Negative Side Of Insider Trading

By Author: Henry Ford
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Insider trading is the trading in a security on the basis of material information that is inaccessible to the public. The US securities prohibit this kind of trade because of its unfairness and its potentiality of destroying investor confidence. A company insider is a person in possession of crucial information of a company that can affect the stock price or influence the decisions investors make. This kind of information is referred to as material information and is possessed by all company executives. The person involved with sales for instance knows the much the company has sold and if it will meet the promised estimates for investors. Other employees inside the company like the accountant and the administrative assistant are also insiders. This essay will address insider trading ion the premise that an investment strategy that does not make the society prosperous is wrong.
Insider trading occurs when transactions relating to securities are taking place and one party is in possession of information which is non-public. Despite that insider trading is not new in the business world, economic and legal discussions concerning ...
... the trade still abound. The first case of insider trading was alleged to have arisen when Rothschilds gained benefits from insider trading after discovering that Wellington had succeeded earlier than the rest of London. Legal and economic scholars still argue over whether insider trading should be regulated. Whether this question is answered in the affirmative, legal scholars and judges from different areas debate over the legal theory of liability and how it is applicable. Insider trading is a current legal problem rather than an issue for legal history. International observers have identified that it requires a world-wide dimension with regard to global financial markets (Fishe & Robe, 2002).

Negative Side of insider trading
Insider trading leads to a conflict of interest between firms and the management. The management of firms believes that insider trading can cause harm to the firms since it motivates insider managers in a manner different from that of managers who maximize profits. Insider managers may not be committed towards achieving the best results for a firm. While profit-maximizing managers endeavor to maximize the difference between returns and costs, insider managers on the other hand concentrate on maximizing profits during good business times but are likely to ignore costs in bad business periods. This may be illustrated by the tendency to give incentives for undertaking risky projects as well as their behavior regarding takeovers (Fishe & Robe, 2002).
Insider managers are known to undertake projects that have minimal risks. They may undertake projects whose stock prices have increased volatility hence giving them chances of benefiting from insider trading. They do not choose projects which promise high returns for the firm but instead projects with a high volatility in stock prices. The projects with high risk are the ones which exhibit high volatility hence the aims of managers and the ones for the firm are not aligned.

Insider trading also becomes unsuitable form of compensation when insiders are allowed to buy fractions of the value of stocks. Managers benefit from the increased prices of stock price but do not lose anything when the prices fail to increase. As a result, their incentive is not geared towards maximizing the value of the firm but instead to maximize volatility and risk. Insider trading also causes negative influences in takeover circumstances (Bernet, 1991). Insiders pursue personal interests instead of pursuing the interests of the organization and the shareholders. When managers of one corporation attempt to take over another corporation, they may apply their knowledge in engaging in transactions using stocks of the targeted corporation or organization. Insider trading therefore increases the transaction costs to the aggressors.

Apart from insider trading increasing the takeover costs, managers may consider possible profits from insider trading instead of the profits the firm will gain from the acquisition. A manager of a target corporation may make use of this knowledge in making the turnover difficult for purposes of maintaining his job. This implies that insider trading has negative effects with respect to the control and monitoring of the management (Bernet, 1991).

The prices of company stocks that are unstable and often change through insider trading do not have any causal event that initiates the change. In general terms, remarkable shifts in the stocks of a company can be associated with public announcements, economic performances or performance reports of a company. Insider activities that have a direct effect on stock prices might lead to lack of confidence in the organization. If a stock experiences a drastic drop in price, this might cause other investors to sell their stocks. If there is a dramatic rise in the prices, long term investors may invest in the company hence bringing in new investors who may have unrealistic expectations with regard to the future performance of the company.

Information received in a way that is not genuine and then used by investors to make transactions in the stock market can cause market instability. All investors are expected to function on the basis of equal access of information about companies that is distributed publicly. Investors are then expected to make decisions concerning transactions on the same level with other investors. Insider trading is known to cause abnormal fluctuations in the prices of company stocks, something which is capable of causing distrust in the fairness expected of the stock market system.

Established laws against insider trading are aimed at preventing those who possess information that is not aimed at benefiting the general public. Though the laws preventing insider trading are aimed at ensuring fairness in the stock market, the laws are at times unrealistic in
their application. Government enforced regulation is important to do away with the problem of adverse selection that is posed by insider trading (Bernet, 1991). One way of determining if regulating insider trading can eliminate the problems it poses is by investigating how effective insiders are prevented from doing business on the basis of information which is non-public. In other wards the question is whether the insiders comply with the law. If they comply with the law, the conclusion is that the regulation works in solving the adverse problems caused by insider trading. Efficacy in preventing insiders from trading with non public information has shown that it is of great importance to economists.

Conclusion
Preventing insider trading is regarded as an important function towards regulating securities. The United States which is among the countries whose financial markets are highly studied regulators uses a lot of resources to prevent the spread of insider trading. In other countries other than the U.S actions from the government against insiders are limited. Many countries are not concerned about preventing insider trading and they do little with regard to enforcing laws to prevent it. For purposes of making sense from insider trading, it is important to have an understanding of the markets and the role they play in the economy. The core function of regulation is encouraging efficiency in the market. It is therefore very important to examine effects of insider trading on market efficiency.

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