University of Porto

FEP - School of Management and Economics

Master in Finance

Insider Trading
Group-work Assignment

Students: Mariami Mindiashvili

Stefanie Lbke
Monica Pedro
Ana Rita Bento

Professor: Joao Lobao

Porto, 2013
 Table of Contents

1. Abstract
2. Introduction of the subject: Insider trading, Inside Information, Corporate Insiders
3. Illegal and legal insider trading
4. Regulation of insider trading, US approach
5. Should insider trading be legalized or not?
6. Market Efficiency, effects on insider-trading.
7. Empirical Data
8. Conclusion
9. References
Abstract

In this paper we try to define main concepts of Insider Trading, though being complex legal
concepts, subject to considerable interpretations. The concepts covered include: Insider
Trading, Inside Information, Corporate Insiders and others depending on the country. We refer
to the definitions offered by US and UK laws and regulations.
Then next chapter covers distinction between legal and illegal insider trading, their definition,
and different approaches.
In the next chapter we explain how regulators enforce insider-trading laws, on the example of
US Securities and Exchange Commission regulations. We also present different views whether
it should be regulated and restricted or not. According to the arguments provided, we introduce
our vision. Also, we will identify the effects that insider trading has on the markets and the
overall economy, based on empirical data.
We are then going to analyse and evaluate the various arguments, for and against the need for
regulation, its appropriateness, and how it may affect the workings in the financial markets.
 Definition of the main concepts: Insider Trading, Inside Information and
Corporate Insiders

There is an evidence of Insider trading when traders base their trades on material
information about the value of a financial instrument that is not publicly available. Mostly, it
involves private information that corporate managers know about the prospects and future of
their company.
In most countries, insider trading is punishable by fines or imprisonment. Insider trading
laws are difficult to enforce. However, United States, Canada and UK regularly and seriously
attempt to enforce laws and regulation concerning the subject.
Insider trading has different economic effects. In financial markets it affects investor
confidence, liquidity and price efficiency. More broadly, it affects the quality of management
decisions.
Inside information and insider trading are complex legal concepts, subject to considerable
interpretations. To have better understanding of the subject, we shall refer to the basic
definitions.
There is a fundamental difference between the legal and economic definitions of insider
trading. Insider trading in an economic sense is trading by parties who are better informed than
their trading partners and in that sense, insider trading includes all trades, whether or not in
securities, where information is asymmetric. On the other hand, insider trading in a legal sense
refers to transactions in a companys securities, made by corporate insiders, based on
information originating within the firm that would, if known publicly, affect the prices of that
securities.

Corporate insiders are individuals who are or were connected with the company or are
deemed to have been connected with the company and are reasonably expected to have access,
to unpublished price sensitive information in respect of securities of the company.

Connected persons include the following:

1) Director of the company

2) Person deemed to be director of the company

3) Person occupying the position as an officer or an employee of the company

4) Person holding a position involving a professional or business relationship between himself
and the company and who may reasonably be expected to have an access to unpublished price
sensitive information relating to that company.

The term insider, however, has occasionally been expanded to include a wide range of
persons with informational advantages, such as third parties with trade relationships with a
corporation (e.g. trade suppliers, subcontractors), security analysts to whom information has
been disclosed selectively, and even persons who accidentally acquired a piece of non-public
information.

A public company, if it is smart, limits the number of people who have access to material
information and, therefore, are considered insiders. This is done for a couple of reasons. First,
they want to limit the likelihood that anyone will leak the information. Second, being an
insider means being subject to severe limits on when you can trade in the company stock,
usually only the middle month of each quarter. The companys senior management are
insiders. So are some of the financial analysts. The top sales people usually also are insiders,
although a regional sales manager who only sees his or her own regions results may not be
one. The individuals in Investor Relations and/or Public Relations who prepare the public
announcements also are insiders. If the company is developing a new product that could be a
big seller, the key people in the Research & Development team would also be considered
insiders, provided the information they have is material. Other individuals who are not
employees, but with whom the company needs to share material information, are also insiders.
This list could include brokers, bankers, lawyers, etc.

