The Securities and Exchange Commission oversees maintaining fairness in the market. However, there will always be concealed information (asymmetrical information), and there is not a massive crackdown on insider trading.
Nearly everyone wants to invest in the stock market. It is one of the best ways to make money over time and secure your financial wellness.
Is it rigged? Not technically, but insiders get away with a lot. Read on to find out more!
Information Asymmetry
Regardless of how much stock and financial information is online, you will not have access to research or in-house experts. In addition, most people don’t have automated trading systems that give trade suggestions or the skills to understand technical analysis.
- Asymmetrical information is otherwise referred to as “information failure.” This takes place in markets where one party of a transaction has more knowledge than the other party.
- Insider information is often used to people’s advantage, even though it is illegal.
The crucial aspect here is the timing of the knowledge. While both parties may eventually have the same understanding, information asymmetry exists if one knows before the other and acts upon it.
Who Are Insiders?
Insiders are senior executives, board members, or shareholders who own over 10% of a company. Over 82,000 insiders exist in the United States.
Whenever they trade, they need to file Form 4, otherwise known as a disclosure, within two days. You can view these on the U.S. Securities and Exchange Commission’s website. However, they aren’t evident.
Directors get some of their compensation as stocks, or they might want to cash out some stocks to buy something, so just because a director sells a little bit of stock doesn’t mean it’s a good time to sell yours.
A bigger tip to pay attention to is when an insider uses their money to buy on the open market.
CEOs and Executives Who’ve Used Insider Trading to Beat the Market
Executives outperform the public by over 5%. This may not seem like a lot, but when you invest the amount of money that executives invest, 5% is a lot of money.
- Steve Mihaylo is the CEO of Crexendo Inc. He owns a $60 million stake. He turned a profit on 83% of his trades within three months throughout the past five years.
- Even more disturbing is Snehal Patel, who is the CEO of Greenwich LifeSciences Inc. He has only bought five stocks but made a 488% return because four of the trades were right before announcing a good result from a trial on cancer drugs.
Although it is illegal to trade based on information that isn’t public, it is common to trade based on this information on Wall Street.
Offloading Shares
Executives often sell right before they know there will be a public scandal related to their company.
Under Armour, Inc. (UAA) fell by 18% in 2019 after reporting that their accounting practices were being examined. But before that information became public, executives started selling their stock to buyers who didn’t know about it.
Shareholdings are suing board members at Viacom CBS (VIAC) for offloading shares before it was disclosed that the CEO was being investigated for sexual harassment.
A Boeing Co. (BA) executive sold $5 million worth of stock after he was told that a problem in software may have been the cause of a fallen plane in 2018. After another crash, the company shared the information with the public.
Disclosure rules
There is something called “disclose or abstain.” Insiders who know things that are nonpublic can’t trade unless the information is first released.
Compared to Europe, U.S. companies have more discretion between what they consider worthy of sharing with the public and what they choose to trade.
10b5-1 plans
At the beginning of the pandemic, many executives of pharmaceutical companies made trades based on the development of vaccines. They did so through 10b5-1 plans.
10b5-1 plans are when trading is scheduled, and then a third party does the trading. They came about in 2000 so that executives could sell shares and avoid being accused of fraud, regardless of how much money they made on their trades.
It is easy to abuse 10b5-1 plans because insiders don’t have to wait after creating a plan to trade.
For example, three days before Moderna Inc. announced that its vaccine would be tested on humans, Tal Zaks, former chief medical officer, created a plan to sell thousands of shares per week for ten weeks. This lined up with the share price going up more than double, and he gained $3.4 million.
This paper about the abuse of 10b5-1 plans found that 14% of executives make plans of transactions within a month and 39% within two months of the project being created. This indicates that the plans are made based on insider information.
Another reason 10b5-1 plans are unfair is that the plan can be canceled at any time. So theoretically, an insider can create an agenda each quarter and then choose whether to use it based on how the quarterly reports are going.
However, in 20 years, there haven’t been any cases regarding trades done through a 10b5-1 plan. More commonly, the government highlights cases that involve information being passed to other co-conspirators instead of the trading done by executives.
The Law
Theoretically, the law is straightforward. The Securities Exchange Act of 1934 states that executives who misuse their knowledge of nonpublic information by passing the info along or trading based on it can be sent to jail and charged with fraud.
However, it is tough to identify and prosecute this action. Both Democrats and Republicans of all different beliefs can agree that this is a problem.
There aren’t any standalone offenses for insider trading. It only became regarded as illegal in 1961 when Robert Gintel was charged with fraud. He sold aviation shares after he heard that there was going to be a dividend cut.
To prove fraud, it isn’t enough to prove that someone made money from nonpublic information. Instead, it must be demonstrated that the person knew the information would cause a change in stock and purposefully cheated.
This makes it one of the most complicated crimes to prosecute. There is no stature, it’s hard to prove, and the law is vague.
There is no evidence like phone calls or emails, unlike situations where information is given to a co-conspirator. It is much easier to crack down on cases when two people are involved than when there is just one.
Another difficulty is that insiders have a considerable advantage over the public. They can interpret public information in ways that the general population can’t.
As a result, defense lawyers can say that the information was already there, even if it was tough to interpret.
The Securities and Exchange Commission
The SEC is an independent federal government regulatory agency. Its job is to protect investors, more specifically the public.
It promotes complete disclosures to the public, protects investors against manipulative and fraudulent market practices, and monitors corporate takeovers.
You can read about Market Manipulations and Case Studies on the SEC’s website, along with yearly Reports and Studies and much more.
The SEC is the most protection that the public has against insider trading and other unfairness in the stock market. In addition, because they are independent, they are supposed to be less influenced by politics and lobbyists.
Capital
A huge disadvantage that small investors face is capital. If you don’t quite know how the stock market works, you’ll have a disadvantage.
If you only want a couple of stocks, you will have to pay full price for them. But if an executive calls a company and says they want thousands of stocks, they will get a discount.
Large clients can get lower prices on fees and commissions. However, average investors can’t subscribe to Initial Public Offerings (IPOs) as institutions can.
IPOs are reserved for people with a high net worth, pension funds, and hedge funds. Average investors can only invest after all these people are offered a subscription. If all the major clients rejected the IPO, it might not be wise to invest.
Politics
Individual investors greatly influence government officials and lobbyists, and the investors are looking out for them. As a result, many government officials end up in huge corporate positions and vice versa.
There are many complexities regarding the stock market. Stay savvy by researching the stock market, and learning how you can excel at investing.
Image by: [Ahmad Ardity]