It may come as a surprise to many people, but insider trading is not specifically defined by any statute. It is understood to describe trading in stocks or securities by people with access to material and confidential non-public information.
Following the stock market crash of 1929 Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934 with the intention of curbing abuses that led to the crash.
Clarifying Section 10(b) of the Securities and Exchange Act of 1934, the Securities and Exchange Commission (SEC) adopted Rule 10b-5 which made it illegal engage in fraud in connection with the purchase or sale of a security.
Throughout the history of insider trading cases, judges have expanded and contracted the meaning of the term as to who is an insider and under what circumstances does it become illegal.
For instance, while it may seem like a simple case where a company executive of a company sells large amounts of his company’s stock based on confidential, material information, what about if that same company executive gave this information to his brother-in-law, who is not a company insider? And what if the brother-in-law did not give anything to the company executive in return for the information? The company executive certainly would be deemed to have violated his fiduciary duty, but what duty did the brother-in-law have? In 2016, the Supreme Court in the case of Salman vs. United States unanimously ruled that the brother-in-law was guilty of insider trading where he knew or should have known that the information given to him was material, non-public information.
MAJOR CASES OF INSIDER TRADING
Martha Stewart
It is interesting to note that when many people think of insider trading they think of Martha Stewart who was never charged with insider trading, but rather was convicted of obstruction of justice and lying to federal investigators when she sold her stock in ImClone Systems after learning from her broker at Merrill Lynch that ImClone Systems’ CEO who was also a client of Merrill Lynch had sold his stock.
Raj Rajaratnam
Hedge fund manager Raj Rajaratnam was convicted of insider trading and sentenced to 11 years in prison. Rajaratnam had a large network of corporate insiders at a wide range of companies who supplied him with confidential non-public information in return for payments.
Ivan Boesky
Boesky profited by investing with inside information obtained from investment bankers involved in mergers and acquisitions. He received a 3-year prison sentence and a $100 million fine. However, he is perhaps best known for being the inspiration behind the famous line of the character Gordon Gekko in the movie “ Wall Street” that “Greed is good.” Boesky’s actual words were “Greed is all right, by the way. I want you to know that. I think greed is healthy.”
SAC Capital and Steven Cohen
Steven Cohen was the founder of the hedge fund SAC Capital. SAC Capital was charged with insider trading and one of its employees Matthew Martoma was convicted of insider trading in relation to confidential information he gathered from doctors involved with pharmaceutical companies working on a potential Alzheimer’s disease drug. Martoma was sentenced to 9 years in prison.
SAC Capital pled guilty to insider trading charges and was assessed $1.8 billion in financial penalties. Pursuant to its settlement plea agreement SAC Capital agreed not to manage any outside investors’ money, but was allowed to remain in business with Steven Cohen as its sole client. Cohen personally was also banned from managing investments for clients other than himself for two years, after which he opened a new hedge fund Point72 Asset Management and presently is the active owner of the NY Mets which he purchased in 2020 for $2.4 billion. No criminal charges were ever brought against Cohen.
Preet Bharara
Preet Bharara was the U.S. Attorney for the Southern District of New York between 2009 and 2017 giving him jurisdiction over crimes affecting Wall Street and he aggressively went after insider traders, winning 84 of the 85 insider trading cases he prosecuted. Notably, however, he was not nearly as aggressive in prosecuting anyone after the 2008 financial meltdown triggered by the greed that fueled the subprime mortgage market. Not a single criminal charge was brought against significant executives at the many companies tied to the crimes that devastated the economy.
And that leads us to should insider trading be illegal.
ARGUMENTS IN FAVOR OF LEGALIZING INSIDER TRADING
1. It can provide a legitimate form of compensation for lower-paid company employees who are able to utilize the information to their benefit while benefiting the company by allowing them to be paid lower salaries
2. Some would classify it as a victimless crime. Unlike the crimes of the 2008 meltdown, no stockholder or company loses money because of insider trading. Who is harmed?
3. Prosecution of insider trading cases is expensive and time-consuming without any apparent major benefits to the public.
And perhaps the strongest argument:
4. Insider trading enhances market efficiency by allowing non-public information to be reflected in a stock’s price more rapidly.
The primary argument in favor of maintaining the criminalization of insider trading is that people would not invest in the stock market because they would not consider the market to be fair, but rather provides greater profits for insiders which proponents of maintaining the illegality of insider trading argue would result in less capital being invested. This argument appears somewhat weak when you consider that institutional investors such as mutual funds, hedge funds, pension funds and large financial institutions account for 90% of today’s stock trades. It is hard to believe that these companies with their own extensive research and analysts would reduce their trading because of the presence of insider trading.