Why is insider trading a crime

Anyone who gives or receives confidential information that leads to a profitable stock trade could be found guilty of insider trading.

A hypothetical example of insider trading involving a third party would be if an individual at a printing company, who was paid to print private documents for a company, came across important information and advised someone else to make a trade.

Inside trading may also be punished by the Securities and Exchange Commission SEC , which may seek several different punishments through a civil trial. One punishment that may be levied is an injunction — an order to desist with a particular act. List of Partners vendors. A debate rages on in the financial community among professionals and academics about whether insider trading is good or bad for markets. Insider trading refers to the purchase or sale of securities by someone with information that is material and not in the public realm.

Insider trading is not limited to company management, directors, and employees. Outside investors, brokers, and fund managers can also violate insider trading laws if they gain access to nonpublic information.

One argument in favor of insider trading is that it allows nonpublic information to be reflected in a security's price and not just public information. Critics of insider trading claim that would make the markets more efficient. As insiders and others with nonpublic information buy or sell the shares of a company, for example, the direction in price conveys information to other investors.

Current investors can buy or sell on the price movements, and prospective investors can do the same. Prospective investors could buy at better prices, while current ones could sell at better prices. Another argument in favor of insider trading is that barring the practice only delays the inevitable and leads to investor errors. A security's price will rise or fall based on material information.

Suppose an insider has good news about a company but cannot buy its stock. Then those who sell in the time between when the insider knows the information and when it becomes public are prevented from seeing a price increase. Barring investors from readily receiving information or getting that information indirectly through price movements can lead to errors. They might buy or sell a stock that they otherwise would not have traded if the information had been available earlier.

Laws against insider trading, especially when vigorously enforced, can result in innocent people going to prison. As rules become more complex, it becomes harder to know what is or is not legal resulting in participants accidentally breaking the law without knowing so. For example, someone with access to material nonpublic information might accidentally disclose it to a visiting relative while talking over the phone. If the relative acts on that information and gets caught, the person who accidentally disclosed it might also go to prison.

These sorts of risks increase fear to the point where talented people pursue careers elsewhere. If you happen to get material nonpublic information, do not make any investment decisions based on it until that information becomes public. Also, never share material nonpublic information with outsiders. Yet another argument for allowing insider trading is that it is not serious enough to be worth prosecuting.

The government must spend its limited resources on catching nonviolent traders to enforce laws against insider trading.

There is an opportunity cost to going after insider trading because the government must divert those resources from cases of outright theft, violent assaults, and even murder. One argument against insider trading is that if a select few people trade on material nonpublic information, then the public might perceive markets as unfair. That could undermine confidence in the financial system and retail investors will not want to participate in rigged markets. Insiders with nonpublic information would be able to avoid losses and benefit from gains.

That effectively eliminates the inherent risk that investors without the undisclosed information take on by investing. As the public gives up on markets, firms would have more difficulty raising funds. Dirks tried to encourage the Wall Street Journal to expose the fraud, but it wouldn't publish the story.

Meanwhile, Dirks told customers of his firm what he had learned, and some of them sold stock of the insurance company. Eventually, the fraud was uncovered, and the insurance company went into receivership. The SEC ruled that Dirks had violated Section 10 b by telling customers about the fraud, stating that when tippees come into possession of material information they know or should know which came from a corporate insider, they must either publicly disclose the information or refrain from trading.

It acknowledged that if a person who is tipped about material information knows the information was disclosed in breach of the tipper's duty, the tippee acquires the tipper's duty to disclose the information or refrain from trading. However, the Supreme Court said that an insider is not liable for disclosing nonpublic information to a person who trades on it unless "the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings" or the insider "makes a gift of confidential information to a trading relative or friend".

The Supreme Court said that because the former insider who told Dirks about the fraud had not received a personal benefit from making the disclosure, the former insider had not violated the securities laws, and therefore people who traded on the basis of what the former insider had disclosed did not violate the securities laws. Since the Dirks decision, there has been frequent litigation regarding what constitutes personal benefit to an insider, including another decision of the Supreme Court, and the question is still not fully resolved.

The third important US Supreme Court decision involved James O'Hagan, a lawyer who learned that a client of his firm was going to make a tender offer for stock of a company that was not a client of the law firm, and purchased stock of the target company before the tender offer was announced.

O'Hagan was convicted of violating Section 10 b , but an appellate court reversed the decision, because there was no fiduciary or other relationship that created a duty for O'Hagan to disclose the likelihood of a tender offer to the persons from whom he purchased stock. The Supreme Court reinstated O'Hagan's conviction, finding that O'Hagan had violated Section 10 b by misappropriating information about the tender offer from his law firm and its client.

In other words, O'Hagan was convicted of breaching an obligation to the source of the information, even though he had no obligations to the people from whom he purchased stock. The Supreme Court did not discuss what would have happened if the law firm's client had told O'Hagan he could purchase the stock. In addition to being convicted of violating Section 10 b and Rule 10b-5, O'Hagan had been convicted of violating Section 14 e of the Securities Exchange Act and Rule 14e-3 a under it.

Section 14 e prohibits fraudulent or deceptive acts in connection with a tender offer, and directed the SEC, for purposes of that subsection, to "prescribe means reasonably designed to prevent, such acts that are fraudulent, deceptive, or manipulative".

Rule 14e-3 a makes it unlawful for a person who knows that someone is taking steps to commence a tender offer because of information obtained from the offering person or the issuer of the securities being sought, to purchase or sell the securities being sought before the information is publicly disclosed.

It totally prohibits a person from purchasing or selling securities when in possession of nonpublic information that someone is going to commence a tender offer, even if there is no fiduciary or other duty to disclose.

The appellate court that reversed O'Hagan's conviction for violating Rule 10b-5 also reversed his conviction for violating Rule 14e-3 a , stating that the SEC had exceeded its powers in adopting a rule that was not limited to instances in which there was a duty to disclose.

The Supreme Court reinstated the conviction, stating that the SEC had authority under Section 14 e to create an absolute "disclose or abstain from trading" rule. It expressly did not address whether the SEC's rulemaking authority under Section 14 e was broader than its authority under Section 10 b. The adoption of Rule 14e-3 in was the first, but not the last, time the SEC used its rule-making power to address trading when in possession of inside information. In , the SEC adopted Regulation FD, which, with some exceptions, prohibits an issuer of securities from disclosing material nonpublic information regarding that issuer or its securities to an investment professional or to "a holder of the issuer's securities, under circumstances in which it is reasonably foreseeable that the person will purchase or sell the issuer's securities on the basis of the information".

Regulation FD was directed primarily at the practice of companies giving securities analysts information that was not available to the investing public generally. It was not viewed as a general prohibition against trading on the basis of material nonpublic information. Nine years later, the SEC adopted two more rules directed at insider trading, Rules 10b and 10b Rule 10b prohibits the purchase or sale of a security by a person who is aware of material nonpublic information about the security or its issuer "in breach of a duty of trust or confidence owed to the issuer of the security, to shareholders of the issuer or to any other person who is the source of the material nonpublic information".

Rule 10b defines a duty of trust or confidence to exist when a a person agrees to maintain information in confidence, b the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern or practice of sharing confidences, or c a person receives material nonpublic information from his or her spouse, parent or child. Therefore, the prohibition in Rule 10b applies to only a very limited number of situations. Despite the unwillingness of both the courts and the SEC to enunciate an outright prohibition against trading in securities when in possession of material nonpublic information, there is a widespread belief that such a prohibition exists.

Financial institutions maintain detailed compliance programmes aimed at ensuring that nobody trades when in possession of material nonpublic information.