INSIDER TRADING
By Elaine Sternberg
Reprinted from Just Business: Business Ethics in Action, Oxford:Oxford University Press,
2000.
Like junk bonds and takeovers, insider trading is a subject that has suffered
from much public misunderstanding, and many conceptual confusions. A large part of
the problem is that the term 'insider trading' is used very loosely, particularly by the
media and politicians. Sometimes it is used to encompass all forms of securitiesrelated illegal or immoral activity. Other times it is used to refer to all questionable
activities by insiders . . . even when not securities-related. Such promiscuous usage
has been encouraged by the term's having no single, generally accepted meaning:
ordinarily, insider trading is just whatever it is interpreted to be under local
regulationi[1]--when such regulation exists. Insider trading is thus a prime example of
the need to distinguish between the ethical and the legal: it is important to identify
exactly what is wrong, so that appropriate action can be taken and legislation can be
properly judged.
The activities referred to as insider trading and the ways in which they are
treated vary enormously, even in sophisticated markets. In some major
jurisdictions, ii[2] insider trading is no crime.iii[3] Traditionally, it has been an expected,
and perfectly acceptable, perquisite of certain sorts of employment: brokers get inside
information, the way that bankers get subsidized mortgages and airline staff get cheap
flights. Until quite recently, this was the attitude to insider trading even in the US and
the UK. Since the late 1960s, however, insider trading has attracted stern disapproval
and strict regulatory control in both America and England. Though meaning very
different things in the two jurisdictions, insider trading was criminalized in both
during the 1980s, and was blamed for many of the major financial scandals of the
1980s and 1990s. But much of the condemnation has been politically motivated,iv[4]
and many of the practices condemned have not been insider trading at all.
So what is insider trading? For the purposes of this discussion, 'insider trading'
will be used to mean what it does in the European Community's 1989 Insider Dealing
Directive: dealing on the basis of material, unpublished price-sensitive information
that is possessed as a result of one's employment, profession or duties. v[5] Besides
being illegal in some jurisdictions, what is wrong about insider trading understood in
this way? In principle it seems only right for the more assiduous, inquiring, analytical
investor--or broker--to be able to achieve better investment results than those not
bothering to do their prep. And who better, after all, to 'counsel' the purchase or sale
of shares than those closest to, and presumably best informed about, a company's
plans and prospects? Yet insider trading is now regularly denounced as immoral. Why
is this so?
Equality of Opportunity
The traditional view is that insider trading is unfair, usually because it is
thought somehow to violate equality of opportunity. But this view is mistaken.
Equality of opportunity is not infringed by insiders' having advantages not enjoyed by
outsiders: equality of opportunity does not require that all potential competitors have
the same natural abilities or positional advantages. To suppose that it does, is to
confound equality of opportunity with equality of outcomes . . . with absurd results.
The essence of equality of opportunity is simply that all those seeking a good be
allowed to compete for it equally on their merits. It does not require that the
candidates or the outcomes be equal; it does not even require that it be equally easy
for all to satisfy the entry requirements and participate in the competition.
How does this analysis of equality of opportunity apply to trading in
securities? The good in question consists of trading profits, or a reduction of trading
losses; the rules for allocating them are the laws of supply and demand operating in
the market.vi[6] For equality of opportunity to exist, all that is required is that access to
the market be unimpeded, and that the rules apply equally to all. No prospective trader
should be excluded from dealing on the basis of his identity, or the size of the mooted
transaction, or the source of funds used, vii[7] and orders should be processed on a
strictly 'first come, first served' basis. viii[8]
It is thus entirely possible for some traders to be better informed or more
perspicacious, or cleverer or richer or even more successful, without there being any
violation of equality of opportunity. Equality of opportunity specifically does not
require that all potential traders have equal information or even equal access to
information. Lacking insiders' information, outsiders' transactions will probably be
less successful than insiders' are. But outsiders' access to the market is nevertheless
unimpeded: the fact of insiders' having privileged information imposes no legal or
coercive or arbitrary barriers to stop the outsiders from trading.
Nor indeed are there any legal or coercive obstacles to prevent outsiders from
becoming insiders: equality of opportunity exists both with respect to trading and to
acquiring positions that potentially have access to unpublished price-sensitive
information. A trader who wants to benefit from insider knowledge can simply do
what is necessary to become an insider--a corporate executive or a corporate cleaner,
a professional adviser or a financial printer. Achieving such positions may well
require considerable time and effort, but so may acquiring the capital with which to
trade. So long as there are no coercive barriers to competing, however, the difficulties
of achieving success are irrelevant to the existence of equality of opportunity.
Does anything in the securities markets violate equality of opportunity?
Certainly. Equality of opportunity is, for example, clearly violated when there is a
legal ban preventing an individual from trading simply because of the relationship he
bears to a company. But this is exactly what happens when insider trading is officially
prohibited. It is therefore regulation against insider trading, not insider trading itself,
that violates equality of opportunity in trading securities.