Inside information is defined as information which relates or is of concern, directly or

indirectly, to a company, and is not generally known or published, but which if published or
known, is likely to materially affect the price of securities of that company in the market.

The following unpublished information can be considered as price sensitive:

1) Financial results of the company

2) Intended declaration of dividend

3) Issue of shares, rights issues, bonus issues, etc.

4) Expansion plans or execution of new projects

5) Mergers, acquisitions and takeovers

6) Disposal of the whole or substantially the whole of the undertaking

7) Such other information as may affect the earning of the company

8) Changes in policies, plans or operations of the company

Insider trading is defined by statutory laws, government regulations and case law created by
successful attempts to prosecute inside traders. The U.S. Securities and Exchange Commission
provides a one-paragraph definition of insider trading on its Web page:
Insider trading refers generally to buying or selling a security, in breach of a fiduciary duty
or other relationship of trust and confidence, while in possession of material, non-public
information about the security. Insider trading violations may also include "tipping" such
information, securities trading by the person "tipped," and securities trading by those who
misappropriate such information.
Examples of insider trading cases that have been brought by the SEC are cases against:

Corporate officers, directors, and employees who traded the corporation's securities after
learning of significant, confidential corporate developments;
Friends, business associates, family members, and other "tippees" of such officers,
directors, and employees, who traded the securities after receiving such information;
Employees of law, banking, brokerage and printing firms who were given such
information to provide services to the corporation whose securities they traded;
Government employees who learned of such information because of their employment by
the government; and
Other persons who misappropriated, and took advantage of, confidential information from
their employers.
These example fully illustrates the complexity of the law on insider trading.

In case of UK, the definitions and rules on insider trading are defined in The Criminal
Justice Act 1993 (CJA). Instead of term insider trading UK legislation uses different term,
insider dealing. So we shall use the same term while referring to UK definitions of insider
trading.
According to CJA, Insider dealing is dealing in securities while in possession of inside
information as an insider, the securities being price-affected by the information.
For the purposes of this definition, securities include shares and associated derivatives, debt
securities and warranties.
 The term inside information is 'price sensitive information' relating to a particular issuer of
securities that are price-affected and not to securities generally. Inside information must, if
made public, be likely to have a significant effect on price and it must be specific or precise.
Specific would, for example, mean information that a takeover bid would be made for a
specific company; precise information would be details of how much would be offered for
shares.
Insiders
Under s 57 a person has information as a primary insider if it is (and they know it is) inside
information, and if they have it (and know they have) from an inside source:
Through being a director, employee or shareholder of an issuer of securities
Through access because of employment, office or profession
If the direct or indirect source is a person within these two previous categories then the person
who has inside information from this source is a secondary insider.
'Made public'
This term is not exhaustively defined by the statute, leaving final determination to the UK
Court. Information is made public if:
It is published under the rules of the regulated market, such as the Stock Exchange
It is in public records, for example, notices in the London Gazette
It can readily be acquired by those likely to deal
It is derived from public information
Information may be treated as made public even though:
It can only be acquired by exercising diligence or expertise (thus helping analysts to
avoid liability).
It is communicated only to a section of the public (thus protecting the 'brokers' lunch'
where a company informs only selected City sources of important information).
It can be acquired only by observation.
It is communicated only on a payment of a fee or is published outside the UK.

To sum up, the theory behind the aims of statutory definitions of insider trading is that it ruins investor
confidence in the fairness and integrity of the securities markets. These two countries claim, that the
detection and prosecution of insider trading is one of their enforcement priorities, and all investors must be
aware of the potential danger in trading on a "tip" from someone who knows non-public information
regarding a security.
 Should insider trading be regulated or not?

