What is insider trading?
Insider trading involves trading in a public company’s stock by someone who has non-public, material information about that stock either as an employee, consultant, or one who has private access to inside information of the issuing company.
However, there are two types of insider trading. One is legal, and the other is illegal. Legal insider trading is when insiders trade the company’s securities (stock, bonds, etc.) and report the trades to the authorities such as the Securities and Exchange Commission (SEC). Insider trading is illegal when the material information is still non-public, and this sort of event comes with harsh consequences – this is our focus for today.
Effects of Illegal insider trading
Although insider trading seems victimless, in truth, it reduces investment, depresses stock market participation and liquidity. It also triggers additional adverse selection problems and inefficient corporate behaviors such as conflict of interest and financial fraud.
Engaging in insider trading increases information asymmetries in the market.Fernandes and Ferreira, 1846
One may say, ‘But it is a common white-collar practice’. Yes, however, common practice doesn’t mean good practice. Insider trading is unethical, expensive, and harmful.
As much as it enriches the insider trader, and some people will call it playing smart, it is unethical because it is an unfair practice. Using inside information to bid against players in the market with no equal information, can be harmful to the issuing company, the stock market, other shareholders, and the insider trader in the following ways discussed below:
It is harmful to public stockholders
Insider trading causes unfair harm to other shareholders of the company to whom the company owes a fiduciary obligation. It betrays shareholders’ trust. Considerably, the insider traders (employees or consultants) are using their advantage of inside eyes/ information to trade and make unfair gains, this is a breach of explicit and implicit contract agreement of trust and confidentiality which is vital to the health of the stock market.
Also, you will agree with me that is a greedy act and an outright rip-off on potential shareholders’ wealth – such that, insider traders as a group are appropriating profits that, but for their activity, would have gone to other shareholders as a group, past and present. It is to the shareholders as a group, including the past, present, and future ones, that the insiders owe moral fiduciary duties, not only to the set of shareholders at a given point in time.
It is harmful to the stock market
Unarguably, this act is unfair and may discourage ordinary people from participating in markets, making it more difficult for companies to raise capital. Insider trading based on material nonpublic information is illegal. It also goes against the fair trading and efficient functionality of the stock market – its indicators and algorithm. Of course, the fewer people invest in the stock market, the less the liquidity of the market and the higher the cost of raising finance in it.
With this occurrence, insiders are sharing the company’s confidential information, thereby provoking a response, and causing damage to the market’s efficiency. As a result of this, prices can’t respond with the normal decline and flow of new information being made public; the market’s general reputation usually suffers. It also widens the spreads between the prices at which market makers are ready to buy and sell securities.
This may also lead to a pump-and-dump scheme thereby causing undue fluctuations in the share price of the company and the credibility of the stock market. With respect to the February 2021 GameStop stock event, we see the effect of unethical trading and the resulting market response. Loss of trust in the stock market can crash an entire country’s economy. Hence, as minute as it may seem, insider trading is seriously harmful.
It is harmful to the issuing company
Insider trading affects the plans of the company by revealing the company’s confidential information. This may affect the company’s ability to raise the desired capital. Insider trading suggests and can lead to the risk of conflict of interest as these insider traders (employees or advisory agents) will subsequently seek personal gain over the company’s or clients’ interest, trading – buying or selling stock holdings – to enrich themselves.
Effect of the insider trader
When caught, the results may be ugly and expensive. It will affect our personal image, brand reputation, and may result in bad media exposure and poor public perception. Do not forget the legal charges, jail time, loss of controlling market trust, profitable business relationships, emotional trauma, loss of any billion empire – imagine this, after all that building stress and sweat, just to lose it all over small pennies? Accordingly, the life and comfort of your peers may also be negatively affected.
So, think about it- Is it really worth the stress?
How to stay free from engaging in insider trading
As tempting as it may seem to engage, we can avoid wahala and stay ethical. Although the initial gain may be appealing; the resulting cost is huge and ugly – the stain never leaves you.
I believe, ethics starts from within – inside out. Therefore, I would advise that we search and motivate willpower and personal virtues from within. We can also adopt the following guideline to help us stay on the holy path.
- As managers or employees, we should learn to build and surround ourselves with ethical people and work culture – iron sharpens iron.
- Control your personal excesses and overzealous habits, that way, we are guarded by contentment, not greed.
- Maintain trust and confidentiality in adherence to the corporate terms and agreement of work relationships.
- Act intelligently; learn to control your tongue – mind what you say and do not be a puppet for unethical errands (like Faneuil)
- Stay accountable to the law (corporate or national) on insider trading. Let’s remember that non-compliance or failure to adhere to the law/ fair practices, attract legal charges, huge losses, and ugly events as seen in the case of Martha Stewart. She lost almost everything: brand reputation, industry respect, profitable relationships, money, productive time, peace and comfort, etc. over little change.
- Finally, if in a position of leadership, practice regular insider trading investigations; restrict risky trading; train employees on insider trading and ethical operations. Also, leverage on technology to monitor, prevent insider trading; control trading activities; set limits; define a clear authorization process for risky trading to avoid boycotting activities, rogue or insider trading, any known unethical dealing as seen in the case of Kweku Adoboli. I believe this will help monitor and motivate employees to honest dealings.
Thank you for reading my post today. I hope we adopt some of these safety ethical strategies. Until next time. Stay happy and safe.
Article by Ezinne Okuku