Insider trading
Insider trading is the trading of a public company's stock or other securities based on material, nonpublic information about the company. In many countries, some kinds of trading based on insider information are illegal. The rationale for this prohibition of insider trading differs between countries and regions. Some view it as unfair to other investors in the market who do not have access to the information, as the investor with inside information can potentially make larger profits than an investor without such information. However, insider trading is also prohibited to prevent the directors of a company from abusing a company's confidential information for the directors' personal gain.
The rules governing insider trading are complex and vary significantly from country to country, as does the extent of enforcement. The definition of 'insider' in one jurisdiction can be broad and may cover not only insiders themselves but also any persons related to them, such as brokers, associates, and even family members. In some jurisdictions, a person who becomes aware of non-public information and then trades on that basis may be guilty of a crime.
Trading by specific insiders, such as employees, is commonly permitted as long as it does not rely on material information not available to the general public. Many jurisdictions require that such trading be reported so the transactions can be monitored. In the United States and several other jurisdictions, trading conducted by corporate officers, key employees, directors, or significant shareholders must be reported to the regulator or publicly disclosed, usually within a few business days of the trade. In such cases, insiders in the United States are required to file Form 4 with the U.S. Securities and Exchange Commission when buying or selling shares of their own companies. The authors of one study concluded that illegal insider trading raises the cost of capital for securities issuers, thus decreasing overall economic growth. On the other hand, some economists, such as Henry Manne, have argued that insider trading should be allowed and can, in fact, benefit markets.
There has long been "considerable academic debate" among business and legal scholars over whether insider trading should be illegal. Several arguments against outlawing insider trading have been identified: for example, although insider trading is illegal, most insider trading is never detected by law enforcement, and thus the illegality of insider trading might give the public the potentially misleading impression that "stock market trading is an unrigged game that anyone can play." Some legal analysis has questioned whether insider trading actually harms anyone in the legal sense, since it can be argued either that insider trading does not cause anyone to suffer an actual "loss" or that anyone who suffers a loss is not owed an actual legal duty by the insiders in question. Opponents of political insider trading also point to conflicts of interest and social distrust.
Legal framework
Rules prohibiting or criminalizing insider trading on material non-public information exist in most jurisdictions around the world, but the details and the efforts to enforce them vary considerably. In the United States, Sections 16 and 10 of the Securities Exchange Act of 1934 directly and indirectly address insider trading. The U.S. Congress enacted this law after the stock market crash of 1929. While the United States is generally viewed as making the most serious efforts to enforce its insider trading laws, the broader scope of the European model legislation provides a stricter framework against illegal insider trading. In the European Union and the United Kingdom, all trading on non-public information is, under the rubric of market abuse, subject at a minimum to civil penalties and possible criminal penalties as well. UK's Financial Conduct Authority has the responsibility to investigate and prosecute insider dealing, defined by the Criminal Justice Act 1993.Financial Action Task Force on Money Laundering can apply to domestic politically exposed persons.
Definition of "insider"
In the United States, Canada, Australia, Germany and Romania for mandatory reporting purposes, corporate insiders are defined as a company's officers, directors and any beneficial owners of more than 10% of a class of the company's equity securities. Trades made by these types of insiders in the company's own stock, based on material non-public information, are considered fraudulent since the insiders are violating the fiduciary duty that they owe to the shareholders. The corporate insider, simply by accepting employment, has undertaken a legal obligation to the shareholders to put the shareholders' interests before their own, in matters related to the corporation. When insiders buy or sell based on company-owned information, they are said to be violating their obligation to the shareholders or investors.For example, illegal insider trading would occur if the chief executive officer of Company A learned that Company A would be taken over and then bought shares in Company A while knowing that the share price would likely rise. In the United States and many other jurisdictions, "insiders" are not just limited to corporate officials and major shareholders where illegal insider trading is concerned but can include any individual who trades shares based on material non-public information in violation of some duty of trust. This duty may be imputed; for example, in many jurisdictions, in cases where a corporate insider "tips" a friend about non-public information likely to have an effect on the company's share price, the duty the corporate insider owes the company is now imputed to the friend and the friend violates a duty to the company if he trades on the basis of this information.
Liability
Liability for inside trading violations generally cannot be avoided by passing on the information in an "I scratch your back; you scratch mine" or quid pro quo arrangement if the person receiving the information knew or should have known that the information was material non-public information. In the United States, at least one court has indicated that the insider who releases the non-public information must have done so for an improper purpose. In the case of a person who receives the insider information, the tippee must also have been aware that the insider released the information for an improper purpose.One commentator has argued that if Company A's CEO did not trade on undisclosed takeover news, but instead passed the information on to his brother-in-law who traded on it, illegal insider trading would still have occurred.
Misappropriation theory
The misappropriation theory of insider trading is now accepted in U.S. law. It states that anyone who misappropriates material non-public information and trades on that information in any stock may be guilty of insider trading. This can include elucidating material non-public information from an insider with the intention of trading on it or passing it on to someone who will.This theory constitutes the background for the securities regulation that enforces the insider trading.
Disgorgement represents ill-gotten gains resulting from individuals violating the securities laws.
In general in the countries where the insider trading is forbidden, the competent Authority seeks disgorgement to ensure that securities law violators do not profit from their illegal activity.
When appropriate, the disgorged funds are returned to the injured investors.
Disgorgements can be ordered in either administrative proceedings or civil actions, and the cases can be settled or litigated. Payment of disgorgement can be either completely or partially waived based on the defendant demonstrating an inability to pay. In settled administrative proceedings, Enforcement may recommend, if appropriate, that the disgorgement be waived.
There are several approaches in order to quantify the disgorgement; an innovative procedure based on probability theory was defined by Marcello Minenna by directly analyzing the time periods of the involved transactions in the insider trading.
Proof of responsibility
Proving that someone has been responsible for a trade can be difficult because traders may try to hide behind nominees, offshore companies, and other proxies. The SEC prosecutes over 50 cases each year, with many being settled administratively out of court. The SEC and several stock exchanges actively monitor trading, looking for suspicious activity. The SEC does not have criminal enforcement authority but can refer serious matters to the U.S. Attorney's Office for further investigation and prosecution.Trading on information in general
In the United States and most non-European jurisdictions, not all trading on non-public information is illegal insider trading. For example, a person in a restaurant who hears the CEO of Company A at the next table tell the CFO that the company's profits will be higher than expected and then buys the stock is not guilty of insider trading—unless he or she had some closer connection to the company or company officers. However, even where the tippee is not himself an insider, where the tippee knows that the information is non-public and the information is paid for, or the tipper receives a benefit for giving it, then in the broader-scope jurisdictions the subsequent trading is illegal.Notwithstanding, information about a tender offer is held to a higher standard. If this type of information is obtained and there is reason to believe it is nonpublic, there is a duty to disclose it or abstain from trading.
In the United States in addition to civil penalties, the trader may also be subject to criminal prosecution for fraud or where SEC regulations have been broken, the U.S. Department of Justice may be called to conduct an independent parallel investigation. If the DOJ finds criminal wrongdoing, the department may file criminal charges.