Level Playing Fields and Handicapping
Perhaps, then, what is unfair about insider trading is instead that it precludes a
'level playing field' between insiders and outsiders? Once again, however, the
suggestion is misguided. The sporting metaphor does not mean what its advocates in
finance often seem to believe. A level playing field is no guarantee that the teams will
be of equal ability, or have equal resources or stamina, or equal chances of winning. It
does not even mean that the field of play will be either smooth or horizontal.
All that provision of a level playing field normally means is that some--not all-of the more obvious physical obstacles facing one side will also be faced by the
other. If the field is steeply inclined, the obstacle to scoring that the slope represents
will normally be reduced--not by getting out the bulldozer, but by making competitors
change sides midway. Even so, however, the sun may still shine unequally into the
eyes of the players.
In the field of securities trading, players regularly change roles. Just as sellers
in one transaction will be buyers in others and vice versa, traders who are insiders in
one transaction will be outsiders in others. Similarly, investors are sometimes existing
shareholders and at other times are not. To the extent that the metaphor of the level
playing field is relevant, therefore, the conditions implied by it seem to be compatible
with insider trading. It is therefore not the absence of a level playing field that makes
insider trading unfair or immoral.
It is interesting to note that although providing a level playing field does
nothing to reduce participants' inequalities, there is a sporting operation that does:
handicapping. Whether the objective is to encourage weaker players, or to create more
exciting contests, handicapping serves precisely to prevent those with obvious natural
advantages, or a record of greater success, from winning as easily as they might--and
it does so specifically by denying them the benefits of their advantages. Thus favored
race-horses carry heavier weights, and skilled golfers start with higher scores.
It is therefore handicapping, not providing a level playing field, that much
British securities regulation seems designed to achieve. In order to encourage wider
share ownership, the UK government has sought to make investing in equities more
attractive to individual investors. One of its main methods has been to try and
convince retail investors that they are not irretrievably disadvantaged vis-a-vis
professional, institutional investors. Accordingly, regulation has been introduced to
limit institutions' ability to benefit from their size and comparative sophistication.
Since one of the chief institutional advantages is direct access to company
information, many traditional practices by which institutions gained that advantage,
such as information meetings with companies, have been attacked by UK insider
trading laws. But though the objective of equalizing investors' chances may make
such handicapping intelligible, it does not address what is really wrong with insider
trading.
Teleopathy and Misappropriation
And some, though by no means all, forms of insider trading are genuinely
unethical. But they are not unethical because everyone is entitled to corporate
information, and outsiders are unfairly disadvantaged compared with insiders: no such
general entitlement exists. The only people who are morally entitled to possess
information about a business are its owners, and even their rights to information are
limited when they are shareholders. But it is only when the owners—the current
shareholdersix[9]--are being deprived of their entitlements that insider trading is unfair.
The immorality of insider trading is that information which belongs to the corporation
(and thus ultimately to the shareholders), and which should in a business corporation
be used to promote owner value, is instead misappropriated for the insiders' own
interests.
Those who possess inside information directly are ordinarily those who have
been entrusted with the information in their capacity as corporate employees, advisers
or agents. When, therefore, they use the information for anything that hinders or
undermines the corporate purposes, as insider trading often does, they violate their
fiduciary responsibilities to the corporation. They violate those responsibilities
regardless of whether they themselves deal on that information in ways that harm
corporate ends, or whether they transmit the information to third parties who do so. It
is equally irrelevant whether the third party is the classic 'tippee' in a dealing ring, or
the in-house market maker in an integrated investment bank.
But not all unethical insider trading results from violations of fiduciary
responsibility. If instead of being given the information by the corporation or its
representatives, the insider dealers have simply taken the information, then what is
involved is outright theft. And it is theft even though the information may remain to
be used by its proper owners for other purposes after it has been used by the insiders:
what is stolen is the chance to use that information first in a securities' transaction. In
efficient markets, timing is critical: it matters when information is acted upon. If the
benefit of being first goes to the errant insider rather than to the corporation or its
shareholders, then they have been robbed of a significant asset.
Ethical insider trading
Understanding that it is misappropriation that makes insider trading unethical
has several important implications. First, it makes it clear that not all insider trading is
unethical: the manner of acquiring the inside information makes a difference to
whether the insider trading is immoral or not. Trading on information obtained by
virtue of conscientious observation and analysis, or assiduous investigation, must be
distinguished from trading on information acquired through a breach of confidence or
theft. The trader's relationship to the source of the information and to the subject of
the information are therefore essential to determining the ethical status of any
particular case of insider trading. If the information has been acquired incidentally or
accidentally, trading on it may not be unethical.
Consider an example. A mathematics professor knows that his best Ph.D.
student, who is capable of great things, is about to go to work for a computing
company. The professor thus has unpublished, price-sensitive information that he has
acquired as the result of his profession. If he then buys shares in the company, he is
guilty of insider trading. But there is nothing immoral about his action. He has not
misappropriated the information: he has no fiduciary responsibility to the company.
And no information has been stolen, from the student or from the university. The
professor is simply in a position to learn and appreciate the significance or a piece of
information that might give rise to a trading advantage.
Equally, insider trading that is performed with the full knowledge and consent
of the shareholders is not unethical. Shareholders who voluntarily surrender the
benefits of the information they own, and who choose to allocate it instead to their
functionaries, have made a legitimate decision about the disposition of their property.
