How Effective is US Enforcement in Deterring Insider Trading?

DOIhttps://doi.org/10.1108/eb025723
Date01 January 1996
Publication Date01 January 1996
Pages283-287
AuthorJed S. Rakoff,Joanne C. Eaton
SubjectAccounting & finance
Journal of Financial Crime Vol. 3 No. 3 Insider Trading
INSIDER TRADING
How Effective is US Enforcement in Deterring Insider
Trading?
Jed S. Rakoff and Joanne C. Eaton
Trading in securities on the basis of non-public
information is too lucrative a temptation ever to
disappear entirely.1 Nevertheless, most qualified
observers believe that US enforcement agencies
have been reasonably effective in reducing the
extent of insider trading in the US. This has been
accomplished, moreover, despite the fact that there
is no single US law that simply and comprehen-
sively outlaws such trading.
As discussed below, the authors believe this suc-
cess is substantially attributable to the flexibility
with which US enforcement agencies have applied
administrative and criminal sanctions, separately
and in tandem, to a wide spectrum of insider-
trading schemes. The putative deterrent effect of
private civil actions, however, is less impressive.
THE SUBSTANTIVE REACH OF THE
APPLICABLE LAWS
There are three basic provisions of the US securi-
ties law that can be applied to insider trading: (1)
s. 16(b) of the Securities Exchange Act of 1934,2
which prohibits short-term trading by certain cor-
porate insiders in the securities of their own com-
pany (regardless of whether there was any use of
inside information); (2) the general anti-fraud pro-
vision of the Securities Exchange Act, ie s. 10(b)3
and Rule 10b-5 promulgated thereunder,4 which,
have been steadily stretched to encompass, and
prohibit, any manifestations of insider trading that
can fairly be characterised as fraudulent in origin
or effect; and (3) the relatively recent Rule
14e-3,5
which directly prohibits insider trading but only in
the context of tender offers. Taken in this order,
they indicate the historical development of US law
in this area.
Section 16(b) of the Securities Exchange Act was
enacted in 1934 specifically to prevent corporate
insiders from using inside information to profit
from speculation in the corporation's stock.6 But
rather than focusing on the use (or misuse) of
confidential information per se, the section simply
prohibits all short-term trading by major corporate
insiders, regardless of whether the use of inside
information can be proven or is even suspected.7
Specifically, the statute provides that any profits
obtained by any officer or director or holder of
more than 10 per cent of any class of equity
security of a company from any short-term trans-
action in the company's equity securities, ie, any
purchase or sale within a six-month period, shall
inure to and be recoverable by the company.
Enforcement is left to private actions to recover
the profits, through a suit by the company or a
stockholder derivative suit on behalf of the com-
pany.
Section 16(b) appears to have been reasonably
effective as far as it goes.8 But note that it does not
prohibit such short-term transactions, but merely
provides that the insider may be deprived of his
profits. Accordingly, criminal penalties and admin-
istrative enforcement sanctions relating to 'viola-
tions'
of the Exchange Act are not applic-
able to s. 16(b).9 More importantly, there remain
innumerable insider-trading situations that are
beyond the limited reach of s. 16(b), such as trad-
ing by lower-level corporate insiders, trading by
such 'quasi-insiders' as lawyers and investment
bankers, and trading by outsiders who are tipped
to or otherwise acquire inside information.
Thus from an early date the Securities and
Exchange Commission (SEC), as the primary US
agency administering these laws, has been moti-
vated to utilise the broad, catchall anti-fraud provi-
sions of the Securities Exchange Act, ie s. 10(b)10
and rule 10b-511 promulgated thereunder, to try to
reach such transactions. The initial thrust was to
Page 283

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