethical behavior, and that both of these types of filters can be analyzed in three different dimensions. The first of these is Utilitarian, which argues that the chief element of ethical action is its usefulness. This is obviously a very problematic standard, since what may be useful for an individual or an individual company may well be very problematic for the market as a whole.

The second of these dimensions is a justice perspective, which is simply whether an action is fair or not. Again, this is not as simple as it sounds because there is the additional question of fair to whom? How far does one have to extend the concept of fairness? The final perspective, that of rights, is simpler, because it can be addressed by the question of legality. Insider trading is illegal, and thus by the relatively narrow rights perspective is wrong.

Insider trading makes people in business mistrust each other because it puts short shrift to the idea that honest effort is what is takes to succeed in business. This trumps the real, measurable damage that insiders do to the markets, as summarized in this analysis, although this author discounts the measureable damage done to the market by insider trades in comparison with other analyses of this issue. (Lakonishok & Lee, 2001).