Is Insider Trading Moral Or Illegal Finance Essay - Free Essay Example

In the latest years insider trading scandals were, very often, holding the first page of well-known journals or news TV channels. Pushed by mass media, the public perception on insider trading has been tailored as something wrong, unethically scandalous, with bad influences on everybodys welfare. The most famous was Martha Stewarts case who was investigated for using inside information about ImClone, but, in fact, accused of deceiving, together with her broker, the Securities and Exchange Commission (SEC) by coming up with an implausible explanation of why she sold her shares. The case received a high amount of media attention, and scholars questioned journalists professionalism and judgment in this type of cases (Brinkley, 2008). In the United States, well-known companies were involved, directly or indirectly, in insider trading investigations initiated by SEC. In May 2010, Walt Disney Company had to face an insider trading investigation due to one of its employees actions. As presented by the SEC investigation (U.S. SEC, 2010), Bonnie Jean Hoxie, an administrative assistant to a high-level executive, and Yonni Sebbag, her boyfriend, got involved in a brazen scheme to sell material non-public information about Disneys financial results and strategic intentions. In 2006, Goldman Sachs former employees, Plotkin and Pajcin, were accused of organizing a widespread and brazen international scheme of insider trading (U.S. SEC, 2006), the illicit revenues resulted from this affair being of at least $6.8 million. In 2001, Microsofts securities traded by Pequot Capital Management on insider trading information supplied by David E. Zilkha (Microsofts employee) generated $14,769,960 gains to the Pequot funds (U.S. SEC, 2001). Behind these famous cases in which the gilt and illicit gain resulted from trading inside information are obvious, legal insider trading may exist (Shell, 2001) and many scholars talk about ethical forms of insider trading (McGee, 2004). This report will examine the theories applicable to insider trading legally and morality depending on the effects that insider trading may have on financial markets evolution. DEFINITION In 1934 Act, the U.S. Congress legislated insider trading as damaging practice for financial markets, delegating to the SEC regulating responsibilities. Consequently, the SEC defined insider trading as buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, non-public information about the security (U.S. SEC, 2010). In the same category, the SEC included tipping inside information, trading by the tipped ones, and trading by persons who steal this information. Additionally, two laws were enacted The Insider Trading and Securities Fraud Enforcement Act of 1988 and The International Securities Enforcement Cooperation Act of 1990 (U.S. SEC, 1998) to enlarge the SEC area of influence and regulation, not only inside the U.S., but also in relation with foreign organizations. To describe the financial market it can be said that in todays market selling or buying securities is much easier than a few years ago. Regardless the action initiated by one party, the final result is the same: acquiring or renouncing to a companys ownership. In 1966 Manne divided these shareholders into investors and traders based on their intentions timeline: long-term, stable revenues for investors and short-term, speculating gains. Considering the players presented above, acting on inside information means that one shareholder sells or buys securities after receiving non-public information about the company or other factors with significant impact on its financial results. The information can be delivered by a company insider, like executives or employees. The law condemns these types of practices, regardless the sources of information, the method of obtaining it, or its real effects on markets efficiency. If the legal requirements for insider trading are clear, rigidly specified by the law, not the same think can be said about the ethical approach of insider trading. Over time the trades based on inside information raised many reactions, with opinions ranging from one extreme to another. ETHICS CURRENTS AND RELATED THEORIES Overcoming the technical definition and analysing what notorious theorists have written about insider trading two different currents of opinions can be distinguished: (i) authors who strongly believed that insider trading is always illegal, immoral, harmful e.g. Werhane (1991), Moore (1990); (ii) authors with opposite positions, sustaining the beneficial effects of insider trading over markets efficiency e.g. Manne (1966), Leland (1992) Machan (1996), McGee (1999, 2004). A short overview of the arguments developed by these authors will be next presented. Moore (1990) examined the ethical reasons against insider trading, such as unfairness, misappropriation of information and damages to good-faith investors and markets, concluding that insider trading real harm are its effects on fiduciary relationships. Werhane (1991) stated that insider trading is unfair to shareholders and other managers from whom that information is withheld. The insider trading issue has been discuss ed for the first time in economic literature by St. Thomas Aquinas (1225-1274) in his Summa Theologica written in the thirteenth century (McGee, 1990). In his writing Aquinas argues that a merchant, arriving in a city to sell his wheat, is not under the obligation to inform his buyers that similar merchants are on their ways to the city. In other words, not disclosing non-public information and taking benefits of this action is not wrong. Manne (1966), a well-known defender of insider trading, insisted for not seeing it in white and black colours, but for deepening the analysis