Skip to main content

Advertisement

Log in

Ethics, Markets, and the Legalization of Insider Trading

  • Original Paper
  • Published:
Journal of Business Ethics Aims and scope Submit manuscript

Abstract

In light of recent doctrinal changes, we examine the confused state of U.S. insider trading law, identifying gaps that permit certain market participants to trade on the basis of material nonpublic information, and contrast U.S. insider trading doctrine with the European approach. We then explore the ethical implications of the status quo in the U.S., explaining why the dominant legal justifications for prohibiting classical insider trading and misappropriation—the fiduciary duty and property rights theories—fail to account for the wrongfulness of insider trading by eavesdroppers and certain tippees. We refute common arguments for legalizing insider trading, including arguments that insider trading is a victimless crime and that the practice promotes efficiency. We explain why insider trading constitutes the moral wrong of cheating, grounding our theory in the legitimate expectations of market participants. Having considered Kantian deontology in other work, we find that virtue ethics theory offers a helpful albeit rough framework for assessing the morality of insider trading independent of its legality. We also find that social contract theories, with norms of equality of opportunity and moral desert, provide a compelling ethical basis for retaining, clarifying and broadening current legal prohibitions against insider trading.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

Notes

  1. Consistent with other scholarship, we define “insider trading” for purposes of this paper as “trading securities on the basis of material nonpublic information.” This definition does not include trading by corporate insiders if not on the basis of material nonpublic information. It also covers trading on material nonpublic information by any person, not just insiders.

  2. The majority’s approach was undoubtedly driven in part by its sympathy for Mr. Secrist and Mr. Dirks. Clearly, those two did not fit the usual mold seen in insider trading cases. Usually, the material nonpublic information is not about ongoing criminal conduct at a company, but rather is confidential information legitimately “owned” by the company such as information about expected earnings or dividends. Usually, the insider is not an altruistic whistleblower, but rather someone who tries to personally benefit either by trading for his own account (as in Texas Gulf Sulphur), or by selling a tip for cash, gifts or future reciprocal benefits from the tippee. Yet, while the Court’s holding achieved the laudable goal of ensuring that corporate whistleblowers and truth-seeking analysts would not be sanctioned for disclosing nefarious corporate activity, there might have been other ways to reach a similar outcome exonerating Dirks. For example, the Court could have decided that insider trading did not occur because information about the ongoing commission of a crime is not a legitimate piece of information in which a corporation may claim a property right.

  3. The four dissenting justices in Dirks expressed concern for the shareholders with whom Dirks’ clients traded, wondering if they were harmed regardless of whether the insider, Secrist, received a personal benefit. The answer appears to be an obvious yes, since Dirks’ clients were able to sell their stock before the Equity Funding accounting fraud became public and were thereby “able to shift the losses that were inevitable due to the Equity Funding fraud from themselves to uninformed market participants.” As recognized by the dissenting Justices in that case, “it makes no difference to the shareholder whether the corporate insider gained or intended to gain personally from the transaction; the shareholder still has lost because of the insider’s misuse of nonpublic information” (Dirks v. SEC 1983).

  4. We find this outcome legally strange, considering that an insider’s fiduciary duties can be breached not only by violating the “duty of loyalty” but also by violating their “duty of care” through negligent disclosure (Macey 2017). We find it ethically suspect as well, considering that counterparties against whom such lucky eavesdroppers trade will be disadvantaged, regardless of whether the unauthorized disclosure that created the advantage was made negligently or intentionally, for free or in exchange for a personal benefit.

  5. After declining to review the Newman case, the Supreme Court soon considered the case of Salman v. U.S. (2017), in which tips of material nonpublic information freely passed from a Citigroup insider to Salman’s brother and eventually to his brother-in-law, who traded on them. Finding the brother-in-law tippee liable for insider trading, the Supreme Court explained that while “the disclosure of confidential information without personal benefit is not enough” under Dirks, uncompensated “gift” tips to family members—or to those with a “meaningfully close personal relationship”––can still provide a personal benefit to the tipper and thus result in insider trading liability to the tippee-trader. According to the unanimous Court, “the tipper personally benefits because giving a gift of trading information to a trading relative is the same thing as trading by the tipper followed by a gift of the proceeds” (Salman v. U.S. 2017). The extent to which a personal benefit to the tipper can be inferred when a gift tip is made from an insider to someone with whom they are not in a “meaningfully close personal relationship” remains unclear because it is not clear how much of the Second Circuit’s decision in Newman survives after the Supreme Court’s decision Salman (U.S. v. Martoma 2017).

