There are remedies for shareholders who have had losses due to insider trading specified by the SEC. The SEC Rule 10b-5 bound insiders, stating that the insider is required to disclose or abstain from trading the securities of the firms.
This rule derives from an SEC response to a 1940s complaint regarding a company that provided indications. That earnings would be weak while it planned to announce much stronger performance. The company’s president then bought shares knowing the true earnings. Two decades later, the SEC informed the market that it would bring civil claims under this little-known rule. However, it was not until the late 1970s that the SEC and federal prosecutors used the rule to bring criminal lawsuits.
Securities Fraud Enforcement
Insider Trading and Securities Fraud Enforcement passage underpinned the law on insider trading. This provision required maximum penalties reaching up to $1 million, as well as 10 years of imprisonment. While also setting up a bounty program where up to 10% of the insider’s profits can be collected by the informants.
This law also developed the possibility of top management being responsible for the insider trading of their subordinates. During the wake of Enron, the Sarbanes-Oxley law increased the maximum penalty for insider trading. It reached up to $5 million and a possible 20-year sentence in jail. The 1988 law followed the passage of the Insider Trading Sanctions Act of 1984. This gave SEC the power to seek treble damages for trading on inside information. The statute offered a 2-pronged approach for regulators. They can finally seek remedies aside from the criminal alternatives available way before the 1984 act was passed. It is possible for illegal insider trading to occur.
For instance, it is possible for insiders, acting on information that is unavailable to other investors. To sell the firm’s securities before an announcement of poor performance. The investors who do not know about this bad news might pay a higher price for the securities of the firms. The opposite may happen if the case is insiders bringing the firm’s stock or calling options before announcing a bid from another firm. Here, stockholders may not have sold the shares to the insiders. If they had known of the upcoming bid and its associated premium.
The Insiders
The insiders are more than just the management of a company. They may involve outsiders like attorneys, investment bankers, financial printers, or consultants who can be deemed as the temporary insiders. However, under rule 10b-5, the US Supreme Court held outside parties. Those who trade for profit according to their acquired information did not have to disclose their inside information. This was the case during 19801980 in Chiarella v. U.S. During the case. A financial printer acquired information on an upcoming tender offer by reviewing documents in his print shop.
Rule 10b-5 will apply if an individual misappropriates confidential information about a merger or acquisition and bases the trade on it. This rule is only applicable to proceedings of SEC enforcement or criminal actions. However, it is not applicable to civil deeds under the Insider Trading Sanctions Act of 1984. It’s because this permits the recovery of treble damages on the profits earned or the loss avoided. One example of an illegal insider trading was the well-known 1963 Texas Gulf Sulphur case.
The company discovered which were not disclosed for many months. In fact, the firm even denied the public the discovery in a false press release. On the other hand, the directors and the other members bought undervalued shares based on their inside information. The insiders faced a lawsuit successfully filed by the SEC. The short-swing profit rule does not allow any officer, director, or owner. With 10% of a company’s stock from a purchase and sale, or a sale and purchase within six months. Profits obtained from the purchases should be paid to the issuer whether or not the transactions were made based on insider information.
When Insider Trading Violation Occurs
Just because a provision of insider information by a tipper to another party or a tippee exists does not necessarily mean it constitutes a violation that requires penalties related to insider trading laws. A personal benefit is required to be derived by the tipper, and this was clarified in 2017. During this time, the Salman decision showed that the US Supreme Court concluded that a tipper giving such valuable information to a family member or friend could be considered to have derived a profit even if there was no monetary exchange.
Can Insider Trading Laws effectively Determine Insider Trading?
A study by Seyhun questioned the effectiveness of laws in stopping insider trading. Another empirical study by Meulbroek confirmed that stock price run-ups before takeover announcements reflect insider trading. There is more research that indicates how these laws have significant effects that are deterrent. For instance, Garfinkel investigated insider trading around earnings announcements and knew that insiders adjusted the timing of their transactions after the passage of the Insider Trading and Securities Fraud Enforcement Act.
Despite the positive effects, insider training seems to remain a part of the merger and acquisition activity of public companies. In more recent research, Augustin, Brenner, and Subrahmanyam found statistically significant abnormal trading volume in US equity options within 30 days before the announcement of an M&A.
They tried to study the trading volume in equity options in days before announcing an M&A in 1,859 corporate transactions from 1996-2012. Then, they compared them to randomly selected days. The obvious observation was that unexpected M&A announcements mean no statistical significance in the trading volume, But the results were opposite as the volume preceding M&A announcements was significantly greater.
This occurred so often in their samples. It proves that, while the SEC exerted effort to publicize its insider trading enforcement actions in some high-profile cases, M&A-related insider trading is not only quite prevalent but also largely unpunished by the SEC. This is evident in smaller M&As as many traders are engaging in insider trading here and get away with it.
© Image credits to Steve Johnson