Should Insider Trading 1

Running head: Should Insider Trading in the United States be a Crime?

Should Insider Trading in the United States Be a Crime?

Sandra Hayden
Managers and Political & Legal Issues (Internet)
Andrew B. Stratton, Esq., CLU
December 23, 2009
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Should Insider Trading in the United States Be a Crime?

“Insider trading” refers to transactions involving a company’s stocks or options by

corporate insiders such as executives and directors or their associates based on information not

known by the public. The insider uses the information to yield significant profits. There are

both legal and illegal forms of insider trading in the United States, but many argue that insider

trading should never be a crime. Given the difficulty successfully prosecuting alleged illegal

insider trading in the United States, one wonders if those who oppose prohibiting insider trading

are correct. Should insider trading in the United States be a crime? Unfortunately, it is

impossible to know the damage, if any, the market would sustain if insider trading were

legalized. But, it seems that the current system works, so, yes, insider trading in the United States

should be a crime.

The United States stock market crash of 1929 resulted in the Securities Act of 1933 and

the Securities Exchange Act of 1934. These acts were aimed primarily at prohibiting fraud and

market manipulation, but also targeted insider trading (Dolgopolov, 2009). The acts were also

intended to control the abuses believed to have contributed to the crash (Newkirk & Robertson,

1998). Insider trading was addressed in the 1934 Act through Section 16(b) and Section10(b).

Section 16(b) prohibits profits realized in any period less than six months by insiders in their

own corporation’s stock. The rule applies only to directors or officers of the corporation and

those holding more than 10% of the stock. The assumption is that these people would be privy

to important confidential information, and therefore, would prevent insider trading.

Regulation of insider trading did not begin until the turn of the twentieth century

(Dolgopolov, 2009), and the last 100 years have not shown much success with attempts to

regulate insider trading. One of the earliest was congressional hearings before the Pujo
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Committee in 1912-1913. The hearings concluded that the “scandalous practices” of officers

and directors speculating on inside information regarding the actions of their corporations may

be curtailed if not stopped (Dolgopolov, 2009). Broader enforcement of the restriction on insider

trading did not begin until the 1960’s, with the Securities and Exchange Commission’s

prosecution of case Cady, Roberts & Co. in 1961. However, the SEC has often been referred to

as a “toothless tiger,” a relatively small agency with a relatively small budget (Rochrlich, 2009).

The agency given the mandate to ferret out and enforce violations has around 1,100 people

responsible for watching the United States’ more than 12,000 publicly traded companies, 10,000

investment advisors managing more than $38 trillion in assets, nearly 1,000 fund complexes,

6,000 broker-dealers with 172,000 branches, and the close to $44 trillion worth of trading

conducted each year on stock options and exchanges (Rochrlich, 2009). In addition, the

development of insider trading law has not kept pace with the expanding anti-fraud provisions

covering insider trading (Newkirk and Robertson, 1998). Federal legislators have never defined

insider trading, and the SEC actually opposed doing so in the 1980’s (Dolgopolov, 2009). The

judicial definition of proscribed activities has become fairly clear since the 1997’s United States

v. O’Hagan was decided by the Supreme Court: it includes trading by corporate insiders and

their associates on inside information as well as trading by individuals who misappropriate

certain types of outside information from third parties (Dolgopolov, 2009).

The Securities and Exchange Commission’s website says that the SEC regularly brings

insider trading enforcement actions against corporate officers, directors, and employees who

traded the corporation's securities after learning of significant, confidential corporate

developments, friends, business associates, family members, and other "tippees" of such officers,

directors, and employees, who traded the securities after receiving such information, and other
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persons who misappropriated, and took advantage of, confidential information from their

employers. A graph on the site shows that 61 actions were taken in 2008, up from 47 the year

before.

Why regulate insider trading at all? And, how extensive should regulations be? Should

those found guilty of insider trading serve time in prison? There are many opinions but not an

abundance of irrefutable facts regarding insider trading. Most people would argue that insider

trading hurts the markets and the economy. But, just as many people argue that it does not. The

truth is that there are both legal and illegal forms of insider trading, and it is incredibly difficult

to prove the illegal form.

Legal insider trading occurs every day. It happens when corporate insiders – officers,

directors, employees and large shareholders – buy and sell stock in their own companies

(Astarita, 2009). These transactions must be reported to the SEC, and many traders and investors

use this information as a gauge as to how well or poorly the company is performing. Insider

trading becomes illegal when the buying or selling of a security breaches a fiduciary duty or

other relationship of trust and confidence (Astarita, 2009). Arguably, the definition has been

expanded over the years to include individuals whose “relationship of trust” is so remote it is

almost non-existent (Astarita, 2009).

