Analyzing the ethical arguments against insider trading

by: Daryl Fritzie Ann A. Ang, CPA

Abstract

This article identifies the real reason why insider trading is unethical and morally wrong. It examines the principal ethical arguments for treating insider trading as morally wrong: the claim that the practice is unfair, the claim that it harms ordinary investors and the society as a whole, the claim that it involves with proprietary rights or “misappropriation: of information and the claim that it is deceptive.  The author concludes that each of these arguments has some serious deficiencies; no one of them by itself provides a sufficient reason for insider trading to be unethical.  The author determined that the most persuasive moral basis for wrongness of insider trading is that it undermines the fiduciary relationships that lies at the heart of the business.

Keywords: Insider trading, insider, inside, morality, moral rights, conflict of interest

Introduction

Behind every great fortune, lies a great crime, so said the French novelist Honore de Balzac. Could this be more pronounced in stock markets around the world where the most brilliant minds perpetrate the most sophisticated financial crimes?

With the recent explosion in insider trading activity, an important set of moral issues is brought to the fore.  Are inside traders glowing examples of selfish criminals exploiting society and the economy for personal gain, with no regard for the effect on others? What are the moral implications of insider trading?

Insider trading phenomena is controversial and is bringing a lot of discussion around itself.  Some claims that it is both unethical and illegal to use information, which is not putted into public knowledge, while others argue that insider trading increases market efficiency and does not cause any harm to anybody.

So the question remains, should insider trading be legal or illegal in the stock market? If it was to be legal, is it then considered moral or immoral as a practice? This article will discuss the morality of insider trading and stating numerous principal ethical arguments against insider trading.

Insider Trading

“Insider trading” as the term is usually used, means the act of buying or selling a company’s stock on the basis of “inside” information about the company.  “Inside” or :”insider” information about a company is confidential or proprietary information about a company that is not available to the general public outside the company, but which would have a material or significant impact on the price of company’s stock (Velasquez, 1998).

Donaldson (1990) also defined insider trading as “exploiting advance knowledge of an important development to buy or sell stock before the public knows about it” – is illegal and is almost universally thought to be immoral.  However, the concept of insider trading itself, as well as the immorality of insider trading may be more difficult to explain than is generally thought.

Accordingly, insiders really do exploit their knowledge.  There are three forms of evidence supporting this phrase.  First, there have been well-publicized convictions of principals in insider trading schemes.  Second, there is considerable evidence of “leakage” of useful information to some traders before any public announcement of that information.  A third form of evidence on insider trading has to do with returns earned on trades by insiders (Bodie, Kane and Marcus, 2013).

Ethical Arguments against Insider Trading

Fairness

Probably the most common reason to thinking that insider trading is unethical is that the information advantage of the insider really is “unfair or unjust”.  According to Moore (1990), there are two versions of the fairness argument: the first argues that insider trading is unfair because two parties do not have equal information; the second argues that insider trading is unfair because the two parties do not have equal access to information.

Taking first the unequal information, it states that insider trading is unfair since the two parties to a transaction do not have equal information.  According to this view, both parties should have the same material information about the conditions that are essential for this transaction.  The second argument is that the information is not available to the shareholder to ascertain the suitability of buying and selling securities in the marketplace.  This argument is more concerned that this information should be public in the sense that hard work on the part of potential dealers in the market will be able to extract it (Teacher, Law, 2013).

In addition, the stock market depends on the assumption that all information relevant to potential investors is public.  The stock market is supposed to be a fair market, one in which everyone potentially has equal access to all information.  It is claimed that the general public’s faith in the stock market would undermined if there was a general belief among investors that the stock market is rigged, or at least the plaything of a privileged few insiders.  Such a belief can be the result of evidence of widespread insider trading, or stock manipulation (Donaldson, 1990).

According to Daniel Fischel, a teacher of corporate law at the University of Chicago, argued that the idea that the stock market should be a level playing field, with everyone having equal access to information and an equal chance to profit, is rubbish.  Obviously, a market professional who spends all his time analyzing stocks is going to have an advantage over the casual investor, and there’s nothing illegal about that.  The point in fairness argument is not whether you knew but whether you could have known.

Proprietary Rights

Some argue that inside trading involve misappropriation of information, a form of stealing.  It is frequently argues, under the rubric of a view known as the “agent-principal thesis”, that employees or outside consultants are implicitly or explicitly obligated to maintain the privacy and secrecy of information gleaned while on the job (Donaldson, 1990).

Morality demands confidentiality of records, whether or not one signs a contract not to divulge such information.  From the moral point of view, one is not free to divulge such information casually, for personal profit, for monetary gain, or even to feel important.  Therefore, an insider who takes confidential information and uses to enrich himself is in effect a thief stealing what is not his.  Like, any common thief who violates the moral rights of those from whom he steals, the insider trader is violating the moral rights of all shareholders, especially those shareholders who unwittingly sell him their stock.

Harm

The argument from harm, popular among the law and economics scholars who dominate securities scholarship in law schools, is not a deontological argument.  Instead, it maintains that insider trading is wrong because of the social harm it causes, given that we understand “causing harm” expansively, as causing a failure to attain optimal social welfare or social good (Strudler, 2009).

