Welcome back to the Deep Dive. Today, we are
taking an exhaustive look into one of the most
tempting and definitely one of the most complex
financial crimes on the planet, insider trading.
It really is. It's the ultimate shortcut, isn't
it? And it's been the subject of regulatory anxiety
for, well, almost a century now. At its heart,
we are talking about buying or selling a company's
stock. or its securities based on material non
-public information. And that right there, that
phrase, material non -public information, is
key. It's information that, if the rest of the
market knew it, would almost certainly cause
a significant shift in the price. Exactly. And
that simple definition, you know, it opens up
this huge legal and ethical fissure. Right. Is
this just a clever, maybe even harmless way to
profit on having superior information? Or is
it fundamentally unfair? Is it fraudulent and
maybe even a threat to the integrity of the entire
financial system? Well, legally, most every jurisdiction
around the world has sided with that latter view.
and this is what makes it so fascinating the
rules defining why it's illegal and more importantly
who counts as an insider are uh constantly being
rewritten. The courts are always trying to keep
pace with sophisticated bad actors. So our mission
today is to go a lot deeper than the typical
headlines. That's the plan. We're going to explore
the complex legal frameworks worldwide. We'll
dissect the fundamental arguments both for and
against its prohibition. And yes, we'll actually
spend time with the Nobel laureate arguments
for outright legalization, which is a mind bending
idea for most people. It is. And we'll examine
how the definition of an insider has just expanded.
dramatically through these landmark U .S. court
decisions. It's not just the CEO anymore. Now
it can catch the proofreader, the consultant,
even the politician. OK, so let's start there.
Let's unpack the two primary reasons for prohibiting
this practice, because fundamentally it feels
like we have a philosophical battle between market
fairness on one side and corporate duty on the
other. That's the perfect way to frame it. That's
the tension. So the first rationale is what you
could call the market integrity argument. OK.
Regulators argue that allowing insider trading
makes the entire system look rigged. And that's,
you know, profoundly unfair to the average investor.
The person putting money in their 401k. Exactly
that person. If an executive knows the stock
price is about to double because of a confidential
product announcement and they buy a ton of shares
before anyone else can, their ability to make
these massive disproportionate profits just destroys
the necessary level playing field. And if the
public loses faith that the game is fair. They
pull their capital out. And that, of course,
hurts everyone. It does. Then the second pillar,
as you said, seems to relate less to the market
as a whole and more to the internal rules of
a company. It's all about corporate governance
and fiduciary duty. Right. So this is about the
promises an executive makes to the company and
its owners. Precisely. It's prohibited to prevent
key personnel, your officers, your directors,
from abusing confidential corporate information
for their own personal gain. They are deemed
to be agents of the shareholders, and because
of that, they owe a fiduciary duty of loyalty
and trust to those shareholders. So using corporate
secrets to line their own pockets is a direct
violation of that trust. It's essentially theft.
It's theft of a corporate opportunity. What's
really fascinating here, though, is the academic
paradox that this whole prohibition creates.
We know regulators catch the big high -profile
cases, but a lot of studies suggest the majority
of illegal insider trading just... slips through
the cracks. That's where the academic debate
gets truly provocative. Scholars point out that
since the vast majority of illegal insider trading
is probably never detected by law enforcement,
the very existence of the prohibition gives the
public a potentially misleading impression. That
stock market trading is an unrigged game. They
argue that this false sense of security might
actually be more detrimental than simply legalizing
it and acknowledging that, look, asymmetric information
is always at play in markets. So the prohibition
itself could be seen as a sort of necessary fiction,
a psychological tool to maintain public participation
and trust, even if it's in reality very unevenly
enforced. Exactly. And this tension, the difficult
proof, the argument over who is actually harmed.
This is why the U .S. legal system in particular
has seen decades of highly complex litigation
as it tries to nail down what constitutes the
necessary fraud required to prosecute these cases.
OK, let's turn to our first section then. The
legal cornerstones defining the insider and the
crime. We need to start with the people who are,
you know, transparently monitored and who have
the clearest possible legal duty. This is the
formal definition of an official insider. It's
used globally for mandatory reporting. So in
the U .S., Canada, Australia, Germany and Romania,
this group includes a company's officers, its
directors and any beneficial owners who hold
more than 10 percent of a class of the company's
equity securities. These are the people who.
by law, are just presumed to have constant access
to Material non -public information. Correct.
And their actions are under intense scrutiny
because, as we mentioned, they have volunteered
to assume that crucial fiduciary obligation.
They have to act in the best interest of the
shareholders above their own personal interests.
The analogy here is pretty clear. They're like
trustees of the corporation's confidential information.
Absolutely. Let's use the classic textbook example.
The CEO learns, maybe in a confidential board
meeting, that a massive all -cash takeover offer
is imminent. The public price is about to jump
40 percent. If that CEO then calls their broker
and buys a million dollars of stock before the
public announcement, knowing the price will skyrocket,
that is the clearest, most unambiguous violation
of their fiduciary duty to the shareholders.