It may be a foolish decision, insofar as it creates a potential conflict of interest:
employees who can profitably trade on information concerning their company's
misfortunes may have less incentive to prevent them. But authorized insider trading
cannot be teleopathic: the corporation's ends are just those determined by its
shareholders. By agreeing that corporate insiders may trade for their own account
using inside information, the shareholders have redefined their representatives'
fiduciary responsibilities concerning their securities' trading activities. Since the
insiders have been expressly allowed to employ the information for the purposes of
their own trading, they will neither have misused nor misappropriated it in doing so.
Consequently, insider trading to which the shareholders consent is not unethical.
Not a 'Victimless Crime'
Nonetheless, unethical insider trading is not a 'victimless crime'.
Understanding that it is misappropriation that renders insider trading wrong makes it
very clear who the victims of unethical insider trading are: they are the shareholders
whose corporate information has been misappropriated.
Shareholders normally suffer when their corporate property is stolen, whether
what is purloined is a trade secret, a company car or material price-sensitive trading
information. The damage to owners that results from insider trading may be most
obvious when the inside information is that of an impending takeover. But it can
result as well from less dramatic news, from the company's entering a new market or
selling a loss-making subsidiary. Trading by corporate insiders automatically harms
owner value when it causes the company's share price to fall. But insider trading can
hurt owners even when it causes prices to rise: if insider trading raises a target
company's share price, it makes a takeover more expensive.
Although the primary victims of unethical insider trading are the shareholders
of the company which is the subject of the inside information, they are not the only
ones to suffer. If the insider trader is employed not by the subject company, but by a
firm which was providing services to it, then that other firm and its shareholders will
suffer as well. Because of the employee's fiduciary irresponsibility or theft, that
organization's reputation as a reliable adviser or agent, and consequently its ability to
attract future custom, can be impaired.
Finally, immoral insider trading harms the market itself. It is not just the
traders who are on the opposite side of the insiders' transactionsx[10] who lose; the
overall reputation and viability of the securities exchange may well be diminished.
When an exchange permits insider traders to rob shareholders of what is rightfully
theirs, investors will be disinclined to trade on that exchange, and will be less willing
to buy securities issued on it. Not only, therefore, will market liquidity be potentially
reduced, but less capital will be available for corporate development.xi[11] Indirectly, at
least, the entire economy is a victim of unethical insider trading.
In summary, then, insider trading is unethical when, but only when, the inside
information has been misappropriated, when it has been acquired through violation of
fiduciary responsibility or through theft. It is therefore not insider trading as such but
misappropriation that should be recognized as the criminal offence. What is unfair
about immoral insider trading is that in it, information that is owned by the
corporation and that should be employed to promote the interests of its owners, is
diverted instead to the private purposes of corporate agents or outright thieves. When,
therefore, owners authorize insiders to use corporate information for their private
purposes, the consequent inside trading is not unethical. When they do not, however,
they are the clearest and most direct victims of unethical insider trading.
i[1]
In many jurisdictions, for example, insider trading restrictions apply only to equities and not to
corporate debt securities.
ii[2]
In Germany, for example, insider dealing only became a criminal offence on 1 August 1994, when
the second Financial Markets Promotions Act became law, implementing the EU Directive. Waller,
David, "Insider dealing law approved by Bundestag", Financial Times, 20June 1994, p. 13.
iii[3]
Even if it is a violation of securities or other regulation.
iv[4]
Starting with the move to protect widows and orphans in the wake of the stock market Crash of
1929, populist attacks on big business have combined with the political ambitions of prosecutors to
make insider trading a favoured US target. In the UK, an ideological commitment to wider share
ownership led to the need to make the securities markets seem attractive to retail investors; legislation
to create a 'level playing field' (about which more later in this chapter) thus became important.
v[5]
Which is reflected in the treatment of insider dealing in the (UK) Criminal Justice Act which came
into effect on 1 March 1994.
vi[6]
Which in practice are subject to the regulations governing financial exchanges in their various
jurisdictions.
vii[7]
Conditions which are, in fact, violated in many jurisdictions; consider, e.g., UK takeover
regulations.
viii[8]
Sequence is important because, at least according to efficient market theory, all information in the
market, including information about the price of the most recent trade, is normally a factor in
determining a security's price.
ix[9]
In aggregate .... The owners can be presumed to be shareholders because insofar as insider trading
relates to dealing in shares, it relates to business in its corporate form.
x[10]
I.e., all those who are selling when insiders are buying, and vice versa; it is not necessary to be the
direct counterparty of the insider to suffer.
xi[11]
According to a study of monthly data for 103 stockmarkets taken from 1969-98 for developed
countries and 1988-98 for developing ones, thos~ countries that had and enforced insider trading laws
lowered their cost of equity by an average of 5%. Bjattacharya, Utpal and Daouk, Hazem, '~Fhe World
Price of Insider Trading", Kelley School of Business, Indiana University working paper, January 2000,
reported in "Insider trading: The cost of equity", The Economist, 22January 2000, p. 97.