Velasquez (1990) mentioned that both empirical and theoretical studies have shown that insider trading has two effects on the stock market that are harmful to everyone in the market and to society in general.  First, insider trading tends to reduce the size of the market, and this harms everyone.  This means that when people suspect that insider trading is going on in the market, the more they will tend to leave the market and the smaller it will get.  The second effect is that it increases the costs of buying and selling stocks in the markets and this is also harmful.  This means that when a specialist, an intermediary who buy and sell stocks for others, senses an insiders are coming to him, he would have to increase his fee he charges for his services to cover from potential future losses for the stocks he would have to hold for others which might later turn out to be worth for less.

Hence, other things being equal, the person with the best information about what is being bought or sold stands in the best position to find bargains and get the best price. Competing against inside traders, who possess superior information, thus increases the risk that one loses.  Ordinary traders will be hesitant at the risk of trading against insiders, and insider trading, then, will undermine confidence in the stock market and deter investment, increasing the price a company must pay to raise capital and hindering both a company's development and a society's economic growth.

Fiduciary Duty

A fiduciary duty is, roughly, a duty of utmost loyalty and trustworthiness that an agent may be said to owe to his principal.  These duties are a staple of legal analysis, have rich moral content, and consistently play a role in judicial thinking about insider trading.  One of the arguments against insider trading is the jeopardizing of fiduciary relationship of an agent and its principal.

Kennon (2019) argued that to be accused of insider trading, you must usually be someone who has a fiduciary duty to another person, institution, corporation, partnership, firm, or entity.  You can get in trouble of you making an investment decision based upon information related to that fiduciary duty that is not available to everyone else.

Donaldson (1990) also added that insider trading is generally conceived of as involving stock transactions based on privileged information gained by someone with a fiduciary responsibility to the company and its stockholders.

So, when an employee of a company fills a certain position within the organization, they cannot morally do what is immoral, even if they are expected or commanded to do so as part of their job. While filling any position in a company, individuals should remain moral beings and persons.  Immanuel Kant argues, “to act in the morally right way, people must act from duty”.  Individuals who do not act out of respect for the moral law do so because they lack duty to do so or choose to act outside of duty.  When individuals choose to act outside of their fiduciary duties, there arises a conflict of interest.

Deception

Courts have always seen insider trading as a kind of fraud, namely, securities fraud.  Historically, wrongful deception forms the heart of fraud.  On the deception argument, insiders deceived shareholders by buying stock from them while concealing material, nonpublic information relevant to the valuation of the securities (Strudler, 2009).

Deception can be understood as inherently wrong, apart from any harm it causes.  Indeed, a standard philosophical analysis of the wrong in deception identifies it as a vicious kind of manipulation.  One person may wrongly deceive another when he intentionally causes that person to have a false belief in a way that compromises the autonomy of his decision making, even if doing so benefits that other person.

Hence, honesty does not always require full disclosure in a competitive business environment, even when a failure to disclose denies benefits to others.  So we are left with the question: what is the moral basis for this duty to disclose? Nothing in argument from deception begins to answer this question, however, the fiduciary duties invoked as the basis of a duty to disclose in securities transactions.

Conclusion

Inside information exists for the benefit of the company and its shareholders.  It is therefore presumptive theft for an insider to trade on this information without the agreement of its owners.  Based on the arguments raised in this paper, we can now conclude that most of the arguments explaining the reasons why it is unethical really do not stand, except the argument regarding the jeopardizing of fiduciary relationships.  This is because fiduciary relationships are critical to the way business operates.  If insider trading were to be legalized, it would place a strain on the relationship between corporate insiders and shareholders and individuals would be much less likely to trust the corporate world and less likely to buy share and invest in companies. And that wouldn’t be good for the company, shareholders or for society in general.

References

Bodie, Z., Kane, A. and Marcus, A. (2013). Essential of Investments (Ninth Edition). McGraw-Hill Companies, Inc. New York.

De George, R. (1999). Business Ethics (Fifth Edition). Prentice Hall, Inc. New Jersey.

Donaldson, T, (1990). Case Studies in Business Ethics (Second Edition). Prentice Hall, Inc. New Jersey.

Velasquez, M. (1998). Business Ethics: Concepts and Cases (Fourth Edition). Simon & Schuster Asia Pte Ltd:Singapore.

Kennon, J. (2019). What Is Insider Trading and Why Is It Illegal. https://www.thebalance.com/what-is-insider-trading-and-why-is-it-illegal-356337

Moore, J. (1990). What is Really Unethical About Insider Trading? https://page-one.springer.com/pdf/preview/10.1007/BF00382642?fbclid=IwAR3FZcPyboPXxct0mG9SHL2NoTQ5aGX0dUih7zuEUdbotM1BTPr3uySkhQI

Strudler, A. (2009). The Moral Problem In Insider Trading. https://repository.upenn.edu/cgi/viewcontent.cgi?article=1056&context=lgst_papers

Teacher, Law. (2013). Insider Trading: Legality & Morality. https://www.lawteacher.net/free-law-essays/company-law/insider-trading-legality-morality-company-law-essay.php?vref=1

Teacher, Law. (2013). Insider Trading: Legality & Morality. https://www.lawteacher.net/free-law-essays/company-law/insider-trading-legality-morality-company-law-essay.php?vref=1