They are, in effect, stealing value directly
from the corporation. Now, it's really important
to clarify for you, the listener, that trading
by these official insiders isn't automatically
a crime. In fact, it's common and totally legal
for employees, officers and directors to hold
and trade stock. They often get it through options
or compensation plans. Right. So what's the dividing
line? What keeps these routine trades on the
right side of the law? The dividing line is actually
quite simple. They must not rely on material
non -public information. If I'm a director and
I sell 5 ,000 shares to pay for my child's college
tuition and I don't possess any confidential
information about the company that would affect
the share price, that's perfectly fine. But there's
a transparency requirement, isn't there? Oh,
absolutely. Crucially, these trades must be transparent.
In the U .S., insiders have to file what's called
a Form 4 with the Securities and Exchange Commission,
the SEC. And that has to be done generally within
two business days. And it details the transaction.
So that public disclosure is the key. It differentiates
legitimate portfolio management from something
that looks suspicious, like pre -knowledge trading.
Exactly. Public disclosure requirement is obviously
critical for maintaining market confidence. But
why does the enforcement apparatus, the SEC,
the Department of Justice, commit so many resources
to this? I mean, does insider trading really
have a negative macroeconomic effect? It absolutely
does. And this is a point that is so often missed
when we just focus on the scandal of one person
getting rich. The critical finding from serious
academic study is that illegal insider trading
raises the cost of capital for securities issuers.
OK, that sounds a bit dense. What does that actually
mean in real terms? Think of it this way. If
you as an investor. perceive the market to be
fundamentally unfair, if you constantly suspect
that the deck is stacked because insiders are
just skimming off the top, you're going to demand
a higher return to compensate you for that hidden
risk. I see. So I want more potential reward
because I feel like I'm taking on more unseen
risk. Precisely. And that premium demanded by
investors, which gets built into the stock price,
is the higher cost of capital for the company.
The company then has less money to invest in
expansion, in R &D, and hiring. So while insider
trading seems like this sort of private crime
between a buyer and a seller, the ripple effect
is actually a break on overall economic growth.
That reframes the whole argument, doesn't it?
It's not just about fairness. It's about economic
efficiency being actively harmed by a lack of
trust. Exactly. When markets are perceived as
fair, capital flows more freely and cheaply.
When they're seen as rife with illegal activity,
Capital becomes more expensive and that slows
down the whole engine of innovation. So if regulators
are trying to protect the sufficiency, how do
they actually prove the crime? I mean, given
that traders can use really sophisticated tactics,
nominees, offshore companies, it must be an absolute
nightmare to link the information possessed to
the trade that was executed. It is notoriously
difficult, which is why enforcement agencies
rely so heavily on advanced surveillance technology.
The SEC and the stock exchanges, they use these
sophisticated data algorithms to actively monitor
trading patterns for anything suspicious. What
would be a red flag for them? Well, if they see
an unusually large volume of trading, particularly
in options, immediately preceding a major corporate
event like a takeover announcement, that immediately
triggers an investigation. And then they have
to follow the trail. Then they have to follow
the trail of money and communication. We're talking
phone records, encrypted messages, email exchanges,
anything to connect the trader back to the original
source of the confidential information. And the
moment they catch a violator, what's the primary
civil mechanism the SEC uses to strip away the
incentive for this crime? It's all about incentive.
Right. The key financial mechanism is called
disgorgement. Disgorgement. This is the forced
repayment of any ill -gotten gains or. and this
is important, the repayment of losses avoided
that resulted from the violation of securities
laws. So the philosophy is simple. You cannot
profit from your crime. The SEC wants to return
the violator to the financial position they would
have been in if the illegal trade had just never
happened. And when they recover these funds,
where does the money go? When it's feasible,
the disgorged funds are returned directly to
the investors who were injured by the scheme.
And while disgorgement is the core civil penalty,
the penalties can be dramatically increased,
especially in the U .S. How so? Well, acts like
the Insider Trading Sanctions Act of 1984 allow
the government to seek penalties of up to three
times the amount of the profit gained or loss
avoided. A triple penalty. That's a pretty strong
deterrent. It's meant to be. And while the SEC
handles the civil side of things, if the case
involves intentional, really egregious fraud,
they'll refer it to the U .S. Department of Justice
for a parallel criminal prosecution, which can
and often does result in lengthy prison sentences.
So we've established the clear rule. If you are
a corporate officer, you owe a duty to the shareholder.
And violating that duty is the textbook crime.
But of course, the smartest bad actors quickly
realized they could just leak the information
to someone else or steal it entirely without
being an official officer. That's exactly right.
Which brings us to how the law had to evolve
to catch those people. The legal frameworks had
to dramatically expand because the crime started
migrating outside the confines of the boardroom.
