Insider Trading Liability and Enforcement Strategy
Arshadi, Nasser, Financial Management
On the grounds that insider trading undermines investor confidence in the fairness and integrity of the securities markets, the Securities and Exchange Commission (SEC) has made the detection and prosecution of illegal insider trading one of its enforcement priorities. To that end, the SEC has functioned both as the chief enforcer of the insider trading laws and as a powerful lobbyist behind new legislation to counter obstacles faced in prosecuting insider trading cases. This has provided the SEC with an unprecedented power not only to enforce the law but also to reshape it to fit its intended goal.
The restrictive regulatory environment and vigorous enforcement by the SEC create the expectation that illegal insider trading will be deterred. Surprisingly, the empirical literature in finance concludes otherwise. For example, Seyhun (1992) concludes that the statutes enacted during the 1980s did not provide additional effective constraints on insider trading. Meulbroek and Hart (1997) find that takeovers with detected illegal insider trading have takeover premia approximately 10 percentage points, or almost one-third, higher than that of a control sample. Arshadi and Eyssell (1993) summarize empirical findings in the literature and conclude that:
"1) despite six decades of anti-insider trading laws, transactions based on material non-public information have continued; 2) the profitability of insider trading has increased over time; 3) registered insiders whose trading is required by law to be disclosed regularly to the SEC have abstained from illegal trading at least in their own names; and 4) ...the evidence strongly supports the contention that insider trading has merely shifted from registered insiders to outside-insiders without a discernible decline in total volume" (p. 120).(1)
I contend that the somewhat puzzling empirical findings can be partially explained by consideration of the laws restricting insider trading. This paper examines legal theories of insider trading and government enforcement efforts in order to shed light on the intricacies of the law and to evaluate the ability of the regulatory structure to cope with the problem of illegal insider trading.
The remainder of the paper proceeds as follows. Section I examines legal theories of insider trading liability that are used by the regulatory authorities to prosecute insider traders. Section II explores the notion of regulation by enforcement where the SEC develops new legal standards as the need arises instead of establishing systematic regulations of the prohibited conduct. Section III presents hypothetical cases of insider trading and discusses the reasons they may or may not be legal under the current law. Section IV concludes the paper with recommendations for future research. The Appendix provides useful background information, including a definition of insider trading and categories of insiders.
I. Legal Theories of Insider Trading Liability
The principal laws that cover illegal insider trading include: 1) the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (the Exchange Act); 2) the SEC rules issued based on provisions of the Exchange Act; 3) amendments to the Exchange Act including the Insider Trading Sanctions Act (ITSA), and the Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA); 4) laws unrelated to securities laws that are used against insider trading, e.g., the Racketeer Influenced and Corrupt Organization Act of 1970 (RICO); and 5) the extant case law and Supreme Court rulings.(2)
A. Section 16(b)
Before the passage of the Exchange Act, no regulation prohibited insider trading. Cases against insider trading were decided on the basis of existing common law and were often unsuccessful. During this period, insider trading was treated as an acceptable perquisite for corporate insiders.
The Exchange Act dealt explicitly with the issue of corporate insider trading. …