Insider Trading - Should It Be Legal or Not?
Insider trading is defined as “trading on the basis of material information that isn’t public”. As the law stands right now, insider trading is illegal in the United States. The maximum penalty for insider trading as an individual is 20 years and a $5,000,000 fine. While there are a number of arguments based on “fairness” against legalizing insider trading, there are also a number of financial and ethical arguments that counter the arguments of the anti-insider trading crowd. Insider trading should be legal because, in the end, it benefits society as a whole more than disadvantages it.
In finance, there is a theory that exists called the efficient market hypothesis. This theory states that a market’s efficiency is based on stock valuation in relation to information available. The basic principle is that the more information found within a market, insider or not, the more accurate a stock’s value becomes. By making insider trading legal, a market will be able to reach the peak level of efficiency called “strong form efficient”. In a strong form efficient market, prices reflect all information, public and private (Ross 338). This implies that if a market is efficient, it will no longer have abnormal returns, or returns that exceed those expected by the market for a given level of risk. This implication exists and is true regardless of the information a person possesses. In his paper Ethics and the Financial Community, Richard T. DeGeorge argues that efficiency is not the only important factor in a market, and that fairness needs to be considered as well. He claims that by investing in a market where insider trading is legal, it is like playing a game that is rigged against you. My counterargument to this claim is that fairness has many different meanings. In one instance, fairness can mean that all parties have an equal opportunity at maximizing their utility. DeGeorge fails to see the idea of fairness in society as a whole. It is unclear whether fairness to an individual is more important than fairness to an entire society. In past cases where fraudulent accounting practices occurred on a large scale -- like Enron or WorldCom -- society was hurt much more than an individual would have been if insider trading had occurred.
Another positive of insider trading is that it can potentially help the market avert major accounting fraud scandals, such as what happened with WorldCom. With over 90,000 employees in sixty-five countries, WorldCom was reporting revenues of roughly $39 billion in the year 2000. Unfortunately for the company, three major issues arose that caused them to participate in a large accounting fraud scandal. First of all, when the dot-com bubble burst that year, many of WorldCom’s customers had trouble paying their bills. Secondly, they were running out of new clients to pursue. Lastly, WorldCom’s strategy of continuous growth through acquisition was becoming difficult to maintain, as the Department of Justice stopped their proposed purchase of Sprint due to antitrust issues. These factors led WorldCom to have a difficult time fulfilling their stock market projections for its revenue. Instead of reporting their losses, WorldCom decided to report $133 million in revenue that they knew they would never collect. By June of 2002, WorldCom had continuous losses, and even the fraudulent accounting practices weren’t enough to cover up major deficits, resulting in their CEO’s resignation. After an internal audit, the fraud was discovered, and WorldCom’s stock fell 90%. The company was forced into bankruptcy. This major scandal could have been avoided if insider trading was legal. The reason this happened is because the CEO of WorldCom, Bernard Ebbers, had over $400 million of personal loans taken out, and all of his fortune was in shares of WorldCom stock. After he noticed the major losses, Ebbers realized that he had two options; one option was to let the stock fall, inevitably turning his fortune to dust. On the other end, he could fraudulently report WorldCom’s income, hoping WorldCom’s revenues would come back before he would be caught. Ebbers’s actions not only hurt investors worldwide, but also the thousands of employees who became unemployed from this scandal. In a perfectly ethical world, we would expect Ebbers to have reported the losses right away, but that is not the world we live in. If insider trading was legal, or regulations on trading were less restrictive, Ebbers could have sold his stock before announcing his company’s losses, which would have allowed him to repay his loans. While this still would affect some who bought the stock before the price drop, the price wouldn’t have dropped anywhere close to 90%, and his company would still be running today, instead of leaving nearly 100,000 people unemployed. By making insider trading legal, the SEC could drastically reduce the risk of accounting fraud occurring in large corporations, making society better off as a whole rather than the individuals who would potentially lose from their investments (Wagner 972-1016).