So the courts realized they needed to stop focusing
only on the fiduciary duty owed to shareholders.
And start looking at the duty owed to the information
itself. This moves us right into section two,
expanding liability tips. misappropriation, and
duty. And when we talk about illegal insider
trading now, the term insider is, as you said,
no longer limited to just the CEO and the board.
Not at all. It includes virtually anyone who
trades shares based on material non -public information
in violation of some duty of trust or confidentiality.
And this expansion started first with the people
who receive the information secondhand, the tipbies.
Okay, so if an insider tips a friend, How does
that friend who owes no direct duty to the corporation,
how do they become criminally liable? Their liability
is established through what's called the Tippie
Doctrine, which was largely defined by the seminal
Supreme Court case, Dirks v. Securities and Exchange
Commission, back in 1984. And what did that case
establish? The court established a critical and
often very confusing two -pronged test. A Tippie
is liable only if they knew or should have known
That the tipper, the insider, breached a fiduciary
duty. OK, that's prong one. And the tipper did
so for an improper purpose. An improper purpose.
So it wasn't enough just to have the inside information
or even to know it came from an insider. The
court had to look into the mind of the person
giving the tip and figure out their motive. What
does that improper purpose or personal benefit
truly mean? This is the subjective, really complex
part of the law. The personal benefit does not
have to be pecuniary. It doesn't have to be cash.
It could be an intangible benefit, like boosting
one's reputation or making some kind of quid
pro quo exchange. The Dirks case itself is the
perfect illustration of why the intent matters
so much. So walk us through Dirks. Why was he
found not guilty in the end? OK, so Raymond Dirks
was a securities analyst. He received confidential
information from a former officer of a corporation
about a massive ongoing fraud within that company.
Dirks then investigated. He confirmed the information
and he shared it with his clients, who then sold
their holdings before the stock completely collapsed.
And the SEC prosecuted him for that. They did.
But the Supreme Court ultimately ruled that the
original insider's motive was to expose fraud.
It was to be a whistleblower, not to gain any
personal benefit. And since the insider had not
breached their fiduciary duty because they weren't
motivated by personal gain, the tippy. Dirks
could not be held liable either. No breach by
the tipper, no derivative breach by the tippy.
That's it. It's a critical distinction. It separates
whistleblowing from self -dealing. But you can
see the problem, right? Isn't that almost impossible
to prove? If I tell my friends something purely
as a favor or a gift, how can the SEC really
prove my internal intangible benefit? Right.
It makes enforcement way too subjective. It absolutely
did. And it led to decades of major confusion
following the Dirks decision. Regulators really
struggled to prove that intangible personal benefit
when the tipper and tippy were just friends,
not business associates exchanging cash. So how
did they resolve that? Well, the issue was significantly
clarified by a 2016 Supreme Court decision in
Salmon v. United States. And how did Salmon broaden
the scope of personal benefit again? Solomon
involved a man who traded on tips he got from
his brother -in -law, who was an insider at an
investment bank. Now, the brother -in -law gave
the information to his own brother, who then
passed it along to Solomon. A whole chain of
tips. Exactly. And the Supreme Court confirmed
that giving a gift of a tip to a family member
or a close friend is presumptively an act for
the tipper's intangible personal benefit. Ah,
so it's assumed to be a benefit. Right. This
ruling essentially ensures that insiders cannot
just hand information to their relatives or friends
to benefit indirectly while avoiding liability
themselves. The court recognized that giving
someone the gift of a guaranteed profit is in
itself a form of benefit to the tipper. Okay,
so the Tippie Doctrine evolved to recognize the
complexity of human relationships in these transactions.
But even that didn't cover everyone. What about
people who simply stole the information without
ever having a direct relationship with the company
whose stock they traded? That's where the law
took its biggest and most important leap. And
this is what we call the misappropriation theory.
Misappropriation theory. This theory doesn't
focus on the duty owed to the company's shareholders.
Instead, it looks at the duty owed to the source
of the information, which is often an employer
or a consultant or a law firm. So using the company's
confidential information is views not just as
a breach of duty, but is literally stealing corporate
property. Precisely. This expansion was pioneered
in cases like SEC versus Materia in 1984 and
later affirmed by the Supreme Court in the landmark
1997 case, United States v. O 'Hagan. And what's
the core legal concept there? The core concept
is that a person commits fraud when they misappropriate
confidential information for securities trading
purposes. And in doing so, they breach a duty
owed to the source of the information. The fraud
is committed against the principal, the employer
or the source, not necessarily against the person
on the other side of the stock trade. So the
O 'Hagan ruling is profound because it explicitly
recognized that a corporation's confidential
information is its property. That's the whole
game changer. The undisclosed, self -serving
use of this principal's property in breach of
a duty of loyalty and confidentiality defrauds
the principle of the exclusive use of that information.
