Why Should Insider Trading Be Illegal? (2024)

In investing law, an insider is someone who is in a position in a company that gives them significant access to information that is important to investors. Insider trading is the purchase or sale of securities by someone with material information that is not public knowledge. Trading by insiders is legal when someone with significant privileged access to information makes a trade and reports it. The debate about insider trading is whether it should be legal or illegal.

Insider trading is not limited to company management, directors, and employees. Outside investors, brokers, and fund managers can also violate insider trading laws if they gain access to nonpublic, materially significant information.

Arguments for Insider Trading

Many arguments support legalizing insider trading. They range from ambiguity in the language of the law to information automatically being reflected in the price. Here are a few.

Price Is Reflected By Non-Public Information

One argument favoring insider trading is that it allows nonpublic information to be reflected in a security's price without being public information. Critics of illegal insider trading claim that it would make the markets more efficient if it were legal.

For example, one thought is that as insiders and others with nonpublic information buy or sell the shares of a company, the price movements caused by the selling convey information to other investors. Current investors can trade on the price movements, and prospective investors can do the same. Prospective investors could buy at better prices, while current ones could sell at better prices.

Delays the Inevitable

Another argument favoring insider trading is that barring the practice only delays the inevitable and leads to investor errors. For example, suppose an insider has news about a company that they know will increase its stock value but is prevented from buying the stock or communicating the news. Non-insiders do not have the information, so they continue selling their holdings. Once the information is released officially by the company, it takes a few days to circulate the market, preventing those who kept selling from benefitting from an earlier price increase.

The theory holds that if the insider could have immediately begun to buy shares, share prices would have increased. Other investors would have noticed and could have held their shares or bought more. So, the price increase or decrease is believed to be only delayed.

Leads To Investor Errors

Barring investors from readily receiving or indirectly getting information through price movements can lead to errors. They might buy or sell a stock they otherwise would not have traded if the information had been available earlier.

Laws against insider trading, especially when vigorously enforced, can result in innocent people going to prison. As rules become more complex, it becomes harder to know what is or is not legal, resulting in participants accidentally breaking the law without knowing so.

Causes False Accusations

Someone with access to material nonpublic information might accidentally disclose it to a visiting relative. If the relative acts on that information and gets caught, the person who accidentally revealed it might also go to prison.

Not Worth Prosecuting

Yet another argument for allowing insider trading is that it is not severe enough to be worth prosecuting. The government must spend its limited resources catching nonviolent traders to enforce laws against insider trading. There is an opportunity cost to going after insider trading because the government must divert those resources from more serious investigations.

Arguments Against Insider Trading

As with arguments for insider trading, there are numerous arguments against legalizing it.

Creates an Unfair Market

One argument against insider trading is that if a select few people trade on material nonpublic information, the public might perceive markets as unfair. That could undermine confidence in the financial system, and retail investors will not want to participate in rigged markets.

Insiders with nonpublic information could avoid losses and benefit from gains. That effectively eliminates the inherent risk that investors without the undisclosed information take on by investing. As the public gave up on markets, firms would have more difficulty raising funds. Eventually, there might be few outsiders left.

Keeps the Investing Public From Benefitting

Another argument against insider trading is that it robs the investors without nonpublic information of receiving the full value for their securities. If nonpublic information became widely known before insider trading occurred, the markets would integrate that information, resulting in accurately priced securities.

For example, suppose a pharmaceutical company has success in its Phase 3 trials for a new vaccine and will make that information public in a week. Then, there is an opportunity for an investor with that nonpublic information to exploit it.

Such an investor could purchase the pharmaceutical company's stock before the public release of the information. The investor could significantly benefit from a rise in the price after the news is made public by buying call options. The investor who sold the shares without knowledge of the success of the Phase 3 trials probably would not have done so with the full information.

Promotes Unethical Trading Practices

If insider trading were legalized, it would allow people with information to take advantage of those who don't have it. An insider with knowledge that an energy research company had discovered an energy source that produced more energy than it consumed would stand to benefit significantly from a stock purchase. That investor could begin purchasing shares at prices other investors believed to be a premium, essentially robbing them of the opportunity to benefit.

The Legality of Insider Trading

Certain types of insider trading have become illegal through court interpretations of other laws, such as the Securities Exchange Act of 1934. Insider trading by a company's directors can be legal as long as they disclose their buying or selling activity to the Securities and Exchange Commission (SEC), and that information subsequently becomes public.

For many years, insider trading laws did not apply to members of Congress. Some lawmakers sought to profit from material nonpublic information during the 2008 financial crisis, bringing this issue to the public's attention. Congress overwhelmingly passed the STOCK Act to remedy this situation, and President Barack Obama signed it into law in 2012.

Example of Insider Trading

An example of insider trading involves Michael Milken, known as the Junk Bond King throughout the 1980s. Milken was famous for trading junk bonds and helped develop the market for below-investment-grade debt during his tenure at the now-defunct investment bank Drexel Burnham Lambert.

Milken was accused of using nonpublic information related to junk bond deals that were being orchestrated by investors and companies to take over other companies. He was charged with using such information to purchase stock in the takeover targets and benefiting from the rise in their stock prices on the takeover announcements.

Suppose the investors selling their stock to Milken had known that bond deals were being arranged to finance the purchase of those companies. There's a good chance they would have held onto their shares to gain from the appreciation. Instead, the information was nonpublic, and only people in Milken's position could benefit. Milken eventually pleaded guilty to securities fraud, paid a $600 million fine, was banned from the securities industry for life, and served two years in prison.

The Bottom Line

Insider trading has both proponents and critics. Those against insider trading believe it tips the balance in favor of those with nonpublic information. Advocates of insider trading believe that it avoids risks and makes markets more efficient.

Regardless of an individual's stance, insider trading is illegal and can be punished through fines and time in prison.