Regulations also prohibit insider trading. It is illegal for anyone to transact in securities to profit from inside information, that is, private information held by officers, directors, or major stockholders that has not yet been divulged to the public. But the definition of insiders can be ambiguous. While it is obvious that the chief financial officer of a firm is an insider, it is less clear whether the firm’s biggest supplier can be considered an insider. Yet a supplier may deduce the firm’s near-term prospects from significant changes in orders. This gives the supplier a unique form of private information, yet the supplier is not technically an insider. These
ambiguities plague security analysts, whose job is to uncover as much information as possible concerning the firm’s expected prospects. The distinction between legal private information and illegal inside information can be fuzzy.
An important Supreme Court decision in 1997, however, ruled on the side of an expansive view of what constitutes illegal insider trading. The decision upheld the so-called misappropriation theory of insider trading, which holds that traders may not trade on nonpublic information even if they are not company insiders.
The SEC requires officers, directors, and major stockholders to report all transactions in their firm’s stock. A compendium of insider trades is published monthly in the SEC’s Official Summary of Securities Transactions and Holdings. The idea is to inform the public of any implicit vote of confidence or no confidence made by insiders.
Insiders do exploit their knowledge. Three forms of evidence support this conclusion. First, there have been well-publicized convictions of principals in insider trading schemes. Second, there is considerable evidence of “leakage” of useful information to some traders before any public announcement of that information. For example, share prices of firms announcing dividend increases (which the market interprets as good news concerning the firm’s prospects) commonly increase in value a few days before the public announcement of the increase. Clearly, some investors are acting on the good news before it is released to the public.
Similarly, share prices tend to increase a few days before the public announcement of abovetrend earnings growth. Share prices still rise substantially on the day of the public release of good news, however, indicating that insiders, or their associates, have not fully bid up the price of the stock to the level commensurate with the news.
A third form of evidence on insider trading has to do with returns earned on trades by insiders. Researchers have examined the SEC’s summary of insider trading to measure the performance of insiders. In one of the best known of these studies, Jaffee (1974) examined the abnormal return of stocks over the months following purchases or sales by insiders. For months in which insider purchasers of a stock exceeded insider sellers of the stock by three or more, the stock had an abnormal return in the following eight months of about 5%. Moreover, when insider sellers exceeded insider buyers, the stock tended to perform poorly.
Restriction of the use of inside information is not universal. Japan has no such prohibition. An argument in favor of free use of inside information is that investors are not misled to believe that the financial market is a level playing field for all. At the same time, free use of inside information means that such information will more quickly be reflected in stock prices.
Most Americans believe, however, that it is valuable as well as virtuous to outlaw such advantage, even if less-than-perfect enforcement may leave the door open for some profitable violations of the law.
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