The court actually likened it to fraud akin to
embezzlement. It's an elegant solution to catch
people who spurt the traditional fiduciary duty
rules. Let's talk about that proofreader. Materia
because his case perfectly demonstrates the power
of this theory. He wasn't a corporate insider
in the traditional sense at all. Not even close.
Materia was an employee at a financial printing
firm. He was proofreading confidential documents
related to upcoming tender offers and corporate
takeovers. He figured out the identities of the
target companies just by reading the sensitive
material as part of his job. And then he traded
on it. And then he used that knowledge to trade.
Now, critically, he owed no fiduciary duty whatsoever
to the companies whose stock he was buying. His
liability was based entirely on the fact that
he stole the information from his employer, the
printing firm, breaching his duty of trust to
them. That theft and subsequent use constituted
the necessary fraud. So to summarize this really
complex legal landscape for you, the listener,
in the U .S., you can be liable for insider trading
if you violate a duty to the shareholders of
the company. That's the traditional theory. Or
if you violate a duty to the source of the information,
even if that source isn't the company who stock
your trading. And that's the misappropriation
theory. That is the perfect synthesis of the
current American framework. And this brings us
back to that extremely narrow line. that still
separates legal from illegal trading in the US
and similar non -European jurisdictions. The
famous overhearing the CEO scenario. Yeah. If
I'm at a restaurant sitting next to a table where
a CEO and CFO are having an unencrypted conversation
about massive impending profits and I buy the
stock right away, I'm generally safe. Why does
that happenstance acquisition of information
not count? Because you did not have a closer
connection or duty of trust to the company or
the officers, and you didn't steal the information.
You were simply a random beneficiary of happenstance.
The key is always the breach of duty. Right.
Since the officers were arguably careless with
the information, but you didn't violate a preexisting
trust relationship by using it, you haven't committed
the necessary fraud required by U .S. law. But
if you had, say, pay the waiter to eavesdrop.
Ah. then the situation would immediately change.
Or if you were a close relative or a business
partner, then duty or personal benefit might
be inferred and you'd be in serious trouble.
That emphasis on duty and fraud is really the
defining characteristic of the U .S. system.
But let's zoom out now and look at how the rest
of the world handles this problem. And this journey
takes us into Section 3, Global Frameworks and
Judicial Nuance. The U .S. model, because it's
rooted in these 1930s anti -fraud statutes, is
actually quite unique. The United Kingdom and
the European Union, in contrast, operate under
a much, much broader framework that's often categorized
simply as market abuse. Market abuse. What does
that broader scope look like in practice, and
how does it shift the burden of proof? Well,
under the U .K.'s Criminal Justice Act of 1993
and the EU's Regulation 596 -2014, it is illegal
simply to trade on market -sensitive information
that is not generally known. So it's simpler.
Much simpler. The crucial distinction here is
that you generally do not need to prove a specific
relationship to the issuer of the security or
to the tipster or a breach of fiduciary duty.
If you trade on non -public price sensitive information,
you've committed market abuse. End of story.
So in that European model, the person who overhears
the CEO in the restaurant. is in much greater
jeopardy. Oh, absolutely. The focus isn't on
duty or theft to a principle. The focus is simply
on protecting the overall integrity of the trading
process itself. And what about the intent? Yeah.
In the U .S., you have to prove scienter, right?
The intent to deceive. Exactly. And that's another
huge difference. In the European model. Mere
possession and use of the information is often
enough to trigger civil or criminal penalties.
This makes prosecution considerably simpler because
they can just bypass all that complex litigation
surrounding the personal benefit test from Dirks
or the duty requirement from O 'Hagan. So despite
these pretty big legal differences, there's a
clear international consensus that insider trading
is detrimental to global markets. Absolutely.
The International Organization of Securities
Commissions, IOSCO, which regulates over 85 percent
of the world's securities markets, explicitly
lists protection from insider trading as a core
principle for ensuring fair, efficient and transparent
markets. This isn't just a U .S. or European
preoccupation. It's a global standard. So organizations
like the World Bank or the IMF. would look for
these rules when they assess a country's financial
health. They do. They often use these IOSCO core
principles, which reinforces the global expectation
that strong anti -insider trading laws exist
and are actually being enforced. Though it's
worth noting that the severity of enforcement
still varies wildly from country to country.
Let's turn back to the U .S. for a moment and
look at the legal protections for legitimate
insiders. If an executive knows major news is
coming, but they have to sell shares for personal
financial planning, say, to diversify their huge
holdings, how do they protect themselves from
the assumption that they are using inside information?
That's the whole purpose of SEC Rule 10b -5 -1.
Since in the U .S., the mere possession of material
non -public information is often enough for the
SEC to infer that you used it when you traded,
Rule 10b -5 -1 provides what's called an affirmative
defense. An affirmative defense. This defense
protects the insider if they can demonstrate
that the trade was executed as part of a pre
-existing contract or a written binding plan.
