Why insider trading should be illegal

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.

Surely this is a better path toward well-functioning capital enterprises than a one-size-fits-all ban on insider trading. He observed that many regulatory functions that normal people think are necessary for the government to undertake — food safety, for example — could be easily discharged by the private sector. Given the choice between a certified safe can of beans and an uncertified can of beans, surely consumers would prefer the safe one.

So a sensible canning firm would want to contract with a credible food inspection service to certify its beans. Sensible people, I think, shy away from this kind of thinking. And when it comes to beans, one of the virtues of the present regulatory system is that it actually works just fine. And the idea of allowing opt-in or opt-out from insider trading rules strikes me as much the same. What problem are we trying to solve by legalizing insider trading?

Meanwhile, John, a question for you: How far would you take this logic? After all, the ban on insider trading is hardly the only rule of corporate governance in America. Should we just make it all opt-in? Establish a board with outside directors if shareholders demand it, but not otherwise?

In other words, is the ban on insider trading a particular bugaboo or just step one to a radical rethink of securities law and corporate governance? Let me admit that I admire your basically conservative instinct not to overturn laws just because they seem to make no sense. Our courts are authorizing invasions of privacy, including open-ended wire-tapping, in pursuit of those the Justice Department suspects of insider trading.

There are real human costs inflicted by the ban on insider trading. The pursuit of insider trading is also diverting resources away from the pursuit of more serious financial wrongdoing. As for the Department of Justice proper, a decision was made in to spread the investigation of financial fraud cases among numerous U. At the same time, the U. While I want to stress again that I have no inside information, as a former chief of that unit I would venture to guess that the cases involving the financial crisis were parceled out to assistant U.

Which do you think an assistant would devote most of her attention to: an insider-trading case that was already nearly ready to go to indictment and that might lead to a high-visibility trial, or a financial crisis case that was just getting started, would take years to complete, and had no guarantee of even leading to an indictment? Of course, she would put her energy into the insider-trading case, and if she was lucky, it would go to trial, she would win, and, in some cases, she would then take a job with a large law firm.

And in the process, the financial fraud case would get lost in the shuffle. In short, a focus on quite different priorities is, I submit, one of the reasons the financial fraud cases have not been brought, especially cases against high-level individuals that would take many years, many investigators, and a great deal of expertise to investigate.

Right now the only option I see available is decriminalization. Which brings me to the answer to the question at the end of your last missive. Advocates of insider trading believe that it avoids risks and makes markets more efficient. Regardless of the stance individuals take, insider trading is currently illegal and can be severely punished through fines and time in prison. Business Leaders. Your Privacy Rights. To change or withdraw your consent choices for Investopedia.

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Your Practice. Popular Courses. Key Takeaways Insider trading refers to the purchase or sale of securities by someone with information that is material and not in the public realm. Critics of insider trading laws claim it should be legal because it provides useful information to markets and the laws against it can harm innocent people, while the offense itself causes little damage to others.

The main argument against insider trading is that it is unfair and discourages ordinary people from participating in markets, making it more difficult for companies to raise capital. Insider trading based on material nonpublic information is illegal. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear.

Investopedia does not include all offers available in the marketplace. Related Articles. Partner Links. However, some people, like Rajat Gupta who received a two-year sentence in June , receive lighter sentences for various reasons. Many shareholders — and others simply contemplating getting involved in the market — are very likely to postpone future dealings with Wall Street out of new fears of being cheated;.

As insider trading increases, law enforcement efforts to fight and control it are weakened due to lack of prosecutorial resources. When this illegal behavior multiplies, some companies and individuals start feeling empowered to keep on coordinating insider trades because they come to believe their chances of being caught are very low.