Insider trading was at the heart of the legislation that brought the Securities and Exchange Commission (SEC) into existence. Albert H. Wiggin, the head of the Chase National Bank had actually shorted 40,000 shares of his own company. Simply put, he had a significant interest in running his company into the ground. This led to a 1934 revision of the Securities Act of 1933 that was much tougher on insider trading. Ever since Wiggin, insider trading has been one of the most contentious issues on Wall Street. In this article we will look at some bizarre and significant cases that have changed the way we view insider trading. (To learn more, see Policing The Securities Market: An Overview Of The SEC.)
One of the first challenges faced by the SEC in the '30s and '40s was how to define an insider. They settled on company officers, directors, and shareholders with 5% or more interest (called beneficial owners). These people had access to information, either formally or informally, before it was made public. Shorting your own company was outlawed and new disclosure requirements were set for insiders. If they did trade using their insider's edge, their profits would be forcibly returned, a fine levied, and they'd face possible jail time. The problem with the new rules was that no firm definition was made as to what constituted material facts, a.k.a. material insider information. (To learn more, see Defining Illegal Insider Trading.)
A Great Deal of Trouble
Two cases over the next two decades left Wall Street deeply confused over what counted as insider trading. In a 1942 case pitting Transamerica Corp against Axton-Fisher minority shareholders, Transamerica - a majority holder of Axton-Fisher - bought out the minority shareholders and then announced that it was liquidating an undervalued inventory of tobacco. The SEC ruled that giving the minority shareholders a lower price than they would have demanded had they realized the inventory was undervalued counted as fraud/insider trading. Before, this was simply smart business. This case effectively put the duty of disclosure on insiders, even if it hurt their potential profits.
The Waiting Period
The water was muddied further in 1959 when a geologist for Texas Gulf Sulphur Company discovered that a site up in Canada was rich in minerals. Not classified as an insider, the geologist told his friends to buy in to his company and bought in himself. Managers and other employees also increased their stock holdings in the company leading up to the official announcement. The SEC took everyone to court and lost - the court ruled that an educated guess can go both ways and employees investing in their company was a positive thing. It was a legitimate way for employees and management to derive additional compensation from their employers while also benefiting industry.
The SEC appealed and got all the decisions reversed, including the directors and managers who bought after the announcement because they did not allow enough time for the news to reach regular investors, Unfortunately, the court refused to define an amount of time that would have been sufficient to act as a future measure. The principle behind the decision was that all market participants must have equal information, and any with an informational edge must disclose or abstain before trading – a decision reinforcing the earlier Transamerica decision.
Raymond Dirks - Falling upon Deaf Ears
Clarity came in 1973 through one of the most flawed cases ever pursued by the SEC. Ronald Secrist, a former Equity Funding Corporation executive, wanted to act as a whistleblower and expose the insurance company's massive fraud. Other employees had attempted this, approaching both state regulators and the SEC at great personal and professional risk, only to be rebuffed. Instead, Secrist turned to analyst Raymond Dirks who believed his story and began to dig into the details. Dirks found ample evidence and took it to the Wall Street Journal. The Journal wouldn't publish anything about the case, delaying until a meeting could be held with Dirks, the whistleblowers and the SEC.
While his message was being ignored, Dirks advised his institutional clients get out of the stock. The Wall Street Journal helped break the news as the selling by Dirk's clients brought broad scrutiny to Equity Funding. When the SEC charges were finally laid, however, Dirks' name was on the list. Because Dirk received material insider information from a former exec and had his clients act upon it, he was guilty of facilitating insider trading. More significantly, these charges exposed him to Equity Funding shareholder lawsuits because he used insider info to damage their holdings.
Whereas management settled for fines or a little jail time, the charges were the start of a 10-year legal battle for Dirks that would go all the way to the Supreme Court. The SEC charged that Dirks was duty bound not to act on the info even though he was unable to turn the matter over to authorities. The Supreme Court found in Dirks' favor. It didn't want to discourage analysts from helping to uncover fraud. Dirks never made any money from exposing Equity Funding, and his case set the criteria to protect whistleblowers and others who expose information that is ultimately beneficial to society. (For more, read Uncovering Insider Trading.)
SEC Bulks Up Enforcement
Another case in the '70s imposed some more limits on the SEC's power to prosecute insider trading. Vincent Chiarella worked for a company specializing in financial printing, including tender offer sheets. Chiarella broke the code used to keep the takeover targets confidential and bought stock in the companies prior to takeover announcements. The Supreme Court ruled in favor of Chiarella because he had no fiduciary responsibility to the companies involved and thus could trade as he pleased. The court also commented on the impossibility of legislating equal information to all investors as well as the concept of information earned through intensive research as a type of property. In this view, property rights support those with informational edges making a profit from their knowledge.
As the Supreme Court tried to reign in the SEC's vague definitions and far-reaching enforcement powers, the SEC was beefing itself up. The 1984 and 1988 insider trading acts upped the penalties while still avoiding a true definition. Penalties were upped from five-10 years and fines jumped from $100,000-1 million for individuals and from $500,000-2.5 million for corporations who were found guilty. New rules made every company culpable for their employees' trades, not just executives, and special rules targeted tender sheet/takeover knowledge. In the SEC's eyes, everyone was an insider until proven guilty.
Although investors like Warren Buffett and Peter Lynch consider insider buying positive, the practice has become more risky for insiders. From 1934 to 1978 insider trading cases averaged slightly less than one a year. Since 1978, there have been dozens annually. There is growing dissension among economists and investors as to whether or not insider trading should even be regulated.
Conclusion: Should it be Illegal?
The argument against regulation is that insider trading adds a source of information to the market. By reacting to information earlier via insider buying or selling, a stocks price will not get terribly over- or undervalued. Buyers with insider knowledge are also likely to pay more for a stock, passing more to the seller who was ready to sell anyway. Whether or not we'll see insider trading legalized one day, it's clear that having a political organization with broad powers running the show isn't a perfect system either. While we don't want another Wiggin, we also don't want to prevent people from investing in their own companies. (For more, see Top 4 Most Scandalous Insider Trading Debacles.)