What Is Insider Trading And Why Is It Illegal?

Insider trading is one aspect of the financial and stock market world in which confidence can really be shaken. It goes without saying that the very nature of insider dealing means that it must remain secret if it is to succeed and thus rarely do such stories come to light, so you won't read much about these trades in the Wall Street Journal or the Financial Times.

When such stories do make it into the daily news, trust in free and fair markets can be damaged. Rightly so.

As a crime, it could be argued that it is 'victimless' and that therefore, punishments are out of proportion to the offence. However, it can also be argued that by making profits in the market by using secret information, all investors in the specific company have lost out. By extension, those investors include people that hold the company stock via a pension or mutual fund. That can include almost everyone.

It should also be noted that in exceptional circumstances, a company may be adversely impacted by share price volatility which could cause job losses for staff. In financial companies, confidence is vitally important, and a swinging share price could - in theory - cause the end of a profitable company. Therefore, it seems entirely reasonable that governments should frown upon insider dealing and try to prosecute offenders where possible.

Insider dealing would generally involve a number of people. Firstly, there must be an 'insider'. This person will be privvy to knowledge that may not be general knowledge or many not even be in the public domain at all. This information may well be related to mergers and acquisitions as there will likely be big price movements as and when a deal is announced - thus offering quick profits and low investment risks.

Perhaps the most famous example of this is Martha Stewart, a television personality in the United States that was convicted of insider trading in her own company.

Watch These Free Videos And Learn How To Trade The Stock Market

Though mergers and acquisitions are obviously sensitive times in the course of a business, the extra numbers of analysts, lawyers and advisory staff offer unusual opportunities. The staff will be forced to sign NDAs - non disclosure agreements - but still, the exceptional profits are tempting.

If, for example, a company is undervalued and possibly vulnerable, other companies in the same sector will be looking at the possibility of a strategic purchase. The analysts and lawyers that begin to work on the deal - long before it exists - know that just the mention of a 'potential interest' in the market will likely send the price of the target company to rocket. Should a takeover not materialise, the insider that has arranged to purchase an interest will make very high percentage returns in a matter of just a few weeks.

It is very easy money.

The insider is likely to have friends or family members that are a party to the transaction. Their job will be to purchase company stock. This additional person, or group of people - who may or may not know each other - make investigation much harder since the link between information and purchase has been blurred or broken.

Quid pro quo

There is always the potential for an insider to not purchase but instead to 'sell' a tip to other fund managers or market participants for other funds and privileged clients. Alternatively, the purchase of their interest can be carried out through an offshore fund or account. This masks the nature of the deal further, making successful investigation of a number of types of stock fraud even harder.

In the fallout of the financial crisis of 2008, around 200 prosecutions of Wall Street insiders were successfully brought in the United States. Investigators tapped the telephones of Galleon Group and it's founder Raj Rajaratnam and discovered a web of high-powered fund managers and corporate executives that were exchanging and sharing tips and secrets. The investigators found buying and selling on the back of insider information and millions of dollars in profits.

To be able to investigate these matters, known as 'suspicious transactions', financial regulators need to be able trace and prove connections. This means that telephone, mobile communications and computer records need to be accessed. In addition, both personal and professional records are required. Needless to say, insider trading is not always easy to prove.

In the United States, immunity from prosecution can be granted to individuals in return for prosecution evidence. This is clearly a very valuable tool in breaking apart insider trading rings in the same way as used against criminal gangs such as The Mafia and anti-competitive companies. The Securities And Exchange Commission in the Unites States has incredible power!

This is clearly a very valuable tool in breaking apart insider trading rings in the same way as used against criminal gangs such as The Mafia and anti-competitive companies.

Watch These Free Videos And Learn How To Trade The Stock Market

It is also worth noting that there have been some very large firms implicated in such dodgy dealings. For example, in late July 2013, the hedge fund behemoth SAC Capital was charged - it is believed to have over US$14 billion in funds under management.

In contrast, the United Kingdom does not currently have these immunity powers which means that many cases are not brought to trial and those that are often collapse through lack of evidence. The UK Financial Services Authority has been quoted as saying that they believe up to a quarter of all takeovers and mergers involve some level of insider deal.

The scale of deals means that individuals can make incredible profits whilst not really influencing the overall scheme of events. For example, in 2007, the City of London Police investigated nearly 300 cases which totalled around £54 million. It must go without saying that there must have been many other transactions which were not deemed suspicious and to be investigated - despite their actual nature.

It is also possible for individuals to abuse a position of authority in the stock market by using, abusing and not declaring their full position. For example, journalists could promote a company when they actually own shares themselves which were bought specifically for the purpose!

An example of this was prosecuted in the United Kingdom in 2005. The "City Slickers" column in the Daily Mirror was used to promote small companies and more details can be read in this BBC story.

Size matters

These examples typically are a very complex form of fraud where the profits are made from an increase in prices. However, the really big financial crimes on Wall Street are those of embezzlement, such as committed by Bernie Madoff, where tens of billions of dollars appear to simply have been stolen from investors.

There was nothing 'insider' about this, it seems to have simply been theft - a giant Ponzi scheme - though it seems that the truth will never be fully discovered. While it is obvious that he could not have acted alone in something of this size, by confessing and taking full responsibility, it will be very difficult for other prosecutions to be brought. Madoff will die in prison.

Company policy?

One element that should worry us all, is that there does seem to be a lot of companies being fined for bad behaviour in both the US and UK. This is a worry because it is starting to feel as though breaking the rules (and therefore, the law) is institutionalised and company policy.

This is evident in part because the firms involved are some of the largest financial giants in the world and because they have been punished for manipulating entire markets. For example, JP Morgan was fined in July 2013 for manipulating energy markets, also in July 2013 Goldman Sachs has been accused of hoarding aluminium which impacts the spot price and a number of companies are implicated in the fixing of LIBOR rates.

None of these examples (there are more) is small beer - each one impacts many markets having an impact on hundreds or thousands of companies and many thousands of staff members. They are such big issues that it seems amazing that corporate management did not know about the practices. With such scandals unfolding and rolling along, it seems astonishing that the banking sector is undercapitalised and in need of assistance still from governments. Trust from the general public and regulators is limited.

Even smaller scale financial frauds (such as the ones mentioned in (this BBC article) mostly total in the millions of dollars. As the article describes, many financial frauds committed by financial advisers and stockbrokers are very low tech and simply opportunistic. That is reassuring that the entire firm isn't involved, but still disconcerting from the perspective of an investor.

To read more about related topics, please also visit:

Are There Really Any Stock Exchange Secrets?

Are Corporate Executives Privvy To Stock Exchange Secrets?

Are Merchant Banks Trading Using Stock Exchange Secrets? 

Are Some Stock Exchange Secrets Available To Everyone?

What Do Central Banks Do? Do They Influence Stock Markets?

Stock Exchange Information

Stock Market Corruption - Just How Common Is It?

What Is High Frequency Trading?

Is The Stock Market For Kids?

What Is After Hours Stock Trading?