Those who believe insider trading should be illegal think that it undermines investor

confidence in the markets, and that it benefits insiders at the expense of outsiders. As Stanislov

Dolgopolov explains in an article for the Concise Encyclopedia of Economics, this is debatable

because most outsiders who bought from or sold to insiders would have traded anyway and

possibly at a worse price. In many cases, if the insider expects the price of a stock to fall and
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sells it, the act of selling may bring the price down to the buyer. In that case the buyer who

would have bought anyway actually gains. There are losers in such a situation – the buyers on

the margin, who would not have bought unless the insider had sold and brought the price down

slightly, and sellers who would have sold for less or could not have sold at all. This leads some

to argue that this diversion of wealth from outsiders to insiders may decrease the share price and

raise the corporate cost of capital (Dolgopolov, 2009). Interestingly, not selling a stock based on

positive information would keep a potential buyer from getting a better deal, and would be

considered insider trading. It would seem practically impossible to prosecute an action like that.

There seem to be more arguments for the legalization of insider trading than against it.

Noble Prize-winning economist Milton Friedman said, “You want more insider trading, not less.

You want to give the people most likely to have knowledge about deficiencies of the company an

incentive to make the public aware of that." Friedman did not believe that the trader should be

required to make his trade known to the public, because the buying or selling pressure itself is

information for the market (Wikipedia, 2009). Henry Manne, dean emeritus of the George

Mason University School of Law, said in an interview that insider trading “helps to move the

price of a share to its ‘correct level.’” He also said trades made using privileged information

provide an “actual reflection of what’s going on” with a certain stock (Rohrlich, 2009). Another

argument for legalizing insider trading is the issue of compensation of CEOs of corporations.

Executives of a corporation are expected to lead the organization successfully, and a sign of

success is a healthy price for the company’s stock. In addition, CEOs and other leaders of a

company are encouraged to be shareholders, yet it is a criminal act for them to trade based on

their own hard-earned experience (Hoenig, 2009). Instead, the CEO is expected to trade his
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shares only after the public at-large has been given the same information he has. Realistically,

how could a CEO not possess inside information?

What are the arguments for keeping insider trading illegal? The prevalent argument is

that to allow it would undermine the investor’s confidence in the market. For instance, if anyone

with information within a corporation could trade based on that information, why would people

not “in the know” bother? If an investor believes he has at least most of the same information

everyone else holds, he will be more likely to participate in the market. In reality, a level playing

field is probably just an illusion, but if the investors believe they have a fair chance, it works.

And, if insider trading were legal, investors would spend all of their time watching the moves of

the insiders, and not concentrating on legitimate information. Or would they? Minyanville

Professor Kevin Depew says that “it’s already considered an insider’s game, so why would

making insider trading unenforceable by legalizing it have any effect on investor psychology?”

(Rohrlich, 2009).

Insider is illegal in the United States, punishable by monetary penalties and

imprisonment. But, how hard is it to prove? Insider trading is an extraordinarily difficult crime

to prove. In fact, almost all successful criminal insider trading prosecution cases in the United

States have rested in part on the testimony of cooperating witnesses (Newkirk and Robertson,

1998). There is no smoking gun or dead body, and direct evidence is rare. More importantly,

the act of buying or selling securities is legal, so it all hinges on the intent of the trader, or the

state of mind.

Henry Manne maintains that the SEC is doing nothing but making headlines, not making

enforcement of the law, because it is impossible to do (Rohrlich, 2009). It does seem that the

SEC uses high-profile cases to deter fraud by investors, but are they the right investors? And, the
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famous cases are not always won by the government; consider the cases against Martha Stewart

and Mark Cuban, for instance. Stewart was embroiled in the ImClone scandal in 2002. She was

charged with securities fraud, but that charge was later thrown out by the judge. Stewart was

found guilty of obstruction of justice, conspiracy and two counts of making false statements

(Wikipedia, 2009). In her case the SEC didn’t exactly win.

Mark Cuban, one of the 400 richest Americans, was charged in November, 2008, by the

SEC with insider trading for selling 600,000 shares of stock of an Internet search company. The

case was thrown out by a judge in July, 2009, who said that the SEC failed to allege that Cuban

undertook a duty to refrain from trading information on a public stock offering that Mamma.com

had planned (MacMillan, 2009). Again, another well-publicized loss for the SEC.

