The Legal Notion of Insider Trading in Economics and Finance

INSIDER TRADING

Cyril Gulevsky-Obolonsky

INSIDER TRADING

1. Definitions

2. Legal Spectrum

3. Case Studies

4. Financial Spectrum

5. Pro & Contra

DEFINITIONS

INSIDER TRADING> insider> insider trader> securities> liability> proof of responsibility

INSIDER TRADING▷ trading/non-public info -> securities▷ legal/illegal -> transactions

▷ legal obligation to the shareholders

▷ proof of innocence -> written binding plan

INSIDER & INSIDER TRADERINSIDERDirector / Senior Officer >10% of a company`s shares

INSIDER TRADER trades in a company's securities based on inside knowledge

SECURITIESFinancial instrument → financial value

Fungible and negotiable

TYPES:> debts (bonds) > equities (stocks)

LIABILITYLIABLE: IF inside info -> profit

E.g. CEOs, executives and directors

LIABILITYAccomplices: > tipper> tippee

TIPPER: deliberately revealed inside informationTIPPEE: purposely uses this information

PROOF OF RESPONSIBILITYComplex Procedure:

third person schemes etc.

Proof of Responsibility

Insider trading is hard to prove. To be convicted, a person must have bought or sold a stock based on material information that is both unknown to the general public and likely to have had an important effect on a company's stock price

- Alex Berenson

AMBIGUOUS DEFINITIONSDIFFICULTIES in determening:• the insider• evaluating the value/info • circumstances/insider trading

LEGAL SPECTRUM

> US UK EU> common/civil law> law enforcement> whistleblowing

USSecurities Exchange Act of 1934 -> establishment of the SEC (US Securities Exchange Commission)

the authoritative federal legal authority until nowadays (surveilles insider trading in the US)

SEC Functions> Oversees and regulates the US securities markets

> prescribes the rules to protect investors

> protects financial markets from fraud

Provides that a person trades on the basis of material nonpublic information if a trader is “aware“ of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.

Rule 10b5-1

Clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.

Rule 10b5-2

Misappropritaion Theory“The actual act of stealing confidential information from one's employer and using it to trade securities based on this insider knowledge. This theory can be expanded to include the use of insider knowledge to profit from buying or selling shares in any company, and not just one's own employer.” - INVESTORWORDS (Online Source)

UK1997 - FSA (Financial Services Act)

2012 - FCA (Financial Conduct Authority): ongoing legal entity of the FSA

PRA (Prudential Regulation Authority): subsidiary of the Bank of England

FSA in the UK

EU2003 - Market Abuse Directive I (MAD I): a comprehensive framework - "market abuse"

2011 - MAR & MAD II:> MAR - update and strengthen the existing rules> MAD II - minimum criminal sanctions for market abuse

Common law / Civil lawCIVIL LAW: core principles are codified into a referable system.

COMMON LAW:case law developed by judges through decisions of courts and similar tribunals.

Impact of enforcement> varies widely among financially developed countries

> expenditures by countries with "common law origins" are larger than those of counrties with "civil law origins"

> U.S more enforcement actions & impose more significant financial penalties than U.K

Whistleblowing> exposes unethical or incorrect info within an organisation

> internal/external whistleblowers

> protection

CASE STUDIES OF INSIDER TRADING

AguirreHerbalife vs. Pershing SquareEx-Schroeders Trader

Aguirre> experienced lawyer

> in 2004 employed by the SEC

> suspected (John Mack) Pequot Capital of insider trading

> SEC supervisors prevented him from attacking Mack

> got fired -> SEC closed the case

> whistleblowing against the SEC

PROFESSIONAL WHISTLE-BLOWER:

(from his whistleblowing masterclass)…Before becoming a whistlblower, I had achieved my financial and professional goals… - Gary Aguirre

Herbalife vs. Pershing Square Capital> battle over Herbalife : Is it a pyramid scheme or not?

> William A. Ackman thinks so plans to announce a bearish view of Herbalife

> Mr. Szymik got insider information from his roommate who was an analyst at Pershing Square (run by William A. Ackman)

Herbalife vs. Pershing Square Capital> Mr. Szymik passed the information to his friend Mr. Peixoto who bought a put-option on Herbalife

> after Mr. Ackman announced a $1 billion bet against Herbalife, Mr. Peixoto reaped $47,100 in illicit profits

> SEC announced charges for insider trading

Herbalife vs. Pershing Square Capital> Mr. Szymik settled the case by paying a $47,100 penalty

(but denies the trading and did not profit from his friend's trade)

> SEC moved to dismiss the charges against Mr. Peixoto

> rare case, because does not involve corporate insiders!

Insider Trading Charges a Schroeders Trader

> 2016

> Damian Clarke, former Schroders trader

> admitted nine counts of insider trading

> information collected during his employment at Schroders

Insider Trading Charges a Schroeders Trader

offences related to stocks incl. Eidos, Invensys no figure was given in court for the amount of profits made.

success / the FCA, the UK's financial watchdog

since 2008 , started to procecute insider traders

ECONOMIC AND FINANCIAL SPECTRUM

Information as a GoodEvaluation of SecuritiesEconomic DefinitionEffects on Financial Markets

4. New Economy: Information as a ProductInfo as an ECONOMIC GOOD:> can be exchanged & traded> specificity: only relatively material i.e. cannot be touched, but has value> the importance has increased in the post-industrial world (21st century)

Economic Definition> risky transactions in company’s securities> based on unequal distribution of info:

▷moral hazards ▷assymetric info

> market transparency > adverse effects on the security markets> decrease in company’s value

Evaluating the Price of Securities> Mosaic Theory> collecting public, non-public and non-material information about a company> non-public info involved

Mosaic Theory> insider info involved> but not publicly diffused> efficient financial markets

Influence/Enforcement on Financial Markets> less transparency> less efficient security markets> companies and shareholders protected> more ‘equity’> less profits> fiduciary duties protected

PRO & CONTRA

> improves market efficiency> more transparency> more attention to real crimes!> time and money saved> pay senior partners less, saving for shareholders

PRO of legalising insider trading

> unfair towards average investors> smaller benefits> potentially less liquidity in the markets, higher transaction costs> discourages public investors and increase capital costs> corporate insiders hide info from their directors and public

CONTRA of legalising insider trading

IS PUBLIC CONTROL NECESSARY?