Insider Trading

One of the important restrictions on trading involves insider trading. It is illegal for anyone to transact in securities to profit from inside information, that is, private information held by officers, directors, or major stockholders that has not yet been divulged to the public. The difficulty is that the definition of insiders can be ambiguous. Although it is obvious that the chief financial officer of a firm is an insider, it is less clear whether the firm's biggest supplier can be considered an insider. However, the supplier may deduce the firm's near-term prospects from significant changes in orders. This gives the supplier a unique form of private information, yet the supplier does not necessarily qualify as an insider. These ambiguities plague security analysts, whose job is to uncover as much information as possible concerning the firm's expected prospects. The distinction between legal private information and illegal inside information can be fuzzy.

An important Supreme Court decision in 1997, however, came down on the side of an expansive view of what constitutes illegal insider trading. The decision upheld the so-called misappropriation theory of insider trading, which holds that traders may not trade on nonpublic information even if they are not company insiders.

The SEC requires officers, directors, and major stockholders of all publicly held firms to report all of their transactions in their firm's stock. A compendium of insider trades is published monthly in the SEC's Official Summary of Securities Transactions and Holdings. The idea is to inform the public of any implicit votes of confidence or no confidence made by insiders.

Do insiders exploit their knowledge? The answer seems to be, to a limited degree, yes. Two forms of evidence support this conclusion. First, there is abundant evidence of "leakage" of useful information to some traders before any public announcement of that information. For example, share prices of firms announcing dividend increases (which the market interprets as good news concerning the firm's prospects) commonly increase in value a few days before the public announcement of the increase.6 Clearly, some investors are acting on the good news before it is released to the public. Similarly, share prices tend to increase a few days before the public announcement of above-trend earnings growth.7 At the same time, share prices still rise substantially on the day of the public release of good news, indicating that insiders, or their associates, have not fully bid up the price of the stock to the level commensurate with that news.

The second sort of evidence on insider trading is based on returns earned on trades by insiders. Researchers have examined the SEC's summary of insider trading to measure the performance of insiders. In one of the best known of these studies, Jaffe8 examined the abnormal return on stock over the months following purchases or sales by insiders. For months in which insider purchasers of a stock exceeded insider sellers of the stock by three or more, the stocks had an abnormal return in the following eight months of about 5%. When insider sellers exceeded inside buyers, however, the stock tended to perform poorly.

SUMMARY

1. Firms issue securities to raise the capital necessary to finance their investments. Investment bankers market these securities to the public on the primary market. Investment bankers generally act as underwriters who purchase the securities from the firm and resell them to the public at a markup. Before the securities may be sold to the public, the firm must publish an SEC-approved prospectus that provides information on the firm's prospects.

2. Issued securities are traded on the secondary market, that is, on organized stock exchanges, the over-the-counter market, or, for large traders, through direct negotiation. Only members of exchanges may trade on the exchange. Brokerage firms holding seats on the exchange sell their services to individuals, charging commissions for executing trades on their behalf. The NYSE has fairly strict listing requirements. Regional exchanges provide listing opportunities for local firms that do not meet the requirements of the national exchanges.

3. Trading of common stocks in exchanges takes place through specialists. Specialists act to maintain an orderly market in the shares of one or more firms, maintaining "books"

6 See, for example, J. Aharony and I. Swary, "Quarterly Dividend and Earnings Announcement and Stockholders' Return: An Empirical Analysis," Journal of Finance 35 (March 1980).

7 See, for example, George Foster, Chris Olsen, and Terry Shevlin, "Earnings Releases, Anomalies, and the Behavior of Security Returns," The Accounting Review, October 1984.

8 Jeffrey F. Jaffe, "Special Information and Insider Trading," Journal of Business 47 (July 1974).

CHAPTER 3 How Securities Are Traded of limit-buy and limit-sell orders and matching trades at mutually acceptable prices. Specialists also will accept market orders by selling from or buying for their own inventory of stocks.

4. The over-the-counter market is not a formal exchange but an informal network of brokers and dealers who negotiate sales of securities. The Nasdaq system provides online computer quotes offered by dealers in the stock. When an individual wishes to purchase or sell a share, the broker can search the listing of offered bid and asked prices, contact the dealer who has the best quote, and execute the trade.

5. Block transactions account for about half of trading volume. These trades often are too large to be handled readily by specialists, and thus block houses have developed that specialize in these transactions, identifying potential trading partners for their clients.

6. Buying on margin means borrowing money from a broker in order to buy more securities. By buying securities on margin, an investor magnifies both the upside potential and the downside risk. If the equity in a margin account falls below the required maintenance level, the investor will get a margin call from the broker.

7. Short selling is the practice of selling securities that the seller does not own. The short seller borrows the securities sold through a broker and may be required to cover the short position at any time on demand. The cash proceeds of a short sale are kept in escrow by the broker, and the broker usually requires that the short seller deposit additional cash or securities to serve as margin (collateral) for the short sale.

8. Securities trading is regulated by the Securities and Exchange Commission, as well as by self-regulation of the exchanges. Many of the important regulations have to do with full disclosure of relevant information concerning the securities in question. Insider trading rules also prohibit traders from attempting to profit from inside information.

9. In addition to providing the basic services of executing buy and sell orders, holding securities for safekeeping, making margin loans, and facilitating short sales, full-service brokers offer investors information, advice, and even investment decisions. Discount brokers offer only the basic brokerage services but usually charge less.

10. Total trading costs consist of commissions, the dealer's bid-asked spread, and price concessions.

KEY TERMS

primary market secondary market initial public offerings underwriters prospectus private placement stock exchanges over-the-counter market

Nasdaq bid price asked price third market fourth market electronic communication network specialist block transactions program trades bid-asked spread margin short sale inside information

WEBSITES

http://www.nasdaq.com

http://www.amex.com

The above sites contain information of listing requirements for each of the markets. The sites also provide substantial data for equities.

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