Question

According to the U.S. Securities and Exchange Commission (SEC), “Illegal insider trading refers generally to buying or selling a security, in breach of fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.”  Your textbook notes that "stockholders require compensation for the risk they face; the higher the risk, the greater the compensation" (196). Some argue that insider trading is illegal and that a select few people trade on material nonpublic information, which results in the perception that markets are unfair and these actions will discourage ordinary people from participating in markets. The other side of the coin argues that insider trading is difficult to prove and that there is an opportunity cost, since the government must divert resources from cases that merit attention (i.e. theft, violent assaults, murder, etc.), and it is not worth prosecuting.

1) Do you believe that insider trading (the purchase or sale of securities by someone with information that is material and not in the public realm) is good or bad for the markets?

2) Do you believe that high-ranking officials whether in government or the private sector should be required to file detailed financial disclosures in order to maintain the trust of investors?

Answer 1

1.

I BELIEVE INSIDER TRADING IS BAD

A debate rages on in the financial community among professionals and academics about whether insider trading is good or bad for markets. Insider trading refers to the purchase or sale of securities by someone with information that is material and not in the public realm. Insider trading is not limited to company management, directors, and employees. Outside investors, brokers, and fund managers can also violate insider trading laws if they gain access to nonpublic information.

INSIDER TRADING SHOULD BE ILLEGAL

1.One argument against insider trading is that if a select few people trade on material nonpublic information, then the public might perceive markets as unfair. That could undermine confidence in the financial system, and retail investors will not want to participate in rigged markets. Insiders with nonpublic information would be able to avoid losses and benefit from gains. That effectively eliminates the inherent risk that investors without the undisclosed information take on by investing. As the public gave up on markets, firms would have more difficulty raising funds. Eventually, there might be few outsiders left. At that point, insider trading could eliminate itself.

2.Another argument against insider trading is that it robs the investors without nonpublic information of receiving the full value for their securities. If nonpublic information became widely known before insider trading occurred, the markets would integrate that information, resulting in accurately priced securities.

Suppose a pharmaceutical company has success in Phase 3 trials for a new vaccine and will make that information public in a week. Then, there is an opportunity for an investor with that nonpublic information to exploit it. Such an investor could purchase the pharmaceutical company's stock before the public release of the information. The investor could significantly benefit from a rise in the price after the news is made public by buying call options. The investor who sold the options without knowledge of the success of the Phase 3 trials probably would not have done so with full information.

2)

Ask investors what kind of financial information they want companies to publish, and you'll probably hear two words: more and better. Quality financial reports allow for effective, informative fundamental analysis.

But let's face it, the financial statements of some firms are designed to hide rather than reveal information. Investors should steer clear of companies that lack transparency in their business operations, financial statements or strategies. Companies with impossible to understand financials and complex business structures are riskier and less valuable investments.

What Are the Benefits of Transparency?

Mounting evidence suggests that the market gives a higher value to firms that are upfront with investors and analysts. Eccles shows that companies with fuller disclosure win more trust from investors. Relevant and reliable information means less risk to investors and thus a lower cost of capital, which naturally translates into higher valuations. The key finding is that companies that share the key metrics and performance indicators that investors consider important are more valuable than those companies that keep information to themselves.

Of course, there are two ways to interpret this evidence. One is that the market rewards more transparent companies with higher valuations because the risk of unpleasant surprises is believed to be lower. The other interpretation is that companies with good results usually release their earnings earlier. Companies that are doing well have nothing to hide and are eager to publicize their good performance as widely as possible. It is in their interest to be transparent and forthcoming with information so that the market can upgrade their fair value.

Further evidence suggests that the tendency among investors to mark down complexity explains the conglomerate discount. Relative to single-market or pure-play firms, conglomerates could be discounted. The positive reaction associated with spin-offs and divestment can be viewed as evidence that the market rewards transparency.

Naturally, there could be other reasons for the conglomerate discount. It could be the lack of focus of these companies and the inefficiencies that follow. Or it could be that the absence of market prices for the separate businesses makes it harder for investors to assess value.

CONCLUSION

Investors should seek disclosure and simplicity. The more companies say about where they are making money and how they are spending their resources, the more confident investors can be about their fundamentals.

It's even better when financial reports provide a line-of-sight view into the company's growth drivers. Transparency makes analysis easier and thus lowers risk when investing in stocks. In that way, the investor is less likely to face unpleasant surprises.