Insider trading is one of the most controversial aspects of securities regulation. The question about
whether it should be regulated or not has been discussed a lot among economists, finance specialists and
lawyers.
One part of scholars consider, that insider trading ought to be prohibited because it discourages
investment in markets resulting in interruption of capital markets development. Also, they
argue, that it violates the fiduciary duties that corporate employees, as agents, owe to the
shareholders (Wilgus 1910). A related argument is that, because managers control inside
information, as well as its access and disclosure, they can transfer wealth from outsiders to
themselves in a hidden way (Brudney 1979; Clark 1986). The economic explanation for
prohibiting insider trading is that such trading can negatively affect securities markets (Khanna
1997) or decrease the firms value (Haft 1982).

Regulation of insider trading is beneficial for some participants of the financial market. The
first part are brokers, dealers, securities analysts, arbitrageurs and traders. They possess an
advantage over public investors in collecting and analysing information (Haddock and Macey
1987). The second group are the regulators, as they gain greater power, prestige and budget
(Bainbridge 2002).

Following Henry Manne (1969)'s publication of Insider Trading and the Stock Market (1969),
the debate surrounding the question of insider trading and whether or not it should be regulated
has received a lot of attention from lawyers, economists, and financiers The major questions
economists tried to answer about this subject are: How extensively should insider trading be
restricted? Should it be mandatory or regulated by government? Would it be better to leave it to
be voluntary by individual companies and securities exchanges? Empirical research about these
areas mostly has focused on the effectiveness of regulation and the effects of insider trading on
securities prices and market efficiency.

Scientists agree that insiders transactions signal future price trends to people, so that current
stock price reflects relevant information sooner, moving current market price close to the future
post-disclosure price. The overall effect is making markets more efficient. There is a little
disagreement whether insider trading is more than public disclosure or not. Insider tradings
advantage is that it does not directly reveal sensitive corporate information, and reduces the
managements displeasure to disclosing negative information. Insider tradings potential
disadvantage is that it may be a more ambiguous and less reliable signal than disclosure
Empirical work demonstrates that insider trading does move prices in the correct direction
(Meulbroek 1992). Some researchers argue, that this phenomenon only redistributes wealth
rather than making capital allocation more efficient, because insider trading speeds up the
process by only a few days or weeks without affecting the long-run attractiveness of a
company as an investment (Klock 1994).

One of the most discussed issue in the economic analysis of insider trading is whether it is an
efficient way to pay managers. Some researchers believe that insider trading gives manager
incentive to innovate, to take risks that increase the firms value (Carlton and Fischel 1983;
Manne 1966). Researchers have argued that compensation in the form of insider trading is
cheap as it does not come from corporate profits (Hu and Noe 1997). Their opponents say
that insider trading has some downside effects: it may encourage managers to disclose
information too soon or delay disclosure in order to arrange stock trades (Schotland 1967), to
delay transmitting information to corporate decision makers (Haft 1982), to pursue excessively
risky projects that increase trading profits but reduce corporate value (Easterbrook 1981). This
controversy is yet to be resolved and has not been tested empirically.

One more common argument is that the presence of insider trading deters many potential
investors from equity markets as decreases public confidence, because of that markets become
less liquid (Loss 1970). But trading with insiders more likely does not make investors refuse to
buy the security, they may just discount its price (Carney 1987). Some argue that insider
trading by increasing transaction costs harms market liquidity.

Empirical research generally shows that regulation of insider trading has been ineffective
internationally. Moreover, enforcement is costly and could be dangerously selective.

Despite various considerable debates, economists still do not agree on a desirable government
policy toward insider trading. On one hand, absolute information consistency is clearly
unattainable, and information-based trading generally increases the efficiency of financial
markets. It is difficult to control the use and dissemination of information. On the other hand,
insider trading may produce unintended negative consequences for the firm, or the market for
information. The incentive effects of insider trading and its impact on the functioning of firms
is not well known, but the effects of insider trading on securities prices and insiders profits
have been broadly studied empirically. Individual firms should compare negative and positive
consequences of insider trading and decide allow it or not in private contracts. What concerns
public regulation of insider trading, it should count on inefficiency of private enforcement or
insider tradings negative impact on securities markets.