A Note on Insider Trading
9 Pages Posted: 21 Oct 2008
The action of insider trading is examined in its legal perspective--namely, as fraud. The proof of insider trading hinges on several factors including the definition of nonpublic information, the action of an insider who is consciously trading or enabling others to trade on inside information, and the breach of fiduciary responsibility. The "test of scienter" requires the deliberate attempt to deceive, manipulate, or defraud. This note examines several court cases in relation to these factors.
A NOTE ON INSIDER TRADING
The laws surrounding the issue of insider trading are not clear. Indeed, the term “insider trading” has never, in fact, been defined in a legal sense. The laws used to prosecute the offense are couched in other terms. Moreover, a great deal of uncertainty surrounds what is and isn't legal; with each successive court ruling minor legal interpretations change the prevailing understanding. Several laws have also been proposed in Congress, the passing of which would obviously change the legal “landscape,” as it were. However, a basic definition of insider trading might be the following: [Insider trading is] “Trading or taking action that causes others to trade on the basis of material, nonpublic information.” Insider trading can involve either the buying or selling of stock, but a number of complicating factors must be proved or disproved before a conviction is obtained. Therefore, when making decisions about insider trading, keep in mind that no definitive consensus exists about what it entails or what is illegal.
Insider trading is prosecuted under two principal sets of laws, neither of which refers to insider trading directly. (The Appendix briefly describes three well–known cases.) The primary law prohibiting insider trading is section 10(b) of the Securities Exchange Act of 1934. This law governs fraud, not “insider trading,” but the courts have decided that trading on the basis of material, nonpublic information constitutes fraud if the trader has a fiduciary relationship with the other party. That is, if a relationship of trust and responsibility exists between the two parties of the trade, an insider cannot take advantage of information known at the expense of the party to whom he or she is responsible. The clearest example of this definition of the term is a corporate executive buying the stock of their corporation the day before they know it is going to announce a revolutionary new product. This purchase violates the trust held by the company's stockholders. The executive defrauds them because the stock was bought at a lower price than the stockholder could have gotten a day later. Obviously, corporate employees, bankers, and stock brokers have a responsibility to the stockholders of a company, and are expected not to cheat them by “beating them to the punch” in either buying or selling stock.
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Keywords: business and society, fraud, investment banking, legal aspects, regulation
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