  6. Efficiency arguments have failed to convince a majority of policy-makers. Two decades after Henry Manne’s influential 1966 book, Congress actually increased penalties for insider trading (Schipani and Seyhun 2016) and 45 years later, the number of insider trading prosecutions has increased (Packer 2011). The willingness of younger employees in the financial industry to cheat is rising (Tenbrunsel and Thomas 2015). Likewise, ethical theories condemning insider trading have not prompted Congress to legally foreclose all forms of the practice, nor dissuaded all market participants from engaging in it.

  7. In Robert Jackall’s account, those at the top often deliberately avoid any substantive feedback on the details of how their orders are implemented, to maintain “plausible deniability.” As Jackall notes, credit is pushed up the chain of command, while attention to detail is pushed downward. At the same time that top management seeks plausible deniability regarding the reality of decisions carried out in the lower levels of the organization, lower-level management seeks to spread around the responsibility for potential failure so that “blame time” does not isolate one manager.

  8. U.S. v. Rajat Gupta, Indictment, Case No. 11-Crim-907, Docket Entry No. 1 (S.D.N.Y. Oct. 25 2011) §11 (“Gupta obtained the Inside Information in his capacity as a member of the Goldman Sachs Board and the P&G Board” and “disclosed the Inside Information to Rajaratnam, with the understanding that Rajaratnam would use the Inside Information to purchase and sell securities”).

  9. According to the results of a financial event study, Proctor & Gamble stock (PG) experienced a statistically significant decline of approximately 2% in its stock price relative to its expected returns (cumulative abnormal return) over the course of the 4 days following the revelations of its director’s involvement in insider trading (Olsen and Klaw 2017).

References

  • Altucher, J. (2011, 17 May). Why insider trading should be legal. MarketWatch.

  • Angel, J., & McCabe, D. (2018). Insider Trading 2.0? The ethics of information sales. Journal of Business Ethics, 147(4), 747–760.

    Article  Google Scholar 

  • Aristotle. (1926). Nicomachean ethics (trans: Loeb Classical Library). Cambridge, MA: Harvard University Press.

  • Augustin, P., Brenner, M., & Subrahmanyam, M. (2014). Informed options trading prior to M&A announcements: Insider trading?. New York: IRRC Institute.

    Google Scholar 

  • Bentham, J. (1781/1988). The principles of moral and legislation. Amherst, NY: Prometheus Books.

  • Bharara, P., & Jackson Jr., R. J. (2018, October 9). Insider trading laws haven’t kept up with the crooks. The New York Times.

  • Bhattacharya, U., & Daouk, H. (2002). The world price of insider trading. Journal of Finance, 57(1), 75–108.

    Article  Google Scholar 

  • Brophy v. Cities Service Co., 31 Del. Ch. 241 (1948).

  • Cady, Roberts & Co., Exchange Act Release No. 34-6668, 40 SEC Docket 907 (1961).

  • Carlton, D., & Fischel, D. (1983). The regulation of insider trading. Stanford Law Review, 35, 857–895.

    Article  Google Scholar 

  • Carney, J. (2014). To catch a trader. Frontline, 32(5).

  • Chiarella v. United States, 445 U.S. 222 (1980).

  • Dirks v. SEC, 463 U.S. 646 (1983).

  • Dorfman, J. (2015, March 22). Make insider trading legal to stop hurting ordinary investors. Forbes.

  • Dunfee, T. (1991). Business ethics and extant social contracts. Business Ethics Quarterly, 1(1), 23–51, 26.

  • Dunfee, T. (1996). On the synergistic, interdependent relationship of business ethics and law. American Business Law Journal, 34, 317–325, 317, 319.

  • Dunfee, T., & Donaldson, T. (1995). Contractarian business ethics: Current status and next steps. Business Ethics Quarterly, 5(2), 173–186.

    Article  Google Scholar 

  • Edde, J., Kumar, N., & Waite, S. (2018, February 27). Investors are paying $1,300 per hour for ‘Expert’ chats. Bloomberg.

  • Engelen, P. J., & Van Liederkerke, L. (2007). The ethics of insider trading revisited. Journal of Business Ethics, 74(4), 497–507.

    Article  Google Scholar 

  • E.U. Market Abuse Regulation, No 596/2014 of the European Parliament and of the Council of 16 April 2014.

  • Franklin, B. (1758/1986). The way to wealth. Carlisle, MA: Applewood Books.

  • Gantler v. Stephens, 965 A.2d 695, 708-09 (Del. 2009).

  • Goldstein, M. (2015, October 22). U.S. Prosecutor to drop insider trading cases against seven. The New York Times.

  • Green, S. (2006). Lying, cheating and stealing: A moral theory of white collar crime. Oxford: Oxford University Press.

    Google Scholar 

  • Guiso, L., Sapienza, P., & Zingales, L. (2008). Trusting the stock market. Journal of Finance, 63(6), 2557–2600.