When insider trading is illegal in a market, I believe it actually creates an illusion of “fairness” to its investors. Since there is information that insiders know about, but are not allowed to invest based upon, stock prices are not going to be as accurate as they should be, and many personal investors are being deceived. While insiders may know about a potential takeover, they are not currently able to invest based upon this information that could be extremely valuable to the price of that certain stock, thus creating the illusion that the price is fair, when it actually may not be even close to fair. This goes back to my point about Richard T. DeGeorge being incorrect in his argument. Another way in which insider trading creates fairness in a market is by cancelling out the deception of price caused by inaccurate valuations that currently happens in markets where insider trading is illegal. John Carney, a senior editor for CNBC.com, brought this concept to my attention. If investors are aware of the fact that there are insiders with information that creates an advantage for them, then some personal investors will be deterred away from investing, realizing it can be a “sucker’s game”, and thus will be better off financially.
Loss prevention can come from insider trading as well. Let’s say that I am looking into investing into a certain company, X. I have done my research on the company, and I’ve decided to buy shares of their stock. Let’s also say that company X is in an unannounced slump, and their stock price is higher than their profits indicate it should be. If I were to buy this stock as planned, and later the company showed their quarter losses, I would lose big time, as the stock would plummet. Now let’s say insider trading is legal. Let’s say that I still am interested in stock X, and there are multiple insiders who are aware of the losses of company X that will attribute to the future price of the stock. At this point, they will compete for me to buy their shares, thus lowering the price. In the end I will still lose once the company is exposed and the price plummets, but this time I will lose by less than the previous scenario. After all, in each scenario I had the intentions to buy the stock, and I was unaware of the inaccuracy in price. Only in the situation in which insider trading is legal was I able to pay the lowest price, as the information available to the multiple insiders contributed to a more accurate price point. This is exactly why the strong form efficient markets will eventually make all price points filter closer their correct levels.
A major counter argument to the efficient market hypothesis is that even in strong form efficient markets prices are fluctuating. A common misconception is that if the market is efficient, the price will find its correct level and stay there. This is completely wrong because those with that belief often fail to realize that new information is found every day, and this new information, whether public or private, is going to affect the price at some point in time. A second counter argument may be that if the market is efficient, no one will make money because by definition of total market efficiency, all net present values of investments will equal zero (Ross 337). My counterclaim to that argument is that there will never be such thing as a totally efficient market. There will always be some form of inefficiency in the market, but they will all be so small that they often will go unnoticed. This also implies that just because a market is efficient, does not mean that people will be mistake-free when choosing investments.
In the end, insider trading’s illegal status in the United States prevents the market from achieving a level of strong form market efficiency. In addition, its illegality creates an illusion of fairness by not allowing stocks to be traded by using the most accurate information available at the time of trade, whether private or public. The “fairness” argument against insider trading subjects society to a greater potential level of hurt compared to the select individuals who stand to lose or gain as a result of their practices. Insider trading should be legal because it reinforces the efficiency of a market and, in turn, provides a more objective judgment of a corporation’s financial standing in a time when the market is more volatile and globalized than ever before.
Works Cited
Carney, John. "Why Insider Trading Should Be Legal." CNBC. N.p., 26 July 2013. Web. 28 Nov. 2015.
DeGeorge, Richard T. "Ethics and the Financial Community: An Overivew." 2015. Ethics and the Investment Industry. By Oliver F. Williams, Frank K. Reilly, and John W. Houck. Savage, MD: Rowman & Littlefield, 1989. 93-96. Print.
Ross, Stephen A., Randolph Westerfield, and Bradford D. Jordan. Essentials of Corporate Finance. 8th ed. Boston, MA: McGraw-Hill/Irwin, 2004. Print.
Wagner, Robert. "GORDON GEKKO TO THE RESCUE?: INSIDER TRADING AS A TOOL TO COMBAT ACCOUNTING FRAUD." University of Cincinnati Law Review 79.3 (2011): 972-1016. Web. 28 Nov. 2015.