THE ETHICS OF INSIDER TRADING

BUSINESS ETHICS
Ethics of Insider Trading

On December 27, 2001, Martha Stewart sold nearly 4,000 shares in ImClone Systems stock. The following day, the Food and Drug Administration delivered some bad news regarding ImClone’s cancer drug, Erbitux, and ImClone’s stock price dropped substantially.

It appeared that Martha Stewart had picked the right time to sell. Martha Stewart was not the only ImClone shareholder who was selling. The company’s founder, Sam Waksal, also tried to sell his stock (brokers refused to execute the sales), as did his daughter.

The U.S. Securities and Exchange Commission and the Federal Bureau of Investigation were soon looking into the transactions. Sam Waksal ultimately received an 87-month prison sentence and $3 million in fines for insider trading and tax evasion.

Martha Stewart was convicted of conspiracy, obstruction, and making false statements to federal investigators and served 5 months in jail, 5 months of home confinement, and 2 years of probation and paid a $30,000 fine.

In addition, she was forced to resign as chairman and CEO of the company she had founded, Martha Stewart Living Omnimedia. On the day of her conviction, the company’s shares lost 23 percent of their value.

Laws prohibiting insider trading were established in the United States in the 1930s. These laws are designed to ensure that all investors have access to relevant information on the same terms.

However, many market participants believe that insider trading should be permitted. Their argument is rooted in the efficient-market hypothesis (EMH).

According to the EMH, stock prices fully reflect all publicly available information. Of course, a significant amount of information about every company is not publicly available.

Thus, stock prices may not accurately reflect all that is known about a company. Those who argue for allowing insider trading believe that market prices influence the allocation of resources among companies.

Firms with higher stock prices find it easier to raise capital, for example. Therefore, it is important that market prices reflect as much information as possible. Advocates of allowing insider trading argue that investors would quickly convert inside information into publicly available information if insider trading were permitted.

If, for example, Sam Waksal had been permitted to sell his stock after learning of the FDA’s decision, market participants might view his actions and come to the judgment that ImClone’s prospects had dimmed. Of course, the other necessary condition is that outsiders can observe the stock market transactions of insiders.

Interestingly, Eugene Fama, who is viewed by many as the father of the efficient-market hypothesis, does not
believe that insider trading should be permitted.a Fama believes that allowing insider trading creates a moral hazard problem.

For example, if insiders are allowed to trade on proprietary information, they may have the incentive to hold back information for their personal gain.