What is insider trading, why is it a crime, and why does Hollywood seem to love it so much?
Millions of words are written on current issues. As a producer of contemporary content myself, it’s easy to fall into the trap of assuming the reader or listener has had an interest in financial markets and investments for decades. This assumption leads to assumed knowledge. To a person new to the investment world, writers assuming readers know all about the Great Depression or Tulip Mania, can present as an insiders club, designed to keep people out.
Almost a year after they were created, I continue to receive great feedback on the history posts I did – ep 107 onwards – Tulip Mania, the Great Depression, Gold standard, and Hyperinflation. My aim with these episodes was to bring people in on these important foundations of todays investment world. The Great Depression explains why central banks move interest rates today. The Gold Standard, amongst other things, highlights the relevancy of Bitcoin and crypto-currencies today.
In a similar vein, today I wanted to discuss Insider Trading. It’s something you’ve likely heard of. The name gives you a sense of roughly what it’s all about, but that’s likely as far as things go.
So let’s explore what Insider Trading is, look at some past examples, consider whether you might be an unknowing victim, and bring you inside the tent in another one of the investment worlds interesting facets.
What is Insider Trading?
Let’s start with the obvious – what is insider trading?
It is an offence under the Corporations Act here in Australia to trade using inside information, or communicate inside information to others who will, or are likely to, trade on the inside information.
The trading referred to here is not restricted just to the stock market. It can apply to any financial market – options, bonds, or futures for instance.
Insider trading means using information that is not generally available, and which is likely to have an effect on the value of a financial product. It’s essentially a form of cheating.
As a really simple example, imagine you’re a senior executive at a gold mining company and you receive a report advising that one of your exploration sites has just uncovered a significant gold find. Before you release this information to the market and make it public, you buy up all the shares you can afford. The information is then released, the share price rises, and you sell out making a tidy profit. This is what insider trading looks like in its most straight forward form.
Insider trading wasn’t always illegal. It was only in 1961 that laws were introduced in the United States, cracking down on unfair financial dealings. Australia followed suit soon after.
Insider trading is notoriously difficult to identify and therefore prosecute. The first prosecution in Australia was in 1973, and between that first attempt and 2000, only 17% of insider trading cases were successful. Improved monitoring tools shifted the playing field. Between 2001 and 2013, success was enjoyed in 65% of cases, though only 3% of all convictions led to jail terms of more than 3 years – causing some to question whether the penalties are harsh enough to dissuade those who might be tempted.
In Australia the maximum penalty for this is ten years imprisonment and/or a $450,000 fine.
Hollywood loves Insider Trading
The original Wall St movie with Gordon Gekko and Bud Fox was all about insider trading. The famous line “Greed, for lack of a better word, is good”, flags Gekko’s win at all cost’s mindset, though more insightful is the line “I only bet on sure things”.
At one point the FBI even used the Gekko character for an insider trading campaign.
More recently, if you’ve watched the fantastic series Billions with Bobby Axelrod and his hedge fund Axe Capital, when Dollar Bill says “I’m not uncertain” you know we’re entering insider trading territory.
But what about insider trading in the real world?
One of the best-known local examples involved a former NAB foreign exchange trader who received confidential information from a friend who worked at the Australian Bureau of Statistics. Armed with this information the trader turned an initial $1,000 investment into almost $7million dollars. He shared $20,000 with his friend for the information. He was convicted and received 7 years in jail. His friend 3 years and 3 months.
In the US, Wall Street Journal columnist R. Foster Winans was convicted in 1985 of giving information to two stockbrokers about stocks he was planning to write about in the Heard on the Street column. They used the information to make about $690,000. Winans’ cut was $31,000. Winans was sentenced to 18 months in prison.
And you might recall the style guru Martha Stewart did a jail stint in 2004. Whilst she wasn’t convicted of insider trading, it was related to an insider trading case – she sold stock seemingly based on some bad regulatory news that wasn’t yet publicly available.
In 2010 one of the most successful hedge funds SAC Capital pleaded guilty to allowing insider trading for more than a decade – paying a $1.8billion fine. Several key traders at the firm were also convicted.
An interesting case went to the High Court in 2012. It involved a question of whether someone can be guilty of insider trading if the underlying information is in fact false. Here it seems a managing director indicated to an associate that his company’s profits would be far greater than the market expected. Armed with this tip, the associate and a friend bought shares heavily. The information from the managing director turned out to be false, but the High Court found that the associate and his friend were guilty of insider trading none-the-less.
Insider trading is not a victimless crime. In any trade, there is always someone else on the other side of the transaction. When one person gains from trading with inside information, someone else misses out on profits they would have enjoyed had they been aware of that information.
Insider trading is also nothing new. Way back in 1929, the head of Chase National Bank, Albert Wiggin, shorted 40,000 shares in his own company, making $4million as the market crashed. He broke no laws at the time. However public outcry resulted in him forgoing his $100,000 per year retirement pension.
We’ll probably never know if we’re the victims of insider trading. But the very fact we have regulators monitoring for this activity, and gaining the odd conviction, is a positive for us all. It provides an even playing field for all investors and is a reason to invest in well-regulated markets.
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