So the key is that the plan must be set up at
a time when they are clearly not in possession
of any material non -public information. information.
Precisely. If I set up a written plan today that
outlines automatic sales of one thousand shares
every single month for the next two years and
then a week later I learn explosive positive
news that sends the stock soaring. Those preplanned
sales are defensible. Because the decision to
sell was made before you had the information.
Exactly. The key is that the plan must be truly
binding. It has to specify the price the amount
and the date of the trades and it must be entered
into in good faith before the insider comes in
to possession of the material non -public information.
It's a mechanism designed to shield routine mechanical
sales from regulatory scrutiny. That seems like
a really necessary safety valve for executives
who need to manage their wealth. But here's where
the legal systems always hit friction. A tool
designed for protection inevitably gets exploited
for gain. We've seen significant conflict surrounding
the alleged abuse of these 10b51 plans recently,
haven't we? Oh, here's where it gets really interesting.
And it highlights how regulators have to constantly
adapt. For years, there was this suspicion that
executives were setting up these plans, waiting
a very short period of time, and then quickly
canceling or amending them based on subsequent
inside information. The defense was being used
offensively. And this all came to a head in a
recent case. It was dramatically highlighted
in the 2023 and 2024 case involving Taryn Prazer,
the CEO and chairman of OnTrack, Inc. So walk
us through what. What the regulators alleged
in that case? What was he doing? Peisser was
convicted of securities fraud. The Department
of Justice and the SEC alleged that he sold $20
million of stock, avoiding $12 million in losses,
by using purported 10b -5 -1 plans while he possessed
negative non -public information. So the fraud
wasn't that he possessed the information and
traded? No, it was that he created the 10b -5
-1 plans fraudulently. The allegation was that
he adopted these plans immediately after learning
negative news about the company's biggest customer
and then use the plans as cover to sell before
that bad news became public. So he essentially
tried to retroactively sanitize his trades by
using the defense mechanism as a shield. But
the timing just betrayed the entire purpose of
the rule. Exactly. The core of the fraud was
the timing and the intent of setting up the plan
itself. The court found that because he possessed
that negative price sensitive information when
he established the plan, the plan was never made
in good faith and therefore it offered him no
legal defense. And that case sent a huge signal
to corporate America. A massive signal. Regulators
are now actively scrutinizing the creation and
adoption of these plans, not just the trades
themselves. And this eventually led to the SEC
implementing rule changes in 2022 and 2023, requiring
mandatory cooling off periods between adopting
a plan and executing the first trade specifically
to close this exact loophole. That's a powerful
illustration of the legal system playing catch
up with corporate sophistication. OK, so we've
established that prohibition is the global standard.
supported by strong legal mechanisms in both
the U .S. and Europe. But we cannot have a deep
dive on this without fully exploring Section
4, the radical argument for legalization. This
is a really robust academic discussion, and it's
championed by influential scholars and economists
who challenge the fundamental economic and philosophical
premise of prohibition. We are talking about
voices like Henry Mann, who wrote the seminal
work on this, and the Nobel laureate Milton Friedman.
And their arguments run completely counter to
that market fairness principle we've established.
So what is their chief argument for repealing
insider trading laws? The primary argument is
based on market efficiency. Friedman, in his
own words, actually said, you want more insider
trading, not less. Wow. The claim is that trading
based on material non -public information benefits
all investors generally by rapidly introducing
new, accurate information into the market, thereby
allowing the stock price to reflect the company's
true value sooner. So if the CEO knows the company
is actually worth $100 per share, but the market
price is only $80, The CEO's aggressive buying
acts as a quick signal to the market, even if
the trade itself isn't immediately publicized.
Right. The resulting price pressure itself contains
information. The market sees a huge buy order
and thinks, someone knows something, and the
price starts to adjust. This rapid price discovery,
the process of the stock price finding its true
value, is beneficial to the broader economy.
That's the argument. If the information is hidden
until a press release, then capital allocation
decisions across the entire market are being
made based on inaccurate, delayed information.
Insider trading, in this view, is the fastest,
most effective mechanism to ensure accurate price
discovery, making the market more efficient overall.
OK, another key philosophical argument put forth
by these scholars is that insider trading is
often a victimless crime. How on earth do they
make that case when someone is clearly losing
money on the other side of the trade? They argue
that it is simply an act where a willing buyer
and a willing seller agree to trade property
that the seller rightfully owns the shares. They
contend that the investor selling the stock was
already going to sell at that price regardless
of the insider's superior knowledge. I'm not
sure I follow that. The idea is this. If I decide
to sell my 100 shares of XYZ Corp at $50 today,
I put that order in. An insider, knowing the
price will soon be $60, buys my shares. The argument
is that I was going to sell at $50 anyway. The
insider didn't force me to sell or lie to me.
