Insider Trading: The Securities Exchange Act Of 1934

The stock market plays a very important part in the lives of investors and companies. Similarly, it is the cornerstone of many historical events. The market allows investors to be partial owners of companies, thus contributing to its growth or even helping it survive. In return, dividends are paid to investors when the company is thriving. Often, those who play an important role in the financials of the company learn information that will dramatically change the future. If one of these people buys or sells stock based on this information, then it creates a type of conundrum called insider trading.
Insider trading is making stock market transactions based on undisclosed, important information. This occurs when individuals buy stock to
gain profits or sell stock to avoid losses when they receive confidential information. These “insiders” are usually a corporation’s’ management, owners, attorneys, accountants, etc. For example, if a management team meets privately to discuss massive layoffs that will be occurring in the next week, and then one of the managers sell its stock to avoid losses, this individual has practiced insider trading. Similarly, if a scientist of a publicly traded pharmaceutical company privately discovers the cure for Ebola, and proceeds to purchase a large amount of stock in the company before announcing the cure, that would be considered insider trading.
The idea of ethics is primarily based on two key components: fairness and transparency. First, profiting or avoiding losing money because of possessing superior knowledge is unfair in every sense of the word. The stock market is no longer on an even playing field for the shareholders (McGee, 2008). Secondly, insider trading relies on a person intentionally acting before information is made public. This is a form of hiding information, and a lack of transparency. Especially with publically traded companies, their growth and success is dependent on shareholders. Their performance attracts investors, and the money invested is used for capital improvements and moving the organization forward. When a company performs well, it rewards its shareholders, again making the company more attractive to stockholders (Yoon & McGee, 2012). Once a company is caught participating in insider trading, trust decreases, and it can be very difficult to attract investors. In this case, investors are not confident in the market, and eventually the company suffers.
Besides the simple unethical nature of profiting or avoiding loss before information is public, it was deemed illegal in 1929 after the infamous stock market crash.
The Securities Exchange Act of 1934 enabled the government to convict inside traders. Section 10b5 of this act defines exactly what constitutes illegal insider trading (Yoon & McGee, 2012). It was not until the first insider trading conviction in 1961 that people started to question whether this was ethical or unethical (Shrestha & Sawicki, 2008). Later, in October of 2000, Sections 10b5-1 and 10b5-2 defined the term “insider,” and detailed insider trading, and explained what makes the act illegal. As a result, stricter regulations were established; for example, corporate management must now complete a form whenever they buy or sell company stock. Since then, there has been controversy on whether to tighten or loosen regulations on insider
trading.
Some economists are not opposed to legalizing insider trading. In their minds, they are buying from people willing to sell, and selling shares to those willing to buy. Economist Henry Manne argued that insider transactions would yield stock prices that reflect both public and private information. This would portray the actual value of the stock, making the market more efficient. Manne also viewed insider trading as a method of incentivizing managers to create good news on which to trade (McGee, 2008). Don Boudreaux, the economics department head at George Mason University, adds that this could fight corporate crime by serving as a silent form of whistleblowing (McGee, 2008). A sudden decline in share value would indicate wrongdoing, or some other mismanagement practice, and initiate a change. Much like other earnings management techniques, this can lead to abusing the practice, and eventually fraud. On the contrary, many economists still believe insider trading is unethical, and from a business perspective could have the opposite effect from what Manne described. If insider trading were legalized, it would undermine public confidence in the securities markets, and may convince those to not invest at all (McGee, 2008). This would decrease market liquidity, increase the cost of trading, and make it more challenging for businesses to raise capital. In order to take a closer look at insider trading and its economic effects, it is helpful to look at an example.
Perhaps the most famous insider-trading example in recent history is Martha Stewart. It was all based around a biotech company named ImClone. ImClone had a cancer medication that they learned the FDA decided not to approve. When the CEO Sam Waksal learned this, he called his stockbroker to sell his stock, and then his stockbroker notified Martha Stewart (Hoffman, 2007). This caused both Waksal and Stewart to sell all of their stock in ImClone. The next day, the announcement about the cancer drug was publicized. To add insult to injury, once the SEC began to investigate Martha Stewart, she lied about the events leading up to the sales of stock. Martha Stewart was charged with a number of crimes, including insider trading (Hoffman, 2007)). While Stewart was not an “insider,” she did act on nonpublic information, earning her the
charge.
In conclusion, earnings management is a very subjective topic. Even though insider trading does not involve GAAP in action, it is a type of earnings management, where information is funneled in a specific manner to get an intended result. Some degrees of these actions are legal, and are practiced across the board by corporations looking to please eager investors. In fact, many believe that manipulating numbers to get the right results on financial statements or telling a loved one privy information to give them a financial boost is acceptable. On the other hand, these actions are scrutinized and regulated because the government found them to be unfair and unethical. Staging financial health, no matter what method is used, can be tempting. Often times, though, it leads to serious scandal and fraud. References
Hoffman, M. (2007). Martha Stewart’s insider trading case: a practical application of Rule 2.1. Georgetown Journal of Legal Ethics, 20(707).
McGee, R. W. (2008). Applying ethics to insider trading. Journal of Business Ethics, 77(2), 205-217. http://dx.doi.org/10.1007/s10551-006-9344-6
Shrestha, K., & Sawicki, J. (2008). Insider trading and earnings management. Journal of Business Finance & Accounting, 35(3/4), 331-346. http://dx.doi.org/10.1111/j.1468-5957.2008.02075.x
Yoon, Y., & McGee, R. W. (2012). Insider trading: An ethical analysis. International Journal of Finance, 24(1), 7070-7084.