    Article  Google Scholar 

  • Guth v. Loft, 5 A.2d 503 (Del. 1939).

  • Hail, L., & Leuz, C. (2006). International differences in the cost of equity capital: Do legal institutions and securities regulation matter? Journal of Accounting Research, 44(3), 485–531.

    Article  Google Scholar 

  • Henning, P. (2018). Making up insider trading law as you go. Washington University Journal of Law and Policy, 56(101–120), 101.

    Google Scholar 

  • Jackall, R. (1988). Moral Mazes: The World of Corporate Managers. New York: Oxford University Press.

    Google Scholar 

  • Josephson, M. (2002). Making Ethical Decisions. Josephson Institute of Ethics.

  • Keefe, P. (2015, October 27). Making insider trading legal. The New Yorker.

  • Kim, S. (2014). Insider trading as private corruption. UCLA Law Review, 61, 928–1008.

    Google Scholar 

  • Klaw, B. W. (2016). Why now is the time to statutorily ban insider trading under the equality of access theory. William and Mary Business Law Review, 7(2), 275–345.

    Google Scholar 

  • Knight, T. (2017). Salman v. U.S.: Another insider trading case. Cato Supreme Court Review, 2016–2017, 181–203.

    Google Scholar 

  • Kolhatkar, S. (2017). Black edge: Inside information, dirty money, and the quest to bring down the most wanted man on Wall Street. New York: Random House.

    Google Scholar 

  • Kwabi, F. O., Boateng, A., & Adegbite, E. (2018). The impact of stringent insider trading laws and institutional quality on cost of capital. International Review of Financial Analysis, 60, 127–137.

    Article  Google Scholar 

  • Lecher, C. (2018, March 14). Former Equifax executive charged with insider trading ahead of massive data breach. The Verge.

  • Levmore, S. (1982). Securities and secrets: Insider trading and the Law of Contracts. Virginia Law Review, 68(117–160), 117.

    Article  Google Scholar 

  • Lewis, M. (2014). Flash boys: A Wall Street revolt. New York: W.W. Norton and Company.

    Google Scholar 

  • Locke, J. (1773). An essay concerning the true original, extent and end of Civil Government. Oxford University Text Archive.

  • Ma, Y., & Sun, H. (1998). Where should the line be drawn on insider trading ethics? Journal of Business Ethics, 17(1), 67–75.

    Article  Google Scholar 

  • Macey, J. (1999). Securities trading, a contractual perspective. Case Western Law Review, 50(269–290), 269.

    Google Scholar 

  • Macey, J. (2007). Getting the word out about fraud: A theoretical analysis of whistleblowing and insider trading. Michigan Law Review, 105, 1899–1940, 1899, 1903, 1920.

  • Macey, J. (2017). Beyond the personal benefit test: The economics of tipping by insiders. Journal of Law and Public Affairs, 2(1), 28–74.

    Google Scholar 

  • Maclntyre, A. (1984). After virtue (2nd ed.). Notre Dame, IN: University of Notre Dame Press.

    Google Scholar 

  • Maclntyre, A. (1988). Whose justice? Which rationality?. Notre Dame, IN: University of Notre Dame Press.

    Google Scholar 

  • Manne, H. (1966). Insider trading and the stock market. New York: The Free Press.

    Google Scholar 

  • Manne, H. (1985). Insider trading and property rights in new information. Cato Journal, 4, 933–943.

    Google Scholar 

  • Manne, H. (2005). Hayek, virtual markets, and the dog that did not bark. Iowa Journal of Corporate Law, 31(1), 167–185.

    Google Scholar 

  • Matthews, D. (2013, July 26). Insider trading in riches and informs us, and could prevent scandals. Legalize it. Washington Post.

  • McGee, R. (2008). Applying ethics to insider trading. Journal of Business Ethics, 77, 205–217.

    Article  Google Scholar 

  • McGee, R. (2009). Analyzing insider trading from the perspectives of utilitarian ethics and rights theory. Journal of Business Ethics, 91, 65–82.

    Article  Google Scholar 

  • Mill, J. S. (1861/1993). Utilitarianism. New York: Bantam Books.

  • Moore, J. (1990). What is really unethical about insider trading? Journal of Business Ethics, 17, 171–182.

    Article  Google Scholar 

  • Morgan, R. (1987). Insider trading and the infringement of property rights. Ohio State Law Journal, 48, 79–116.

    Google Scholar 

  • Murphy, P. (1999). Character and virtue ethics in international marketing: An agenda for managers, researchers and educators. Journal of Business Ethics, 18(1), 107–124.

    Article  Google Scholar 

  • Northern District of Georgia U.S. Attorney’s Office, DOJ Press Release. (2018). Former Equifax manager pleads guilty to insider trading, 23 July.