So they believe the only true violation occurs
if there is a breach of a pre -existing contractual
duty or an outright lie, not just information
asymmetry. This sounds like a pure challenge
to the entire concept of regulating information
asymmetry, which outside of corporate secrets
is often celebrated in business. It leads directly
to the geologist analogy, which is often cited
to highlight the perceived inconsistency in the
law. Explain that analogy for the listener. Sure.
If a geologist, through hard work and private
research, determines there is a high likelihood
of discovering a major oil reserve under farmer
Smith's undeveloped land, the geologist is legally
entitled to make Smith an offer for that land
and buy it without disclosing the geological
data. Right. That happens all the time. The land
is Smith's property and the information is the
geologist's private research. The law does not
require the geologist to correct the farmer's
ignorance about the land's true value. So the
proponents of legalization ask, if that's legal
in land acquisition, why is it fraud in stock
trading? And the answer, as we established earlier,
comes back to that corporate fiduciary duty and
the company's property rights to its own information,
which just doesn't exist between the geologist
and the farmer. That is the regulatory answer.
But the analogy really forces us to confront
the consistency of the law when it comes to information
asymmetry. And some advocates also make free
speech arguments, suggesting that punishing someone
for communicating accurate information about
a company's financial status is an act of censorship,
limiting the flow of vital information that the
market needs. Is there any form of middle ground
proposed by these challenging scholars, something
that might appease both the efficiency and the
fairness camps? There is a fascinating middle
ground that's been suggested. Legalizing insider
trading on negative information only, but keeping
the prohibition on positive information. Negative
information only. Why? The argument for this
is pragmatic. Companies are naturally incentivized
to release good news as quickly as possible,
but they often withhold bad news for as long
as possible using every delay tactic available.
So allowing insiders to short the stock when
they know bad news is coming would force the
price to reflect reality much more quickly than
waiting for a delayed corporate announcement.
It would act as a powerful, rapid correction
mechanism. The proponents argue that negative
information has a higher marginal value for market
truthfulness than positive information, which
will eventually come out anyway. It's an intellectual
solution aimed at forcing transparency, where
corporate incentives often resist it. Now that
we've established the legal and academic arguments,
let's move into Section 5. High -stakes examples,
corporate fraud, and Capitol Hill. These cases
really illustrate the sheer scale of the profits
and losses avoided and how seriously the system
takes this crime when the financial stakes are
high. These cases are critical because they put
a human face on the breach of duty. Take the
case of Matthew Martoma, a former portfolio manager
at SAC Capital Advisors. He was accused of generating
possibly the largest single insider trading transaction
profit in history. What were the numbers? It
was valued at an astonishing $276 million from
insider information about a drug trial failure.
$276 million. That really puts the risk -reward
calculation into stark perspective, doesn't it?
The temptation must be overwhelming when those
kinds of figures are on the table. It is, and
Martomo is convicted and sentenced to nine years
in prison, which reflects the severity of the
financial harm and the fraud committed. Another
high -profile example that demonstrated the corruption
of duty at the very top was the case of Rajat
Gupta. Gupta was the former head of McKinsey
& Co. and a director at Goldman Sachs. I mean,
he was the epitome of the trusted insider. He
was. And he was convicted in 2012 for leaking
confidential board information, including critical
details about Goldman Sachs' financial results
and a major investment from Berkshire Hathaway
to the hedge fund manager, Raj Rajarat. A textbook
violation of his duty as a director. Absolutely.
Rajaratnam was sentenced to 11 years and Gupta
received two years in prison, proving that even
the most well -connected corporate figures are
not immune from prosecution when that fiduciary
duty is breached. We also have these almost anecdotal
cases that show how creative and complex traitors
can be when they try to conceal their activity,
making the investigation extremely difficult.
The Billy Walters case is classic in this regard.
Billy Walters, a famous Las Vegas sports better,
was convicted for making $40 million in profits
and avoided losses in Dean Foods stock between
2008 and 2014. His source was a director at the
company. And how did they try to hide it? To
conceal their activity, they used prepaid burner
cell phones and, most memorably, employed complex
code words for the company in their communications,
sometimes referring to Dean Foods as the Dallas
Cowboys to evade detection. The audacity of using
such a recognizable code. That must have been
a Herculean effort for the regulators to connect
those dots and prove the connection between Dallas
Cowboys references and specific stock trades.
It absolutely underscores the difficulty of modern...
financial crime investigation, they had to prove
beyond a reasonable doubt that a message like,
I need five cowboys by next Tuesday, was a clear
instruction to buy stock in Dean Foods. The prosecution's
success in connecting those subtle, concealed
actions really demonstrated the resources the
DOJ commits to building these complex fraud cases.
Now, beyond disgorgement, the courts sometimes
use an additional, more unusual tool to punish
insiders who violate their corporate trust. the
faithless servant doctrine. That was showcased
in the Morgan Stanley v. Skowron case in 2013.
