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Legal Versus Illegal Insider Trading
Even as the U.S. Congress of 1934 was legislating its rules against illegal insider trading, it realized that the disclosure it was mandating wouldn't completely stop the practice. "Because it is difficult to draw a clear line between truly inside information and information generally known by better-informed investors, the most potent weapon against abuse of inside information is full and prompt publicity," states government records from that time.
Continuing the discussion back then: "The (Congressional) Committee is aware that these requirements are not air-tight and the unscrupulous insider may still, within the law, use inside information for his own advantage. It is hoped, however, that the publicity features of the bill will tend to bring these practices into disrepute and encourage voluntary maintenance of proper fiduciary standards by those in control of large corporate enterprises whose securities are registered on the public exchanges."
The emphasis on "within the law" is ours, but the wording shows that lawmakers were being realistic with their expectations of what the new regulations would accomplish. It doesn't imply that insiders are allowed to use material, non-public information. It does imply, however, that, since it so hard to prove, insiders will likely get away with using it.
It's not that insiders necessarily act unscrupulously (although some most certainly do). More to the point is that insiders can hardly clear their minds of all they know about their company when they are on the phone with their stock broker. Seeing a sales report one day, discussing new product strategies in meetings, talking in the halls with someone on the research and development team--all of these bits of information make the insider form an opinion of how prospects look at the company. Is any one of these pieces of information material and non-public? Maybe, maybe not. If so, it would be difficult for the SEC or U.S. Justice Department to prove.
But insiders need not be privy to company secrets to trade well. Even if none of the above data inputs are material, non-public information, putting them all together can paint a very obvious investment conclusion. The insider can easily argue that he was simply acting as a "better-informed investor," and not an "illegal insider trader."
What separates these two distinctions? A rather large gray area.
The fact is that neither the U.S. Congress, Justice Department, or the SEC actually inked specific definitions of what makes an insider's trading illegal. It has been left to lawyers arguing actual cases to build a body of "case law" to help determine when an insider (or anyone else trading securities in the United States) is wearing a white hat or a black hat.
Watershed cases whose decisions formed the backbone of today's body of case law include: Chiarella v. United States (1980), Dirks v. SEC (1983), United States v. Chesterman (19TK), TSE Industries v. Northway (19TK), and United States v. O'Hagan (1997).
All of these cases were tried by SEC and U.S. Justice Department lawyers under their authority to enforce the broad anti-fraud provisions of Rule 10b-5 of the Federal Code of Rules and Regulations. The broadness of Rule 10b-5 resulted, no doubt, from a realization that specific definitions of illegalities would be virtually impossible to formulate. Also, a specific list of illegal trading practices would quickly become obsolete as the securities markets evolved. The result was the short-but-sweet Rule that ensures a lifetime of employment for lawyers arguing the cases to define its very general terms.
Case law has reached some consensus of differentiating legal and illegal insider trading activity--but, again, only a general one. The three things that must be proved in order to label insider trading activity illegal are:
1) trading occurred;
2) the trade occurred while the person was in possession of material, non-public information, and;
3) the person who did the trading had access to the information as a result of a relationship of trust or fiduciary duty that was subsequently violated by the trading. In other words, the information was misappropriated.
The term "material, non-public" also has a working definition. Basically it is any information about a company not disclosed to the marketplace, but which if disclosed would likely significantly affect the market price of the securities of the company, or would be considered to do so by a reasonable investor.
The three-point framework of prosecuting insider fraud cases, and the definition of "material, non-public" information helps to clear up the gray area a bit, but the wiggle room for insiders is clearly visible between all the vagaries that the SEC and Justice Department must prove in court. Cases have been decided on whether a "relationship of trust" existed. Others focused on whether such a relationship was "violated" by a trade. Proving that information was "material and non-public" is just as hard. Agreeing on what a "reasonable investor" would think, or what a "significant" movement is in a security is also hardly set in stone.
This doesn't deter the SEC from policing transactions closely for insider trading violations. John Heine, Deputy Director of Public Affairs for the SEC, reports that 6% of the SEC's legal actions as of late have involved cases of insider fraud. That is a healthy concentration considering all that the SEC keeps its eyes on. This agency is hardly on a witch hunt, however, and does not prosecute insiders just for trading well. "The securities laws are not designed to punish people for making money," points out Mr. Heine. "If anything they are meant to foster commerce."
Don't Look A Gift Horse In The Mouth
The fact is that, even with numerous laws in place to combat illegal insider trading, and the SEC and U.S. Justice Department doing their best to enforce them, there are still a remarkable number of examples of insiders trading well--too many to dismiss the executives' transactions as merely lucky. In a victory for common sense, academic studies confirm that insiders have a knack for calling their stocks' movements, and professional investors wouldn't be paying what they are for timely insider trading data and analysis if they didn't think it gave them useful signals.
Yet most of the prescient insiders never hear a peep of inquiry from the authorities. Is the SEC just missing something? Are all the profits made by these officers just ill-gotten gains from trading on material, non-public information?
Possibly. Some of them are certainly trading on information they shouldn't be, but as we've pointed out proving fraud is not easy. Most insiders are probably making their money by acting as "better-informed investors," however, and there is nothing illegal with that.
For investors analyzing Form 4 data, the more pragmatic answer to the question of whether the insider trading indicated on a Form 4 is legal or not is: who cares?
As long as it's useful information that can help make money, we should leave the legal worries to the insider who make the trade, and simply use it. The laws and enforcement in place should catch most of the serious offenders, and keep the securities markets from deteriorating into their pre-1929 state of unfairness. And in any case, the really unscrupulous insiders trading blatantly on material, non-public information probably are not taking the time to fill out a Form 4 to document their illegal trades.
For any insider that does fill out their Form 4s properly, I actually hope that they are pushing the limits of legality, and making the most of their unfair advantage in trading their own companies' shares. Gaining a little advantage is why we follow this data. We may not know what the insiders know, but as long as we know what they do we can use the insider data filed with the SEC to alert us to when a stock-moving event may be brewing at a company.
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