through some additional questions: first, trying to find the winners and losers from trading inside information; second, searching the long-term effects of insider trading; third, if trading on inside information is, indeed, evil finding the way to avoid it and evaluating the costs. Leland (1992) linked the concept of insider trading with markets uncertainty and their specific functioning mechanisms. In his research Leland showed that insider trading can have several benefits such as (i) shares prices reacting better and higher; (ii) markets delivering increased expected real investment; (iii) decreased liquidity; (iv) gains for both, insider traders and owners of investment projects; (v) outside investors and liquidity traders will be hurt. Machan (1996) explained that insider trading can be formulated as using for financial advantages the information acquired from non-public sources. The way the information is obtained and the causation of the insiders act can make the difference between fraudulent intentions and morally right actions. McGee (2007a) evaluated insider trading through ethics approach, concluding that this practice should not be prohibited by laws, unless clear damaging effects are identified violating private peoples rights or markets efficiency. Over time two main theories were used to assess the ethical side of insider trading: the utilitarian theory an d the right-based approach. Summarizing, the utilitarianism states that an action/situation is good as long as the benefits are higher than the costs. McGee (2007b) proposes a logic scheme to assess ethical side of utilitarianism (see appendix 1). Furthermore, additional conditions are included in the utilitarian equation, conditions related with assessing the breach of fiduciary duty before determining the gains (see appendix 2). Still, the utilitarian theory is not perfect and some problems can be mentioned (McGee, 2009), such as: (i) difficulties in measuring the gains and losses; (ii) individuals benefit or are harmed differently from certain rules; (iii) individuals have different utilities/values for different things; (iv) rights are not taken into consideration. Finding a perfect fit between utilitarian theory and insider trading is not obvious. When trading securities the estimation of gains and losses is almost impossible. Moreover, identifying buyers and sellers its not possible due to anonymous character of stocks trades. Those who are selling dont know the identity of those who are buying (Ali, P.U., Gregoriou, G.N., 2009). The reasons for trading are different among traders (investors or inside traders), and consequently they have different utilities of their investment decisions. Because estimates of gains and losses are no longer needed, the rights theory eliminates one of utilitarian theory weaknesses. Instead of questioning if gains are higher than losses, the new theory evaluates if someones rights were violated (McGee, 2009). As for the previous theory, a flowchart drawn by McGee simplifies the logic (see appendix 3). The rights theory encounters the same problem as utilitarian theory. The parties involved in trade are not known which makes it more difficult to identify their rights. Supporting the theory of rights Ali (2009) argues that it can be successfully applied only if the property limits are specified for both parties, wh ich is not always the case for insider trading. INSIDER TRADING LEGAL ASPECTS As mentioned before, the legal framework for insider trading is provided by the 1934 Act, sections 16(b) and 10(b). Sections 16(b) refers to companies insiders like executives, high-level employees and to shareholders who own more than 10% of the shares because, in legal view, they will be more incentivized to use inside, sensitive information due to their high stake in the company. The section censures only the profits obtained in less than six months period (U.S. SEC, 1998). Section 10(b) broadens the spectrum of activities considered as insider trading to any purchase or sale of any security registered or not registered, regardless the trades status, if its acted with manipulative or deceiving intentions (U.S. SEC, 1998). Trying to make the law as broaden as possible in order to include all types of frauds, the SECs approach leaves place for many interpretations and ingenious schemes. Summarizing, the insider trading can be proved with the existence of two criteria: (i) a dir ect or indirect source of non-public, corporate information, and (ii) the use of this information for personal benefits, consciously knowing that is not fair for other people who dont have access to the same information. In order to avoid charges, the insider should disclose his information prior to transactions or refrain from trading until the information is available to all market traders (U.S. SEC, 1998). The discussion of the legality of insider trading which does not involve market manipulation or abuse of dominant position must touch two critical points: (i) the existence of legal provisions related to insider trading effects on market which could, theoretically, differentiate the gravity of legal charges or set-up a different reason for acting on inside information; (ii) the fairness for other traders could have different levels? In its present form, the law does not specify legal distinctions based on the effects that insider trading could have on market operations . Acting on inside information to manipulate the market or abusing of the companies/personal dominant position may or may not be intermediary steps for those involved in insider trading, the final target remaining the achievement of personal financial advantages. As an exemplification, in 1998, Ma and Sun summarized the motives for which managers or shareholders would involve in insider trading as