Insider Trading Essay Research Paper The Stock

Insider Trading Essay, Research Paper

The Stock Market is an organized market for the trading of stocks and bonds. In Europe a stock exchange is often called a bourse. Stock exchanges exist in all-important financial centers of the world. Members of an exchange buy and sell for themselves or for others, charging commissions. A stock may be traded only if it is listed on an exchange after having met certain requirements. The New York Stock Exchange (founded 1790) is the largest in the U.S., handling more than 70% (in market value) of all transactions. The American Stock Exchange (Amex), also in New York City, and regional exchanges account for the remainder. Unlisted shares, often of smaller companies, are traded in the growing over-the-counter market. The NASDAQ (National Association of Securities Dealers Automated Quotations) system, an over-the-counter U.S. organization, accounts for the fifth largest stock trade in the world. Increasing computerization of stock trading may eventually render trading on a stock exchange floor obsolete.

In the stock market allot of illegal and unethical things go on. One of the most known crimes is insider trading. Insider trading occurs when someone has information that is not available to the public. The information obtained through insider trading is used to profit from trading in a company’s publicly traded securities. In the United States, insider trading has been illegal since 1934. This practice is protected by the Securities and Exchange Commission (SEC), the United States government agency created by the Securities Exchange Act (1934). It requires companies to submit full public-disclosure statements before issuing securities on the open market. The SEC regards the practice of insider trading as unfair to investors. It also regulates stock exchanges, brokers, and dealers in securities, and sets margin requirements for bank credit in security trading.

The laws restricting insider trading define “inside information” as information that is both “material” and “nonpublic.” Material information includes any information that is public.

Corporate directors and officers often obtain advance inside information because of their positions. Sometimes the information can affect the future market value of the corporate stock. It is obvious that their positions can give them a trading advantage over the general public and shareholders. Often times the insider is the company manager; other times it is the company’s lawyer, investment banker, or even the printer of the company’s financial statement. Anyone who has knowledge before public dissemination of that information stands to benefit from good news or bad news.

An individual who obtains “inside information” about plans of large corporations can often make stock-trading profits by using the information to guide decisions relating to the purchase or sale of corporate securities.

The primary constraint on firms’ ability to permit their insiders to trade on the basis of the nonpublic information they obtain in the course of the employment is rule 10b-5, which is the SEC’s principal weapon against insider trading. The SEC’s authority to enact rule 10b-5 is based on 10(b) of the 1934 act, a broad provision that authorizes the SEC to prohibit “any manipulative or deceptive device or contrivance.”

In other words, federal securities laws do not expressly prohibit insider trading, the crime of insider trading was not defined in any statutes or rules administered by the SEC, and federal securities laws provide only one specific remedy for insider trading: an injunction against future violations. The SEC preferred the days when the law of insider trading was vague.

Some people believe that insider trading should be permitted. One reasons is, if insider trading is best viewed from a property rights perspective, some firms will probably allocate those rights to corporate insiders to reduce insiders’ demands for fixed wages at little or no cost to outside shareholders. Additional reasons for permitting insiders to trade exist as well. Not all firms will find these benefits compelling. Rather, given immense variety of firms and the diversity of tastes and preferences among managers and shareholders, a blanket prohibition on trading by insiders is unlikely to be advantageous to all firms. Firms that wish to prohibit insider trading can do so by private negotiation with their managers. Insider trading will reduce insiders’ salary demands, this trading can benefit shareholders by bringing the interests of managers and shareholders closer together and causing managers to behave with less risk. Permitting insider trading might benefit shareholders, then such shareholders are better off by allocating the rights to trade in such information to the insiders. When this happens, insider trading can hardly be called unfair to the shareholders.

In contrast many still believe that insider trading should remain illegal. One argument is that insider trading should be remained banned because it is unfair. In addition to the unfairness arguments, insider trading has been condemned on other grounds:

(1) encourages managers to make to make risky investments.

(2) imposes a “moral hazard” problem on corporate managers to profit on the basis of good news.

(3) skews the process of information gathering and dissemination

within firms.

(4) causes a “lemons problem” within firms by making it

(5) impossible for firms to tell whether the managers they are selecting will trade information or not.

(5) drives investors from the marketplace by undermining public confidence in the integrity of the stock markets.

(6) involves the misappropriation of corporate property.

During most of the early history of the regulation of insider trading, the legal system searched for an internally consistent justification for banning such trading. That quest culminated in the early 1980’s when the Supreme Court issued its two most important insider trading decisions, at that time, Chiarella v. United States and Dirks v. SEC. These decisions brought clarity and coherence to the law as applied to insider trading.

Several major Wall Street news stories in the early 1990s involved insider trading by Ivan Boesky and Dennis Levine. Both were sentenced to jail, and Ivan Boesky was barred from trading stock and forced to return $100 million in illegal insider profits. The prosecution of Boesky uncovered a large ring of insiders and led to Michael Milken, the famous junk bond deal maker for Drexel Burnham Lambert.

Junk bond- a bond that involves greater than usual risk as an investment and pays a relatively high rate of interest, typically issued by a company lacking an established earnings history or having a questionable credit history. Junk bonds became a common means for raising business capital in the 1980’s, when they were used to help finance the purchase of companies, especially by leveraged buyouts.

Milken transformed corporate takeovers by the use of high-yield junkbonds, becoming enormously wealthy in the process. In 1989, federal grand jury handed down a 98-count indictment against Milken for violations of federal securities and racketeering. He pled guilty to securities fraud and charges in 1990, and government dropped the more serious charges of insider trading and racketeering.

The regulation of insider trading cannot be justified on the grounds that it promotes the goals of efficiency, fairness, or market integrity. The only conceivable justification for banning insider trading is that such trading involves the theft of valuable corporate property from its rightful owner. The attempts to justify insider trading regulation on other grounds simply reflect efforts by special interest groups to obtain private advantage through the regulatory process.

In conclusion, the discussion of insider trading has not been to show that insider trading is inevitably good, rather that it need not be harmful and that it can benefit both shareholders and society. All the available evidence

suggests that insider trading is best viewed from a property rights perspective. The best way to protect this property right is through private, intrafirms contracts between insiders and their shareholders.

1) Manne, Henry G. (1966). Insider Trading and the Stock Market.

New York: The Free Press

2) Macey, Jonathan R. (1991). Indsider Trading.

Washington, D.C.: The AEI Press

3) Frank B. Cross and Roger LeRoy Miller (1998),

West’s Legal Environment of Business

United States of America:West Educational Publishing

4) http://www.SEC.com

5) http://www.encyclopedia.com

6) http://www.hamptonu.edu (LEXIS-NEXIS)

7) http://www.barrons.com

8) http://www.wsj.com

9) http://www.marketedge.com

10) http://www.bloomberg.com