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What makes insider trading wrong?

(Article published in the Nov 9,2011 issue of Manila Standard Today) 

That the Honourable Roberto V. Ongpin went out of his way to take out a paid advertisement in a major broadsheet last October 13 in order to deny the accusation that he had engaged in “insider trading” when he bought, over time, and then sold to Manny Pangilinan in one shot his block of Philex Mining Corporation shares demonstrates the stigma currently attached to insider trading.  What, indeed, makes insider trading wrong?

The first theory, which is behind Section 27.1 of our Securities Regulation Code, considers the insider to be a fiduciary to his fellow stockholders directly and indirectly to the community of marketplace traders.  As a fiduciary, his obligation is either to abstain or to disclose, i.e. either to abstain from trading until such time as the market gets to get wind of and absorb the material information or actively disclose said information prior to trading on it.  Thus, the insider is prohibited from selling or buying or selling a security while in the possession of material information with respect to the issuer or security until such time that the marketplace is able to absorb, assess and intelligently react to it.  In current lingo, what Section 27.1 does is to try to level the playing field between the insider and the non-insider.

The playing field is level, under Section 27.1, if the insider’s information was not gained from his being an insider, or if the insider has basis to believe that that his counterparty has the same material information because the insider told him, or because he (the counterparty) can be reasonably assumed to have already known or to have, under the circumstances, ought to have so known.  What thus makes insider trading wrong under this “abstain or disclose” theory is breach of by the insider of the implicit covenant amongst members of the stockholding community to deal with one another fairly; and each one’s implicit pre-existing duty to trade, indeed, to trade blows only in accordance with and under the rules equivalent to those of the Marquess of  Queensberry.


A second rationale for considering insider trading wrong is the misappropriation theory.  Under this theory, the insider is supposed to have received material non-public information for a particular corporate purpose.  In contrast with the “abstain or disclose” theory where the wrong is in the breach of common standard of behaviour adopted by those in the market place, akin, by way of example, to the unstated rule of not talking loud while having dinner in a fine dining restaurant, the misappropriation theory considers insider trading as a wrong or offense against the particular source of the material non-public information. 

In other words, the insider is deemed to have received from his source, be it the company itself or someone though not employed or working with the company is in the know on account of his particular connection  to the company, the non-public material information for a specific corporate purpose.  The insider, although receiving under such circumstances, proceeds to disregard the purpose of his receipt and misuses the information for his own benefit. 

The repudiation by the insider of the purpose of the giver and his utilization of the information for a different purpose is thus akin to a woman who boards a crowded bus.  In an era long gone by, she would likely be offered to take the seat given up by a gentleman (a “boy scout” that man is now derided) in deference to the purported weakness of the fairer sex.  If she were to forthwith herself in turn yield the given seat to her boyfriend companion, she has in fact misappropriated what was given to her.  The insider who trades based on his non-public information similarly received is deemed also to have misappropriated such information.  Clearly this theory of misappropriation by an insider is independent from and can be advanced without any reference to the insider’s fiduciary duty to the stockholders in general of the issuer. 

The third theory addresses insider trading in the specific context of a tender offer.  A typical case of a tender offer is when the minority shareholders of a company (whose majority shareholders have decided to sell out to a third party) is given the opportunity to similarly sell out to the same buyer under the substantially the same terms enjoyed by the selling majority.  It is considered wrong for someone who has non-public information that such a tender offer is about to be made officially to buy or sell the security of the affected corporation to anticipate such tender offer by enticing unsuspecting members of the minority shareholders to sell to him at a price lower than the tender offer price. 

It is unlawful, says Section 27.4 (a) of the Securities Regulation Code, for any insider, at the time a tender offer has commenced or about to commence, who has material non-public information relating to such tender offer, to buy or sell the securities of the issuer that are sought or to be sought by such tender offer.  It is an outright ban.

        All told, insider trading is wrong because it involves an inherent unfairness in the act itself, a flaw that makes the act, per se, contrary to the social nature of man.