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How Insiders Use Private Information and Don’t Get Caught

Have you ever wondered how insiders use private information, yet don’t get caught and enjoy high returns? Insider trading per se is not illegal. Our case law clearly delivered the message to insiders that it is not OK to trade right before corporate events. However, another message delivered by regulators is that it is pretty much safe to trade 6 or 9 months prior to major events.

It takes months, sometimes years to finalize major corporate events such as a merger or an acquisition. Insiders know whether their companies intend to go on the market or other firms are interested in acquiring their companies. So they trade in advance of any “material” developments. Insiders have an idea whether their prototype products have significant chance of being successful or they will most likely fail. So they trade well in advance of any “material” developments. Insiders know whether their accounting is very conservative or very aggressive and they know when there is a shift in their stance. So they trade in advance of any “material” developments. Insiders know whether they are beating their competition or they are beaten before the general public knows. So they trade in advance of any “material” developments.

Martha Stewart Living Omnimedia, Inc.

Prosecutors can try only certain cases successfully. They could not even prove that Martha Stewart traded illegally even when she suddenly sold her holdings just days before a major negative announcement. Mark Cuban insider trading case was also thrown out by a judge. Knowing something is different from proving something beyond reasonable doubt. Insiders know this. Insiders also know that even when they get caught, in most cases SEC settles the case out of court, so they can get away by paying a financial penalty without admitting any wrongdoing. In most cases though, SEC charges people with insider trading only after several different transactions. It is apparent that SEC’s surveillance systems are not very robust in detecting a couple of illegal insider transactions. They can only detect a “pattern” after several illegal transactions in different companies.

Speaking of the surveillance systems, SEC does not have real-time access to transaction data. They have to make several requests to brokerage firms to get the complete transaction data about a specific security in a given time period. If they don’t receive any tips or complaints, they won’t be investigating anything. That’s why SEC was recently asking for real-time information to detect illegal insider trading.

I can confidently say that there are insiders out there illegally trading based on material non-public information but don’t get caught. This is like drug smuggling. Law enforcement agencies catch smugglers once in a while, but you know that there are several other smugglers who are not caught. What you see is only the tip of the iceberg. How do we know this? Indirectly. Several academic studies have shown that insider purchases perform better than market averages even after adjusting for several known market anomalies. This implies that either insiders were really, really, I mean really lucky or they were better informed! Hey, I know this is not definite proof of illegal insider trading. Regulators and prosecutors know this too, and they can’t do anything about it. That’s why insider trading has been profitable for more than 40 years.

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