  • O’Toole, J. (1993). The executive’s compass: Business and the good society. New York: Oxford University Press.

    Google Scholar 

  • Olsen, T., & Klaw, B. W. (2017). Do investors punish corporations for malfeasance? Disclosure, materiality and market reactions to corporate irresponsibility. Journal of Corporate Citizenship, 65, 67–88.

    Google Scholar 

  • Packer, G. (2011, June, 27). A dirty business: New York City’s top prosecutor takes on Wall Street crime. The New Yorker.

  • Padilla, A., & Gardiner, B. (2009). Insider trading: Is there an economist in the room? The Journal of Private Enterprise, 24(2), 113–136.

    Google Scholar 

  • Patel, P. (2013). Applying virtue ethics: The Rajat Gupta Case. Seven Pillars Institute for Global Finance and Ethics, February 11.

  • Posner, R. (1983). The economics of justice. Cambridge, MA: Harvard University Press.

    Google Scholar 

  • Posner, R. (1998). Economic analysis of law (5th ed.). New York: Aspen Law and Business.

    Google Scholar 

  • Prentice, R., & Donelson, D. (2010). Insider trading as a signaling device. American Business Law Journal, 47(1), 1–63.

    Article  Google Scholar 

  • Ragavan, A. (2017, August 15). For Rajat Gupta, returning is a hard road. The New York Times.

  • Rawls, J. (2003). Justice as fairness: A restatement. Cambridge, MA: Belknap Press of Harvard University Press.

    Google Scholar 

  • Salbu, S. (1995). Insider trading and the social contract. Business Ethics Quarterly, 5(2), 313–338, 317.

  • Salman v. United States, 137 S. Ct. 420 (2016).

  • Scheppele, K. L. (1993). ‘It’s Just Not Right’: The ethics of insider trading. Law and Contemporary Problems, 56(123–173), 123.

    Article  Google Scholar 

  • Schipani, C., & Seyhun, H. J. (2016). Defining ‘Material Nonpublic’: What should constitute illegal insider information? Fordham Journal of Corporate and Financial Law, XXI(2), 327–378.

    Google Scholar 

  • SEC Rule 10b-5, 17 C.F.R. § 240.10b-5.

  • SEC v. Mozilo et al, Case No. CV 09-03994, Complaint (C.D. Cal. 2009).

  • SEC v. Switzer, 590 F. Supp. 756 (W.D. Okla. 1984).

  • SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1968).

  • Securities Exchange Act of 1934, Section 10b, 15 U.S.C. § 78j(b) (2010).

  • Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228 (2d. Cir 1974).

  • Shiller, R. (2012). Finance and the good society. Princeton, NJ: Princeton University Press.

    Google Scholar 

  • Smith v. Van Gorkum, 488 A.2d 858 (Del. 1985).

  • Strudler, A., & Orts, E. (1999). Moral principle in the law of insider trading. Texas Law Review, 78(2), 375–438.

    Google Scholar 

  • Tenbrunsel, A., & Thomas, J. (2015). The street, the bull, and the crisis: A survey of the US & UK financial services industry. New York: Labaton Sucharow.

    Google Scholar 

  • Thomson-DeVeaux, A. (2016, October 5). What’s so wrong with insider trading anyway? Five Thirty Eight.

  • Trading and Securities Fraud Enforcement Act of 1988, Pub. L. No. 100-704, 102 Stat. 4677 (1988).

  • Tramontano, K. (2017, March 7). America is failing workers left behind by the new economy. Washington Monthly.

  • United States v. Martoma, 894 F.3d 64 (2d Cir. 2017) (amended June 25 and corrected July 3, 2018).

  • United States v. Newman, 773 F.3d 438 (2d Cir. 2014).

  • United States v. O’Hagan, 521 U.S. 642 (1997).

  • United States v. Rajat Gupta, No. 11-Crim-907, Indictment (S.D.N.Y. Oct. 25, 2011).

  • Werhane, P. (1989). The ethics of insider trading. Journal of Business Ethics, 8(11), 841–845.

    Article  Google Scholar 

  • Zingales, L. (2012). A capitalism for the people: Recapturing the lost genius of American prosperity. New York: Basic Books.

    Google Scholar 

Download references

Author information

Authors and Affiliations

Authors

Corresponding author

Correspondence to Bruce W. Klaw.

Ethics declarations

Conflict of interest

Authors declare that they have no conflict of interest.

Ethical Approval

This article does not contain any studies with human participants or animals performed by any of the authors.

Additional information

Publisher's Note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Klaw, B.W., Mayer, D. Ethics, Markets, and the Legalization of Insider Trading. J Bus Ethics 168, 55–70 (2021). https://doi.org/10.1007/s10551-019-04238-0

Download citation

  • Received:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10551-019-04238-0

Keywords

Navigation