It is bad. Bad for every investor. It’s really bad. Let’s look at what insider trading is and why it hurts other market participants (hey, that’s us!)
Insider Trading
Insider trading is when a company “insider” places trades based on Material Non-Public Information (MNPI).
Real Example
What got me started on this was reading this article. In December 2022, Loudon secretly listened to his wife’s private work calls discussing BP’s acquisition of TravelCenters while they were working remotely in a small Airbnb during a trip to Rome, according to the SEC’s civil complaint filed in Houston federal court.
The husband traded on the information and made $1.76 million.
We all know how trading works. There is a buyer and there is a seller. They come together in a capital market and agree to a price. This is the bid/ask process where the buyer bids an amount he’s willing to pay for a certain number of shares, and the seller sets an ask price that he’s willing to take for a certain number of shares. When the bid and ask come together, a trade happens.
The husband in this scenario has knowledge of an upcoming acquisition that will be lucrative for the company. This information is not public. The parties involved in the transaction – his wife for example, are prohibited by law from trading in the specific security until the deal is announced publicly. Companies have complex systems and processes to oversee this. I’ll give an example shortly.
The husband buys shares knowing that they will increase in price once the deal is announced to the public.
Is This Wrong?
What’s so bad about this? The husband is using a little info he overheard to stick it to the man right? Wrong. He’s sticking it to you and me, or whoever is on the other side of that trade.
Assume that prior to this, you are the shareholder. On this particular day, for whatever reason, you are looking to sell your shares. Had you known about this deal, would you still have sold? Maybe you needed the money to pay for your kid’s braces. But maybe you would have decided to sell another security if you knew about the upcoming acquisition.
Yes this is wrong. The $1.76 million was taken from other investors.
MNPI
Material Non-Public Information. In order for this to be a crime, the information needs to be non-public. Every day, corporations are working on mergers, acquisitions, bankruptcies, and other major corporate actions as part of their daily activities in running their business. This is not unusual. The people involved in these activities have information about their companies that have not yet been announced to the public (us). That’s OK. That’s how business works.
At some point, the company will be ready to disclose this information and they will let shareholders and the general public know. At that point the information becomes public.
In order for this to be a crime, the information also has to be material. It needs to be a significant piece of information that could move the stock price. This could be a new product that is about to be launched, or in this case, it’s an upcoming acquisition. That is definitely material.
Trade Oversight
How do you stop people from trading on MNPI? The honor system doesn’t work. We need controls. I worked for an investment firm and we were very tightly controlled and monitored.
- All of my brokerage accounts and all of my immediate family member’s who lived in the same household, brokerage accounts had to be held at the firm I worked for. This was so their compliance department could oversee my trades.
- If I wanted to trade a security, I had to ask permission. This was an automated process. I entered the symbol and the system told me if I could trade or not.
- The brokerage system would not allow me to enter a trade unless I had prior authorization to trade that security.
Pretty tight security because as an investment firm, we had MNPI on lots of companies. I may not have had personal knowledge, but because the firm was involved and I could have seen/overheard, we were all excluded from trading the security in question.
All companies have compliance departments and have similar processes in place to ensure company insiders do not trade on MNPI.
Raj Rajaratnam
There was a very public and widespread case of insider trading back in 2009. Click here. This involves business executives sharing confidential information in order to generate over $60 million in profits. Again, the profits are coming from you and I, or maybe from our 401k if it holds a mutual fund that invests in the underlying security. The victims are not big business, the victims are not the 1%, the victims are all the folks who participate in the capital markets. And again, that’s us!
Where Else is There Insider Trading?
This is bordering on political, but is not partisan. Anyone who wishes to disengage, we have lots of interesting posts, so I won’t be offended if you move on.
For the rest, an area of concern regarding insider trading is our politicians. Here is some background on Nancy and her husband Paul Pelosi and their stock trading. They tend to get the lion’s share of the publicity, but many other congressmen and women on both sides of the aisle have drawn attention.
Why Politicians?
Poliiticians create legislation. That legislation can significantly impact the future of companies trading in the capital markets. A popular discussion recently is on the CHIPS act – an act meant to grow our computer chip manufacturing capabilities onshore.
Let’s say you are a politician, or an aide to a politician and you are working on the CHIPs act. You know that this may benefit a US company like Intel that builds computer chips and is based in the US. Should you be allowed to trade Intel stock while working on this legislation?
What Controls Are In Place To Prevent This?
Today, we largely rely on the honor system and pinky swear. Lots of legislation has been proposed to limit or prevent trading by members of congress. The STOCK Act (Stop Trading on Congressional Knowledge) is meant to protect us, but it’s pretty loose. Some proposed legislation would require sitting members of congress to only trade in mutual funds, not stocks and bonds. Given the legislative reach and the knowledge these folks have, that sounds like a pretty good idea to me.
Surprisingly, since this legislation would govern the people who create the legislation, it is not moving very quickly. In the mean time, these folks are continuing to trade securities in the capital markets alongside us while they potentially have information that could impact the futures of the companies we trade.
Subversive Whales
One company has decided to have some fun and make some money off of this. Subversive Capital LLC has designed 2 ETFs – the Subversive Unusual Whales Democratic ETF (NANC) and the Subversive Unusual Whales Republican ETF (KRUZ). These ETFs try and help the rest of us trade like Pelosi and Cruz.
I looked into these a bit and I believe that as investments, they suffer from some of the same pitfalls as the STOCK act itself. While the STOCK act requires congress to file reports of their trades. There can be a huge time lag between the trade and the report. The managers of the 2 ETFs it seems also experience this lag, which likely means the ETF will not see a huge benefit in following any given trade. But kinda funny none the less.
That’s what I think, how about you?