being: (i) portfolio diversification and liquidity adjustment; (ii) corporate control; (iii) sentimental reasons; (iv) insider trading based on private information. For all four reasons, the final outcomes are personal financial advantages for insiders involved in trading. In laws approach the use of inside information at a lower level which will not trigger a significant impact on market is not less serious than any other insider trading. Regardless the reasons or the amplitude of actions, the law is rigid in considering any form of insider trading as illegal. The same logic can be used to assess the level of fairness for other people trading in good faith. The fact that the insiders transactions dont have a significant amount cant change the unfairness of insider trading. The market traders still have different levels of information and act according to them. In conclusion, as long as the traders were performed on inside information, the actions effects are no longer relevant for the law. Insider trading is illegal. IS IT INSIDER TRADING MORALLY RIGHT? In general insider trading practices are perceived as unfair and immoral behaviours with very bad consequences for markets and society, preventing equality among market players. Next to the law, ethical reasons are highly used for condemning insider trading. In 2002, Abdolmohammadi, M, and Sultan, J., showed that ethical reasoning is strongly linked with ethical behaviour, meaning that whenever a person uses ethical reasoning it is a low probability for that person to involve in insider trading. Still, part of scholars strongly state that insider trading can have favourable, morally acceptable, sides which may change the current black picture. In order to evaluate insider trading moral aspects a separation of market manipulation from acting on inside information must be made. This separation is based on Engelen and Liedekerkes reasoning (2007) who, starting from Mannes distinction between market manipulation and insider trading, argued that while insider trading by definition in creases market efficiency, market manipulation has not a positive effect on markets efficiency, deregulating dramatically the stocks price (see appendix 4). In assessing the morality issue of insider trading three dimensions can be considered: the relationships among financial markets players, the methods used to obtain inside information, the insider trading effects on market. Trades on todays financial markets imply the existence of sellers and buyers who dont know each other and who, a priori, have different amounts of information. At every moment in time, one seller/buyer may have information which is unknown to other players, information which are not necessarily obtained from inside. Using this information to trade cant be considered immoral or unfair for the rest of the market. Furthermore, there is no legal obligation to share it with other players (unless a previous contract with clear provisions exists). The same reasoning can be applied if we supplement this variati on of information among traders with inside information. The methods used to obtain or to diffuse inside information can be questionable. If the information is stolen, spied or extorted, that can be considered an immoral action, but doesnt make insider trading immoral (Machan, 1996). Obtaining the information and trading on it are two separate actions. One harmless way of obtaining non-public information can be by accident. Actually, Shell (2001), developing his reasoning for legal insider trading, described one innocent case of obtaining non-public information in an elevator, by accident. Insider trading can have favourable effects on financial markets. McGee (2007; 2009) summarizes all the arguments developed by theorists over time to sustain insider trading, arguments such as: (i) trading on inside information can be seen as a supplement to executives compensation, decreasing companies costs; (ii) acting on inside information increases market efficiency; (iii) rights-based arguments sustaining the owners right to use their properties as they want; (iv) insider trading can support management to fulfil its obligations to shareholders, meaning increased stocks prices. Next to these arguments the increased market liquidity (Aktas, N., et al., 2007) can be added. If the overall effects on market are positive, can we draw the conclusion that what is good for market (and, implicitly, for society and people) is also morally acceptable? The response could suggest that insider trading can be defined as moral as long as insider traders will not exaggerate in their practices only by motivating that is good for people, but using insider trading as a mechanism to leverage the market. Appendices Appendix 1 Modern Utilitarian Ethics Source: McGee, R.W., 2007b, A Flow Chart Approach to Analyzing the Ethics of Insider Trading, Andreas School of Business Working Paper Series, Barry University, Miami Shores, (September 2007), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1015052 Appendix 2 Electic Utilitarian Ethics Source: McGee, R.W., 2007b, A Flow Chart Approach to Analyzing the Ethics of Insider Trading, Andreas School of Business Working Paper Series, Barry University, Miami Shores, (September 2007), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1015052 Appendix 3 Rights-based Approach Source: McGee, R.W., 2007b, A Flow Chart Approach to Analyzing the Ethics of Insider Trading, Andreas School of Business Working Paper Series, Barry University, Miami Shores, (September 2007), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1015052 Appendix 4 The Impact of Insider Trading on Security Prices Source: Engelen, P.J., and Van Liedekerke, L., 2007, The Ethics of Insider Trading Revisited, Journal of Business Ethics, p. 497-507, Volume 74