The latest headlines concern Raj Rajaratnam, the New York hedge-fund

billionaire charged with the biggest insider trading scheme ever. Rajaratnam allegedly built a

hedge fund that managed $7 billion at its peak before being reduced to $2.6 billion in assets as of

March 31 (Helyar, 2009). The bad news for Rajaratnam is that the government says it has

wiretapped proof of insider trading and an informant willing to testify against him. Prosecutors

say that the wiretaps, which hadn’t previously been used to catch those dealing in inside

information, showed Rajaratnam, unlike some others accused of that crime, preferred bartering

for confidential intelligence to paying for it (Helyar, 2009). Prosecutors say that the insider

trading schemes netted more than $20 million in illegal profits, but another trade by Galleon

resulted in a loss of about $30 million. Some legal experts say that the fact that Rajaratnam lost

money could be powerful evidence for the defendants, giving the defense some fodder to argue

that the information used was not material (Berenson, 2009). According to Steven Feldman, a

partner in the litigation practice of Herrick, Feinstein, because Rajartanam lost money on the
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trades, he could receive a shorter sentence even if he is convicted. (Berenson, 2009).

Rajartanam pleaded not guilty to the charges on December 21, 2009.

The Acts of 1933 and 1934 prohibited insider trading in the United States, and the

Securities and Exchange Commission works to enforce the law. Probably just as many experts

argue for legalization of insider trading as argue keeping it against the law. Those who argue for

the legalization of insider trading say that doing so would have no discernable effect on the

market, and those who say that insider trading should remain a crime claim that investor

confidence in the market would collapse. Unfortunately, we can only guess at what the result

would be.

It stands to reason that there are at least some investors deterred from inside trading for

fear of criminal prosecution. And since there has been a prohibition against insider trading for 76

years, an agency actively working to uncover and prosecute violations, and the fact that the

market seems to have remained relatively balanced for many years, insider trading in the United

States should be a crime. It cannot be said that the system in place is broken; therefore there is

no “fix.” The system works, and should be left as-is.

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References

Astarita, M. J. (2009). Introduction to Insider Trading. Retrieved December 17, 2009, from:

http://www.seclaw.com/docs/insidertrading033104.htm

Berenson, A. (2009, October 19). Thin line separates insider trading and research. New York Times,

Retrieved December 17, 2009, from

http://www.nytimes.com/2009/10/20/business/20insider.html

Berenson, A. (2009, October 21). A Deal that lost millions for galleon. New York Times, Retrieved

December 15, 2009, from http://www.nytimes.com/2009/10/21/business/21insider.html?_r=1

Dolgopolov, S., Insider Trading. (n.d.). In Library of Economics and Liberty. Retrieved December 17,

2009, from http://www.econlib.org/library/Enc/InsiderTrading.html

Helyar, J. (2009, October 19). Galleon Insider-Trading Case Opens Window on Secret Hedge Funds.

Retrieved December 21, 2009, from : http://www.bloomberg.com/apps/news?

pid=20601087&sid=a01GJ_ryEtms

Hoenig, J. (2009, October 22). Ponder this: should insider trading be a crime?. Retrieved from

http://www.smartmoney.com/investing/stocks/ponder-this-should-insider-trading-be-a-crime/

ImClone Systems. (2009, November 29). In Wikipedia, The Free Encyclopedia. Retrieved 02:40,

December 23, 2009, from http://en.wikipedia.org/w/index.php?

title=ImClone_Systems&oldid=328671713
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Indiviglio, D. (2009, October 26). Is Insider Trading Okay? The Atlantic, Retrieved December 17, 2009,

from http://business.theatlantic.com/2009/10/is_insider_trading_okay.php

Insider trading. (2009, December 22). In Wikipedia, The Free Encyclopedia. Retrieved 02:41, December

23, 2009, from http://en.wikipedia.org/w/index.php?title=Insider_trading&oldid=333175552

MacMillan, R. (2009, July 17). Mark cubam insider trading case thrown out. Retrieved from

http://www.reuters.com/article/idUSTRE56G4TS20090717

Robertson, M & Newkirk, T. “Insider Trading – A U.S. Perspective.” 16th International Symposium on

Economic Crime. Jesus College, Cambridge England, September 19, 1998.

Rohrlich, J. (2009, October 19). Should Insider Trading Be Legalized? Retrieved December 18, 2009,

from : http://www.minyanville.com/articles/insider-trading-Rajaratnam-

minyanville/index/a/24985