David Skowron, a portfolio manager, engaged in
insider trading, directly violating his employment
contract and the firm's code of conduct. The
court, applying New York's faithless servant
doctrine, ordered him to repay his employer the
full $31 million compensation he received during
his period of faithlessness. Wait, not just the
profits he gained from the illegal trades, which
he had to forfeit anyway. But his entire salary
and bonuses earned while he was engaged in the
misconduct. That goes far beyond typical financial
penalties. It's a punitive measure based on the
concept that a servant, an employee who is disloyal,
forfeits their right to compensation for the
period of disloyalty. The judge in that case
noted that Skowron's behavior damaged Morgan
Stanley's reputation, which is a valuable corporate
asset. Since he was paid to be loyal and he was
disloyal, he had to give back what he was paid.
It's an extremely aggressive and effective form
of deterrence. Now let's turn to the highly sensitive
area of political insider trading. Members of
the U .S. Congress are clearly not exempt from
insider trading laws, yet they often seem to
operate in a legal gray area that official corporate
insiders do not enjoy. This comes right back
to the foundation of U .S. law, the need to prove
a breach of fiduciary duty or a misappropriation
of property. Members of Congress and their staff
generally do not meet the legal definition of
an insider because they typically lack a confidential
or fiduciary relationship with the source of
the information they receive, especially government
information or the companies they oversee. The
evidence of information asymmetry, the ability
of politicians to profit from privileged knowledge,
is hard to deny. It is statistically significant.
A famous 2004 study found that stock sales and
purchases by US senators over a sustained period
outperformed the general market by a massive
12 .3 % per year. That suggests they clearly
possess and act upon valuable information that
the general public just does not have access
to. And... We saw this play out in the clearest
possible terms during the 2008 financial crisis,
which was a real watershed moment for public
awareness of this issue. It certainly was. On
the evening of September 18th, 2008, Treasury
Secretary Hank Paulson and Fed Chairman Ben Bernanke
held a private closed -door meeting briefing
members of Congress on the escalating financial
crisis. They communicated that the situation
was far, far worse than the public knew. And
what happened the next day? The very next day,
several lawmakers made highly timely trades or
portfolio reallocations. Can you give us some
specific examples of those timely trades? Representative
Spencer Baucus, who was the ranking Republican
on the House Financial Services Committee at
the time, not only sold several investments,
but actually shorted the stocks. He bet on them
to fall the very next morning. He cashed in his
profits within a week just before the full market
collapsed. And he wasn't the only one. No. Others,
like Senator Dick Durbin and then House Speaker
John Boehner, also made timely sales or shifted
assets out of equities effective the morning
after that closed door briefing. They possessed
information that caused them to act while the
public remained completely in the dark. The public
outcry over this clear asymmetry eventually forced
legislative action. That's right. The public
pressure led to the passage of the Stop Trading
on Congressional Knowledge Act or the Stock Act
in 2012. This law explicitly affirmed that insider
trading laws apply to members of Congress and
federal employees. And crucially, it imposed
new transparency requirements, forcing them to
report stock trades publicly. promptly, usually
within 45 days. So the goal was to increase visibility
and make it easier to identify suspicious activity.
That was the idea. But even with the stock act
in place, the 2020 COVID -19 scandal became another
stark reminder of the gap between what's ethical
and what's technically legal. This occurred in
February 2020. Several senators received confidential,
closed -door briefings about the severe potential
impact of the emerging COVID -19 threat, well
before the administration publicly acknowledged
the crisis's scale. Allegations quickly surfaced
that these senators then sold large amounts of
stock, particularly in sectors that would be
hit hardest, like travel and hospitality, just
before the market plummeted. And the public reaction
was one of immediate condemnation and outrage,
and the Department of Justice launched... They
did, which is important. However, here is the
crucial legal complexity. While the information
was critical and non -public, the DOJ ultimately
closed its investigations into several of the
senators without bringing any charges. Because
the information they possessed, sourced from
government briefings, was not legally classified
as corporate property, nor did the politicians
have a specific fiduciary duty to the source
of the government information in the same way
a corporate director does to a company's shareholders.
The lack of a clear legal mechanism for prosecution,
even with strong ethical evidence, highlights
the continuing loophole in the U .S. fraud -based
system. The fact that critical non -public information
held by politicians often doesn't trigger the
legal definition of fraud is a huge loophole
that continues to erode public trust. Absolutely.
The Stock Act increased transparency, which is
progress, but it didn't fundamentally change
the definition of fraud required to prosecute.
The ethical duty is crystal clear, but the legal
duty, as interpreted by the courts, is much,
much harder to apply in the political realm.
