Insider Trading Regulations: Are They Effective

1
Insider Trading Regulations Are They Effective?

• Created by Christa Hughes
• ECON 4353

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Purpose of Insider Trading Regulations

• To halt the use of insider information to make
  stock transactions (Seyhun 149). This includes
  buying or selling securities while committing
  fraudulent activities (SEC-laws).
• Insiders with this kind of information can make a
  huge profit or save themselves from tremendous
  loss, while the public cannot react to this
  information because they dont have access to it.
• Insider trading regulations strive to make the
  financial markets fair for everyone.

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Who benefits?

• This program benefits the general public and
  anyone who invests in the stock market. People
  do not want to be involved in the market if it is
  biased towards insiders who use information
  illegally (SEC-bounties).
• Insider trading regulations put everyone on an
  equal level and encourage full disclosure of all
  information important to the market with acts
  such as the Sarbanes-Oxley Act of 2002 (SEC-laws
  4).
• The bounty program benefits those who turn in
  insiders. Though they do not always receive a
  bounty, they often get a portion of the fines
  paid to the SEC (SEC-bounties).

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Criteria

• Any law passed by Congress that governs the SEC
  (such as the Sarbanes-Oxley Act of 2002) is a
  part of the program (SEC-laws).
• The bounty program through the SEC is included as
  well (SEC-bounties). This program allows for
  people to apply for a bounty when they turn in
  cases of insider trading.
• Case law is also important to the program (Seyhun
  151).
• All companies must follow these laws or suffer
  severe punishment if convicted by the SEC (SEC
  bounties).

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Is the program justified?

• The program is necessary to ensure equality in
  the markets. The markets cannot be efficient if
  only a handful of those involved know what is
  going on.
• The stock market is an important part of the US
  economy. The government is involved to make sure
  it is fair.
• If insiders follow the private decision rule, and
  their costs are lower than the costs to society,
  then a market failure will occur. Therefore, it
  is justified for the government to make sure that
  markets run efficiently and fairly (Mrozek 3).

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Intended Effects

• The intended effect is for insider trading to be
  reduced (Khan and Lamba 4).
• The program also strives to make the markets
  fair.

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Unintended Effects

• It is important to note that the intended effects
  are not achieved through the trading regulations!
• The most important unintended effect is the boost
  in frequency of insider trading. It increased
  substantially (nearly 30) during the 1980s,
  when the SEC and Congress were coming down hard
  on insiders (Seyhun 162).
• Not only did the frequency increase, but the
  profitability did as well (Seyhun 162). Insiders
  who chose to break the law were reaping the
  benefits more than ever before.
• Khan and Lamba also found that before and after
  the Insider Trading Sanctions Act was passed in
  1984, insider trading was not significantly
  reduced (13-14).

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Recommendation 1

• One way to improve the program is to fine
  companies when their employees are found guilty
  of insider trading. This would encourage
  companies to increase their awareness program and
  prevent employees from breaking the law (Bettis
  et al. 10).

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The problem is . . .

• Some would argue that this is unfair to the
  company. Should they be held responsible for the
  actions of one or a few employees?

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Recommendation 2

• The SEC could completely take away the ability of
  insiders to trade (Bettis et al. 10). This would
  ensure that no one is using information that they
  are not supposed to.

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The problem is . . .

• Although we could now ensure that insiders are
  not taking advantage of information, it would be
  discriminatory for them to not be able to trade
  at all.
• This solution would take away any attractiveness
  about employee stock inventive programs (Bettis
  et al. 10).

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Recommendation 3

• Require that companies have insider trading
  awareness programs. This way, the companies
  could better ensure that their employees are
  following the law (Bettis and Chang 3).
• The companies would not be creating programs just
  because they had to pay a fine (reference to
  recommendation 1). They would have to make sure
  their employees are informed.

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The problem is . . .

• The most apparent problem with this program is
  that companies might have to take on some extra
  costs to implement the program. However, if it
  saves them from being fined due to employee
  insider trading later down the road, these costs
  will be worth it.

14
The Martha Stewart Trial

• Fortunately for Martha, the judge decided not to
  charge her with insider trading (WNBC-TV 4).
• However, it seems suspicious that Martha sold
  stock for 228,000 the day before the FDA
  disapproved a cancer drug made by ImClone
  Systems, in which she held a lot of stock
  (WNBC-TV 2).
• The CEO of ImClone Systems, Sam Waksal, was
  convicted of insider trading and will spend 7
  years in prison for it (WNBC-TV 2).

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The Martha Stewart Trial

• Juror Hartridge comments,Maybe its a victory
  for the little guys who lose money in the market
  because of these kinds of transactions (WNBC-TV
  1).
• Martha will likely spend anywhere from 10 to 24
  months in prison for her actions (Appleson 2).
• During Hardball with Chris Matthews, the former
  Chairman of the SEC, Harvey Pitt, talks about the
  implications of the Stewart trial, saying, The
  governments going to go after you. Thats a
  positive (Hardball 5).
• Though the end of the 20th century was not
  encouraging regarding reductions in insider
  trading due to increased regulations, perhaps
  after the popularity of this trial, more people
  will obey the law.

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Negative Cost Externality
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Coasean Solution
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Positive Benefit Externality of Bounty
Program
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References

• The Laws That Govern the Securities Industry
  U.S.
  Securities and Exchange Commission website.
  Retrieved on March 21, 2004 from
• http//www.sec.gov/about/laws.shtml.
  
• Insider Trading Information on Bounties
  U.S. Securities and Exchange Commission
  website. Retrieved on March 21, 2004 from
  http//www.sec.gov/divisions/enforce/insider.htm.
  

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References

• (2004) Martha Stewart Guilty of All
  Counts In ImClone Case
  WNBC-TV. Retrieved on March 21, 2004 from
  http//www.msnbc.msn.com/id/4461934/.
  
• (2004) Former SEC chair on the Martha
  Stewart verdict MSNBC TV.
• Transcript from Hardball with Chris Matthews.
  Retrieved on March 22, 2004 from
  http//www.msnbc.msn.com/id/4466848/.
• Appleson, Gail. Experts say Martha
  Stewart faces tough appeal
  MSNBC Wire Services. Retrieved on March 22,
  2004 from
• http//www.msnbc.msn.com/id/4490411/.

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References

• Bettis, J. Carr and Stanley Y. Chang.
  Insider Trading Regulations, Internal
  Auditor. Vol. 53, Issue 1, February 1996.
  p53-56.
• Seyhun, H. Nejat. The Effectiveness of
  Insider-Trading Sanctions ,
  
  
• Journal of Law and Economics. Vol.
  35, No. 1 (April 1992), p149- 182.
• Mrozek, Janusz R. Market Failures and
  Efficiency in the Principles
• Course. Journal of Economic Education.
  Vol. 30, No. 4 (Fall
• 1999), p411-420.

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References

• Bettis, J. Carr, et al. The Effectiveness
  of Insider Trading Regulations , Journal
  of Applied Business Research. Vol. 14,
  Issue 4 (Fall 1998).
• Khan, Walayet A. and Asjeet S. Lamba. The
  Effectivness of Legal Sanctions in
  Curtailing Insider Trading Evidence
  from Exchange Listings, Quarterly
• Journal of Business and Economics. Vol.
  40, Issue 1, (Winter 2001). p3-16.