Blog Why is Insider Trading Bad

Why is Insider Trading Bad






For a long time now, there has been a debate in the financial and marketing community, with its academics and professionals expressing different views about the effect of insider trading.

The main question is whether insider trading is advantageous or disadvantageous to the markets.

This article explains why insider trading is bad. We’ve outlined a few examples that reveal why it’s not a risk worth taking. Read on to understand more about insider trading.

What is Insider Trading?

Insider trading refers to the purchase or sale of securities by someone with material information that’s not yet available to the public.

Mind you, this kind of trading is not limited to the company, its management, directors, and employees only.

On the contrary, outside investors, fund managers, and stockbrokers can also accomplish insider trading, violating its laws. This happens if they gain access to information that’s not in the public domain.

The Legality of Insider Trading

Before going into details of why this kind of trading is wrong, note that there’s one type of insider trading that’s legal and ethically acceptable—insider trading that a company’s directors or executives carry out. 

This legal insider trading involves the purchase and sale of their company shares. But they must disclose this to the Securities and Exchange Commission (SEC), which subsequently makes this information available to the public.

In general, there’s no law prohibiting investors from taking part in insider trading in most states. However, certain types of insider trading have been declared illegal by courts through their interpretation of laws such as the Securities Exchange Act of 1934.

Previously, insider trading laws applied to everyone except Congress members.

Some lawmakers seized the opportunity during the financial crisis in 2008 to profit themselves from material information that was not in the public domain. This caught the public’s attention, and Congress moved quickly, passing the STOCK Act to deal with the situation.

Later in 2012 is when President Obama signed the act to pass as a law.

Negative Effects of Insider Trading

Some of the reasons why insider trading is bad include:

1. It Compromises Transparency

Transparency is one of the principal values that govern how capital markets operate. Therefore, all investors should have access to the available information in the same capacity.

Let’s approach the issue of transparency in capital markets more simply. Consider, for example, being a shareholder in a company, and the company makes data on quarterly earnings only available to 50% of its investors, hiding the same from the other 50%. I’m sure you would not like this.

Similarly, this is what happens with insider trading. The fact that only a few of the participants in the market gain access to information that would have otherwise benefited everyone makes it ethically wrong.

2. Lack of Fairness

It’s no secret that insider trading is not fair at all. I’m sure you can relate to how difficult it is to make money in a capital market.

Now, to make it even more challenging, as a small investor, you are competing against others who are not only bigger and heavily pocketed.

If only some participants are privy to information, the playing ground becomes unfair. Therefore, if capital markets are to encourage more participation, equality is critical. Otherwise, insider trading will remain bad because of its lack of fairness.

3. It’s No Different to Thievery

Insider trading is an illegal act that involves the perpetrator, mostly an associate of a particular company, exploiting nonpublic material information for their selfish gains.

Often, this is information that the company plans to avail to the public sometime later.

The critical point here is that this is the company’s property. Therefore, when an insider trader ‘steals’ the information and releases it to the public domain without the company’s approval, there’s no difference between such action and what happens in a home burglary.

4. It’s a Confidence Killer

As an ordinary investor, anytime an insider trading scandal occurs, it damages your confidence in the capital market.

Imagine a situation where about five insider trading instances happen within a short period. It’s not only frustrating but demoralizing. Additionally, it leaves you wondering whether you’ll ever make money in stocks with unscrupulous insider traders out to play unfairly.

It’s a pity that inside trading drives investors away from the market. Unfortunately, this has consequences because the market will undoubtedly suffer liquidity issues, affecting everyone.

Examples of Insider Trading

To further demonstrate how bad insider trading is, below are two case examples of insider trading. In both, the perpetrators had to pay the price.

Insider trading has nothing good to offer. Instead, it gets ugly and leaves perpetrators with a bad public reputation, results in heavy penalties, and may even get you jailed.

#1 Martha Stewart Insider Trading Case

Martha Stewart, a well-known television star, was convicted and charged with insider buying and selling in 2004.

The lady owned inventory at ImClone Systems.

She received insider information that the biopharmaceutical firm would not have one of the drugs they were developing accepted by the FDA (Food and Drug Administration). Since this would result in substantial future losses, Martha acted quickly and sold some of her shares.

Martha further lied that she had planned to sell the shares beforehand. The court found her guilty of insider trading and lying, jailing her for five months.

What was the source of information? Her broker heard that the company’s CEO had sold his entire shares. And because Martha used nonpublic information to sell her shares and avoid loss, she was charged and paid dearly for it.

#2 Chris Collins Insider Trading Case

Chris Collins was convicted and charged with insider trading in 2018. He owned a large percentage of shares at Innate Immunotherapeutic Biotechnology Company.

Chris was accused of leaking nonpublic information to his father-in-law about a sclerosis drug the company was making.

You see, the trial test performed on Chris’s son was unsuccessful. The two gentlemen were quick to sell their shares before making the information public. They were evading making potentially huge losses.

Takeaway

Over the years, there have been many insider trading scandals globally. Generally, there’s just some negativity associated with insider trading. With all the bad things tied to insider trading, it’s no doubt a wrong thing. And although this doesn’t apply to all cases, it’s illegal, unethical, and unfair. All investors should have equal rights in a company or investment in which they own shares.