Finance | Insider Trading: Legal and Economic Spectra | #finance & #legal

We live in the post-industrial age of information where information has become a tradable good, which can be exchanged, bought and sold. Insider trading - transactions in a company's confidential information - has always existed, but it is several decades ago that it was proclaimed illegal. In this post we shall address the topic of insider trading. We are going to see why insider trading has been systemic in both common law and civil law jurisdictions and will see what makes that topic so interesting and controversial for the world of finance and law. 

Finance & Legal Aspects of Insider Trading with a Company's Securities

Insider Trading and other Definitions

The modern definition of insider trading can be summed up as dealing in a company's non-public, i.e. confidential info concerning the securities of the former. It can be both legal and illegal, although in most cases today it is associated with fraudulous activities. 

The insider is a company's director or manager in possession of more than 10% of the shares of the company in question. Having some inside knowledge (inside information) about the company's strategic decisions and plans, the insider may become an inside trader (or insider trader) by resorting for different reasons to trading in the inside knowledge, by either selling it directly to outsiders or dealing in the company's securities (financial instruments reflecting the value of the company: bonds and stocks).  

Legal Spectrum of Insider Trading

Insider trading is hard to prove. To be convicted, a person must have bought or sold a stock based on material information that is both unknown to the general public and likely to have had an important effect on a company's stock price.

- Alex Berenson, journalist and writer

In case of insider trading, the proof of responsibility is very hard due to the presence of various schemes allowing those involved in insider trading schemes often use third-persons legal companies and offshores. However, the contemporary legislation prescribes that CEOs, executives and directors who use the company's inside information for their own profit are liable. Both the tipper who deliberately reveals the inside information and the tippee who purposely uses the information are liable. Let's have a look at some recent cases.

Herbalife vs. Pershing Square Capital Management (2014)

In 2014, people whose liability of involvement in insider trading was difficult to prove were accused. The hedge fund Pershing Square Capital Management’s was planning to attack Herbalife at Wall Street. Mr. Szymik, a consultant at Herbalife, although he had no connection to the company's trading and not knowing that the information he possessed was of sensitive and confidential character, shared it with another friend of his who, in turn, shared it with a Pershing Square Capital Management’s employee Mr. Peixoto who had connection to the trading decisions of his company and, finally, made a profit thanks to the info he received indirectly from Mr. Szymik. The case mesmerised Wall Street. According to the court's decision, Mr. Szymik had to pay the fine equalling to Mr. Peixoto's profit and Mr. Peixoto was prosecuted for insider trading.

Multiple insider trading charges for an ex-schroeders trader (2016) 

Mr. Damian Clarke (UK) has managed to collect a huge amount of insider information during his career life valuable connections at various financial organisations. He applied his inside knowledge at Schroeders, the world-known asset management group (first, as a fund manager’s assistant and then as a fund manager). In spring 2016 he had admitted more than 9 charges of insider trading, being accused of even more.

Deontology of insider trading

Having seen the legal cases, we cannot but conclude that the concept of insider trading has become rather ambiguous today. People suspected of insider trading in the cases above, were not insiders in the legal sense, although they may have caused damage to the companies in question. Read my essay The Legal Notion of Insider Trading in Economics and Finance to have a more detailed view over the cases.

The notion of insider trading is recent, but insider trading itself has existed for a long time. It is due to insider trading that many of the rich families such as the Rothschilds have accumulated their fortunes. They used namely their connections in various fields and places. Those connections sold or often gave away for free sensitive information of financial kind. That is how it worked in the 19th century. In the 20th century, however, the situation changed. 

The state started to pay more attention to the lucrative phenomenon of insider trading. Wishing to hinder the most industrious and successful circles of society from doing their best and using the popular at that time Keynesian paroles of the necessity of more state control, the state, playing the Great Depression card, has been intervening more and more aggressively into the financial sector since the 1920s.

Yes, the first attempts to curb the insider trading started in the US. At the dawn of the 20th century, the first laws against "market manipulation" were adopted. Later, in 1934 the SEC (Securities Exchange Commission) appeared which was and remains the federal legal authority in that field. Among its numerous functions is control against insider trading in the US. However, it is only in the 1960s that the notion of insider trading was defined fully and properly enough by the rules 10b5-2 and 10b5-1. At that time, insider trading was illegal only in the US.

The legislation against insider trading came much later to Europe. In the UK, the FSA (Financial Services Authority) pronounced insider trading illegal only at the end of the 1980s. The rules prohibiting insider trading practices were, however, adopted by the FSA only in 2000 (Financial Services and Markets Act 2000).

In the continental Europe, insider trading was legal up to the beginning of the 2000s. That could be explained by two reasons. First, European countries belong to the so-called Civil Law jurisdiction where the core legal principles are codified into a referable system (the Civil Code) and interpreted based on it as opposed to the common law countries (the US and the UK) with the presence of the so-called case law developed by judges through decisions of courts and similar tribunals. Traditionally, in Common Law countries the legal enforcement power is stronger due to the higher level of retail ownership and more experience in stock market regulations than in Civil Law countries.

