Why is insider trading illegal?

Question

I feel I must first make the confession that I know very little about stocks and trading them. But when I heard the news of Raj Rajaratnam convicted and what he was convicted of (insider trading), it go me to thinking. Why is it considered illegal? Isn't using privileged information when trading stocks akin to having a "secret formula" that you keep from your competitors?

Answer 1

A practical issue is that insider trading transfers wealth from most investors to the few insiders. If this were permitted, non-insiders would rarely make any money, and they'd stop investing. That would then defeat the purpose of the capital markets which is to attract capital.

A moral issue is that managers and operators of a company should act in shareholders' interests. Insider trading directly takes money from other shareholders and transfers it to the insider. It's a nasty conflict of interest (and would allow any CEO of a public company to make ton of money quickly, regardless of their job performance).

In short, shareholders and management should succeed or suffer together, so their interests are as aligned as possible and managers have the proper incentives.

Answer 2

@sdg - If you can be flippant, I can be pedantic. Insider Trading is not illegal. Any employee of a company can be an insider, yet most of their trades are perfectly legal. What is illegal is trading on Inside Information. Such information may be available to those within a company, or those who have some contact with an employee. In fact, if I am seated at a restaurant table and hear Bill and Warren talking about a purchase they plan to make, I am in possession of inside information and risk prosecution should I purchase shares and profit. Often, a company will have a "quiet period" before earnings reports or potential stock-price-moving-news. During this time, employees are forbidden from buying or selling shares, excluding those that would be automatically bought in their retirement accounts or ESPP.

Answer 3

I'm surprised at the tone of the answers to this question!

Trading with insider information is corruption and encourages fraud. As in many areas, there's an ethical line where behavior the gap between "ok" and "illegal" or unethical is thin.

The classic local government insider information example is when the local councilman finds out that a highway exit is being constructed in an area that consists mostly of farmland. Knowing this, he buys out the farmers at what they think is a premium, and turns around for 10x profit a few months later.

In that context, do you think that the councilman acting on that insider information is committing a crime or ethical lapse? Most people say yes.

Even in this case, the line is thin. If the same councilman has his finger on the pulse of growth patterns in the area, and realizes that the terrain makes a certain area a prime candiate for a highway and exit, buying up land would not be criminal -- but it would be risky as it creates a perception that he is abusing his position.

Answer 4

To be flippant: it is illegal because it is against the law; there is no considered involved, it just is.

To elaborate, part of the illusion of the stock exchange and other market-like entities is that of (apparent) fairness.

If I think a stock will go up because it is involved in a growing industry, that is generally public information. Conversely if I have a dim view of a particular company because of its track record of product launches, that is similarly out in the open.

A secret formula is something that I invented or discovered, not (presumably) something that I stole from someone else.

To stretch that further: If I notice that Company X stock always moves with Company Y stock, that is indeed something that I have found, that I can try to profit from. It is secret to me, but not particularly dependent upon information not available to others, just that my interpretation is better.

So trading on information in the public domain is fine, as it preserves the principal of fairness I mentioned, whereas inside knowledge breaks that principal.

Answer 5

Capitalism works best when there is transparency. Your secret formula for wealth in the stocks should be based on a fair and free market, as sdg said, it is your clever interpretation of the facts, not the facts themselves. The keyword is fair.

Secrets are useful for manufacturing or production, which is only a small part of capitalism. Even then we had to devise a system to protect ideas (patents, trademarks and copyrights) because as they succeed in the market, their secrecy goes away quickly.

Answer 6

Illusions of transparency. Mitigation of risk. Emotion. The system.

Short answer per sdg's post - it's the law.

Long answer which I wont get into - it's a philosophical stance. It makes people feel better. It encourages a sense of "the system really does work."

Answer 7

"Secret formulas" are legal, "privileged information" is not. And that may be the whole point.

People are allowed to trade stocks profitably if doing so results only from their skill. A "secret formula" (for evaluating information) is part of that skill.

But having "privileged information" is not considered skill. It is considered an unfair, illegal advantage. Because company officials (and others) with privileged information are 1) not permitted to trade stocks while that information is privileged and 2) are not allowed to share that information with others. Inevitably, some do one or the other, which is why they are prosecuted.

"Raj" took the process to new highs (or lows). He not only "dealt" in privileged information, he PAID for it. Anything from a new car or house to $500,000 a year in cash. In essence, he had a bunch of strategically placed "spies" inside or close to corporations including one on the board of Goldman Sachs, "selling out" their companies, and thereby practicing a form of corporate "treason."

Answer 8

It is illegal because laws are written by people, and laws of stock trade are written, in part, to make it appear "fair" and thus contribute to the willingness of the people to invest their money in that particular venue. Profiting from information on the stock market that some people have and some can't have is considered "unfair", since it presumably excludes the latter from profit-making opportunities and thus makes their trades less profitable than otherwise. Since it is universally felt so, people made laws that prohibit such behavior.

I am not aware of any research that shows beyond doubt that allowing insider trading would really ruin stock markets, but such thing would be very hard to prove. There are arguments to both sides, and the side that supports prohibiting such trade has a clear majority, so it is prohibited.

Answer 9

Most people are not insiders, so they support laws that pre-empt ways of defrauding them. Insider trading results in insiders making money at the outsiders' expense, as a result it is often banned in democratic countries.

Even an autocratic country has a reason to reduce insider trading. It is not hard to see that there is practically no point to trading as an outsider in a market where insider trading is common active. They would take all your money. The safe thing from you to do is withdraw from that market, and only invest in companies where you are an insider. The result is that most people will not invest in most stocks and there will be a capital shortage. This obviously grinds the economy to a halt - something most governments abhor, as a result they block insider trading to keep everything running smoothly.

Answer 10

Insider trading is considered illegal because it is considered fraud. This is true for both selling and buying.

Fraud on the selling side is easy to picture - insider sales are like a used car salesman who sells a car without mentioning critical issues. You knew it was flawed (about to lose value) and you then trick somebody into buying it to your benefit and their detriment.

Fraud on the buying side is trickier. Normal purchases don't require the buyer to disclose information about the property to the seller. But in insider purchases, the buyer (or whoever gave them the inside information) has a fiduciary duty to the seller, since companies and their executives owe a duty to their shareholders. Without the fiduciary duty, it's just somebody who thinks they've got a bargain buying from somebody who's willing to sell at that price. With the fiduciary duty, it's betraying a legal obligation.

Insider purchasing is the side that directly answers your question:

Isn't using privileged information when trading stocks akin to having a "secret formula" that you keep from your competitors?

Because NO, buying using privileged information when trading stocks is akin to having a secret formula that you keep from your shareholders.

Finally, some clarifications/definitions:

• Various countries have various standards on insider trading - the standard is by no means universal.
• Insider trading is not merely when insiders trade stocks. Insiders trade stocks all the time, and that's fine. Insider trading is when insiders trade stocks differently due to their non-public information. Most insiders trade very carefully to avoid being accused of "insider trading" - there are a variety of ways to do this, but the most common is to avoid trading anytime near a public announcement.
• It is possible to make money if you know almost anything about the future of a stock for certain - even knowing that the price won't deviate is enough to make money (e.g. the iron condor strategy.)