How can capital markets weather the storm of insider trading?

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Upoma Dutta's picture

How can capital markets weather the storm of insider trading?

In 1994, the news of Rajat Gupta’s ascendency to the helm of the globally renowned McKinsey & Co. was a source of inspiration for all young aspirants in the East. His rags-to-riches story reinforced the belief that an Indian boy – orphaned in his teens and shackled by destituteness – could eventually overcome all obstacles – through his sheer hard work and belief in free will – and realize the American dream. Over the years, his tale of success continued as he found his way into the boardrooms of a myriad of organizations, including Goldman Sachs and Procter and Gamble. I cannot help but feel a pang of envy for all the aspiring professionals who were motivated to join Corporate America by Gupta’s newfound fortune. After all, they had a role model who could influence their career goals and motivate them to strive harder to reach those goals.

Now, after almost eighteen years, Rajat Gupta has become the very person who can make young Asian business executives change their career tracks. His recent conviction for involvement in the world’s largest insider-trading (that is, the practice of profiting from information that is not yet public) scheme till date and for tipping off his friend Raj Rajaratnam, a Sri Lankan American hedge fund manager, about several pieces of market-moving information has made people like me question the rationality behind their career choice. A career is meant to serve as a means to grow both professionally and mentally. How could then somebody – at the acme of his career – risk his reputation and get engaged in an activity that is not only unethical but also illegal? More importantly, the trials of Gupta and Rajaratnam shake investors’ confidence in not just Wall Street but also the financial system as a whole. If insider trading is as rampant on the world’s largest financial district as the recent string of scandals suggests, how much worse is the scenario for Tokyo’s Marunouchi, Shanghai’s Lujiazui, Mumbai’s Dalal Street and Dhaka’s Motijheel?

The greed for wealth must be boundless – at least for some reigning in Wall Street and other financial districts throughout the world. After all, an insightful researchi reveals that the higher the salary earned by an executive, the greater the likelihood that he or she will engage in an insider-trading scheme. Is it possible that, under the absence of draconian regulations against insider trading, the entire spectrum of market participants would resort to such unscrupulous practice? Or is it just a few bad apples ruining the reputation of the entire bunch? In this scenario, the recent statementii made by David Chaves, a senior FBI agent investigating insider-trading cases, would provide some relief to those who still want to have firm faith in the integrity of the capital markets. Mr. Chaves affirms that just 1 percent of the hedge-fund industry may be involved in this illegal practice; the rest strive to achieve their targeted portfolio returns through diligent research and prudent judgment.

The recent curbs on insider trading on Wall Street are owed to the Securities Exchange Act of 1934, which has clearly defined insider trading as illegal, as well as regulators’ incessant efforts to prosecute the guilty, though the same cannot be said about the capital markets in the developing countries. Moreover, every CFA (Chartered Financial Analyst) charterholder or candidate, by his or her agreement to abide to the Standard IIA of the Standards of Professional Conductiii, is prohibited from acting upon or causing others to act upon material, non-public information. Yet, there is no

denying that insider trading is more prevalent than either the law or the CFA Institute would want it to be.

The prevalence of insider-trading instances may be explained by the fact that this action, despite being illegal, creates a grey zone, where market participants become ambivalent about the morality of insider trading. Certainly, insider trading is often not considered as “unethical” as misreporting earnings or artificially inflating trading volume of a stock. Many college graduates who have just landed a job at a hedge fund or an investment bank are likely to confide that they know that insider trading is unethical, but they just do not have the reasons for that.

Not surprisingly, there are a sizable number of advocates of insider trading who would argue that there is nothing morally wrong with acting on material non-public information ahead of others; after all, doing so is going to benefit the insider without violating the rights of anybody else. However, such an argument overlooks the fact that the insider is essentially “stealing” information from a corporation without the consent of the latter. Moreover, the insider is unjustly exploiting information asymmetry by engaging in a transaction with a party who cannot avail the information even after conducting diligent research and analysis. As a result, more rigorous ethics training is required for incumbent market participants to make them realize not only that insider trading is unethical but also why it is unethical. Such training may be more successful than double-digit prison sentences in combating insider trading.

Finally, corporations must be proactive if they are to prevent their information from being stolen by those who are constantly on the lookout for insider-trading opportunities. And such proactive stance can be reflected through regular guidance (that is, estimate) on earnings – at least every quarter – so that market prices of the stocks quickly adjust to their fair values, leaving little room for benefiting from inside information.

Being an impediment to perfect competition, insider trading can drastically damage the integrity as well as the efficiency of the capital markets. Moreover, rampant insider trading can make those in possession of insider information well off at the expense of the outsiders relying on hard work and diligent research to make a living. In a nutshell, more stringent regulation – coupled by effective ethics training and frequent earnings guidance – can deter insider trading and take the capital markets one step closer to efficiency.

References: 
  1. Andrews, E. (2010). Inside Insider Trading. Retrieved from http://www.kelley.iu.edu/ubhattac/Featured%20on%20IU%20Magazine%20April%...
  2.  Strasburg, J. and Albergotti, R. (2012, February 28). Insider Targets Expanding. The Wall Street Journal. Retrieved from http://online.wsj.com/article/SB1000142405297020383300457724971050463872...
  3. Standards of Practice Handbook (10th ed.) (2010). CFA Institute. Retrieved from http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2010.n2.1