Second, the EU integration took too much of the time and effort of legislators so that they could come up with the relevant solutions only in the 2010s. As in previous cases, the first legislative acts touching upon insider trading were mainly directed against market manipulations (see MAD I, MAR & MAD II). It was in 2014 that insider trading was finally defined by the so-called market abuse directive (Directive 2014/57/EU of the European Parliament and the Council on criminal sanctions for market abuse).

Insider trading, Realpolitik and Gary Aguirre 

In order to summarise our discussion of the legal side of insider trading and at the same highlight the establishment's crackdown on insider trading, we shall use the expression coined several decades ago by Max Weber - Realpolitik. It has found a broader acclaim in the Anglo-Saxon than German speaking world and could be very well applied to the world of finance and business law today. We can extend the term Realpolitik beyond its initial political use in order to show the pragmatic course of action of the market actors from both sides, hence promoting the idea of the survival of the fittest and balancing the trading interests of their company with their private trading interests.

Indeed, it is difficult to prohibit something that has always been legal, on the spot. People will naturally be looking for loopholes fighting for their financial survival. And that will happen from both sides: from the side of the companies used to taking responsibility and from the side of the government seeking an opportunity to cash in on the private sector. For sure, there will always be people trying to stay between the two barricades, looking for their own profits. Like Gary Aguirre.

Gary Aguirre was a mediocre lawyer specialising in securities law. He practised his profession by protecting, in particular, clients who were involved in insider trading. At some point of his life he managed to achieve his "financial and career goals" as he put it in one of his whistleblowing masterclasses where he teaches young lawyers the basics of whistleblowing. After that he went on a five year holiday to Spain where got an idea to "commit himself to public service". On his return to the US, he made another master and joined the SEC. There, he prosecuted his former clients having now the support of the SEC. In 2006, however, his ambition was to attack John. J. Mack, an accomplished self-made investor and broker who afterwards successfully guided Morgan Stanley through the financial crisis of 2008. Mr. Aguirre failed to do that and was dismissed. As a consequence, he became critical of the SEC accusing it of conspiracy with Wall Street against public. Even more, he betrayed his partners by exposing some of the SEC secret documents. After that, of course, he needed move out of New York and do what he did before his work at the SEC. Although he has naturally fewer clients than ever before, he can earn money by giving whistleblowing masterclasses and trying to justify his deeds. 

The whole episode proofs the idea of Realpolitik in the world of finance. Aguirre, having lost his integrity by "committing himself" (we are going to use his expressions) to whistleblowing, hasn't exposed anything new. We face the very same reality: the state is trying to get as deep as possible (hope you will excuse me your connotations) by cracking down on the private sector. And it is nothing new that it also tries to make money. 

Financial and Economic Spectrum of Insider Trading

How is the price of securities is evaluated? In order to gather the information about a company, all-round analysis of its activities is necessary. It includes both public and non-material information concerning the company. That procedure is called the mosaic theory. A metaphor of the mosaic is used to make a comparison between the company’s image and a puzzle whose different parts need to be assembled in order to get the whole picture.

After collecting the information, it is possible - with more or less precision - to estimate the value of the company’s securities. The analyst involved in that procedure can make recommendation without revealing the essence of confidential information based on the information which he has. In some situations, the analysis based on the mosaic theory may be perceived as manipulation of insider information because giving recommendations, the analyst has to disclose - directly or indirectly - certain insider details of the company. Nevertheless, that procedure is legal. Therefore, prohibiting the over-the-counter insider trading and punishing insider managers and CEOs, the legislation against insider trading benefits not only the SEC, FSA etc., but also the second-row market analysts and brokers.

How does insider trading affects financial market and economy in general? 

On the one hand, insider trading can make financial markets more transparent and, therefore, efficient. By that we mean that the prices of securities will be adjusted with more precision to the market value of the company. That is enabled by more information about the company with the reduced level of moral hazards and asymetricity. In this respect, we can claim that insider trading is ‘socially beneficial’, for it renders the market prices of securities more efficient in economic sense. Moreover, according to some proponents of insider trading, it also compensates corporate innovations.

The adversaries of insider trading, besides legal and moral considerations (some of which have been brought up above), point out that insider trading destroys mainstream investors’ confidence in stock markets. As a result, demand for securities decreases which, consequently, reduces market liquidity. Both theories, while being plausible, have little empirical evidence in the favour of each. One final conclusion to make after comparing and weighing them up would be that insider trading has the positive and the negative sides and its effects depend on particular circumstances that companies and stock markets find themselves in. Thus, the effects of insider trading on markets remains as blurry as the concept of insider trading itself.

For more info about the topic, read my essay and watch my presentation:

The Legal Notion of Insider Trading in Economics and Finance from Cyril Gulevsky-Obolonsky