Why Is Insider Trading Illegal?
Insider trading is the practice of trading a stock, a bond, a stock option, or other securities by individuals that have access to information about the company that has not been made public. The United States actually have the strictest insider trade laws.
The bulk of reasoning behind the current restrictions and laws that prohibit insider trading date back to the 1920s and the stock market crash of 1929.
After the stock market crashed, numerous individuals claimed that the market itself was rigged. They claimed that there were certain individuals on the “inside” who made money from the market, while the majority of individuals suffered.
These claims were not unfounded. There were groups of traders that would run the prices of stocks higher, and then announce news that would entice the public to purchase the stocks. These “groups” were usually bank insiders, or Wall Street bankers.
The public, seeing the higher price and hearing the exciting news, would rush to purchase the stock. These insiders would then sell their stocks, the stock would drop, and the public would be the ones that suffered from the trade.
What Exactly Is Illegal?
Actually, not all insider trading is illegal in the United States. Obviously, individuals know certain information about their own companies and still purchase stock or sell stock from their companies.
This is a form of legal insider trading—when a CEO or a company insider purchases or sells stock from their own company. However, they must notify the SEC of these trades. The SEC can then notify the public about these purchases, so that the public gains a little bit of information about the purchase or sale as well.
Restrictions on Insider Trading
Thus, the SEC and the courts began to instill restrictions against insider trading for the purpose of making the stock market fairer to the public. Specifically, a number of court cases have influenced insider trading restrictions by supporting the SEC’s restrictions, as well as prohibiting companies or individuals from acting in certain ways.
In the 1966 case of SEC v. Texas Gulf Sulphur, Co, a federal court ruled that anyone who possessed insider trading information had to either disclose it to the public or the SEC, or refrain from trading that stock.
In 1984, the Court made an important ruling against tippees. Tippees are individuals who receive second hand information, and tippers are the individuals that pass on the information. In the case of Dirks v. SEC, the Supreme Court ruled that tippees are liable for being guilty of insider trading if the tippee should have realized that the tipper had breached a fiduciary duty to disclose confidential information and the tipper was receiving a personal benefit by disclosing the information to the tippee.
In 1986, in the case of United States v. Carpenter, the Supreme Court placed the majority of responsibility on the individual who received the insider information from a journalist, rather than placing blame on the company.
In 1997, in the case of United States v. O’Hagan, the Supreme Court adopted the misappropriation theory that is used today with insider trading. The theory believes that a person commits fraud “in connection with” a securities transaction when he or she misappropriates confidential information that is used for securities trading purposes. According to the Supreme Court, the company’s information is its property. Another individual cannot misappropriate this information for his or her financial gain.
Other Regulations
Outside of the court rulings that have helped shape the definition of insider trading and what is legal and what is not, the SEC have created several regulations to curb the practice of insider trading. The SEC created the Fair Disclosure regulation which states that if one company intentionally discloses material that is not known to the public to one individual, it has to simultaneously disclose it to all individuals.