Okay, let's move to our final section. modern
threats, and global reactions. The digital age
has unfortunately made the commodification and
distribution of non -public information easier
than ever, creating brand new avenues for insider
trading. The primary modern threat is the dark
web market. A 2016 report revealed that sophisticated
dark websites were operating specifically as
marketplaces to sell non -public, commercially
sensitive information. And these are hard to
trace, I assume. Extremely. They often use cryptocurrencies
like Bitcoin to facilitate anonymous transactions
and circumvent traditional currency restrictions.
And this information isn't confined to being
used just for stock trading anymore. That's the
scary part. That confidential data, maybe a company's
proprietary algorithm or details about a regulator's
upcoming ruling, can be used for purposes far
beyond securities trading. Think corporate espionage,
gaining a competitive edge in contract bids or
even assisting in acts of corporate sabotage.
The criminal utility of stolen confidential information
has expanded significantly beyond just making
a quick buck in the stock market. So let's look
at some international enforcement examples to
show the varied responses globally. This illustrates
that while the law exists pretty much everywhere,
the severity of the response differs. We can
start with Brazil, a major emerging market economy.
Brazil's law clearly defines the conduct as misuse
of privileged information. However, despite the
law being in place since 2001, the country's
first criminal conviction for this didn't occur
until 2011 in the Sadia -Perdigom merger case.
And that case was significant. It was. It resulted
in fines and, importantly, the inability of the
convicted individuals to serve on public company
boards. Meanwhile, Canada delivered one of the
longest sentences in the world. for an insider
trading scheme. Yes. In 2009, a Canadian lawyer
named Stan Gromovsek pleaded guilty to a conspiracy
that spanned 14 years and generated over $10
million in illegal profits. He received a 39
-month prison sentence, which was at the time
the longest term ever imposed for insider trading
in Canadian history. It signaled a clear shift
toward harsher enforcement, mirroring the U .S.
approach. India presents a more frustrating regulatory
environment where insider trading is widely believed
to be rampant, but prosecution remains incredibly
difficult. The challenge in India is often procedural.
Despite the widespread belief that insider trading
takes place regularly, cases can take over a
decade to reach a resolution. Enforcement is
slow and historically the punishments have been
relatively light. While SEBI, the regulator,
has the power to demand substantial financial
penalties, the fines levied have often been viewed
as minimal, especially when compared to the potential
profits. This slow moving system really undermines
the deterrence factor. And finally, China is
a good example of regulatory inconsistency. historically
lax but capable of massive crackdowns. Before
the country's major financial reforms in the
mid -2000s, punishment was generally rare and
often just limited to monetary fees. However,
as China's financial markets matured, the state
has demonstrated its capacity for severe sentences.
In a high -profile crackdown in 2017, the major
fund manager Xu Zhang was sentenced to five and
a half years in prison and fined an enormous
11 billion yuan. That's one of the largest financial
penalties ever imposed. It is. And it illustrates
that while regulatory enforcement can be inconsistent,
Chinese authorities are certainly capable of
imposing brutal sentences to maintain control
and signal state authority. So after all that,
what does this all mean for you, the informed
investor and observer? We've navigated the global
commitment to prohibition, which is driven by
the absolute need for fair markets and corporate
integrity. We've also seen the U .S. legal framework
constantly having to evolve, moving from a strict
fiduciary duty model to the sprawling misappropriation
theory just to catch the cleverest criminals.
I think the key takeaway is that understanding
insider trading isn't just about reading headlines
of corporate malfeasance. It is about appreciating
this complex web of duty of corporate property
rights and the legislative attempts to keep pace
with information asymmetry in a global, rapidly
evolving market. The core tension remains fundamental.
How do you foster public trust and enforce fairness
without suffocating the flow of valuable price
correcting information that is vital for market
efficiency? I think we have to end with a question
that connects the corporate and political spheres.
Particularly given the U .S. adoption of the
misappropriation theory, the idea that a company's
non -public information is its property to be
protected from theft. That property theory is
what makes the final question so relevant. There
was the notable case of United States v. Blasac,
where the so -called king of political intelligence
was convicted for trading on confidential government
regulatory information that was stolen from the
Centers for Medicare and Medicaid Services. The
law actually extended the misappropriation theory
to protect government data, treating it similarly
to corporate property. Which raises a really
important question for you, the listener, especially
in light of the 2020 scandals involving Congress.
If the US law views the theft and trading of
confidential corporate secrets as fraud akin
to embezzlement, should the theft and trading
of confidential government regulatory information,
which clearly affects markets, be viewed as equally
harmful? And what ethical duty do politicians
and their sources owe to the market when they
receive non -public, price -sensitive information?
And how far should the law go to enforce this
duty, even when the information isn't a traditional
corporate secret, but a public one just waiting
to be announced? It's a question of whether the
legal duty is strictly to the company, or if
the duty now must extend to the integrity of
the market itself. As information continues to
be the most valuable and volatile commodity in
the world, that answer will define the future.
of securities law.