by Harald Baum
1. Phenomenon and economic implications
The term ‘insider dealing’ (United Kingdom) or ‘insider trading’ (United States) denotes the acquisition or disposal of financial instruments based on information that is known to the buyer or seller as an ‘insider’ but which has not yet been made public and could have a significant effect on the evolution and forming of the prices of a regulated market in those financial instruments. The insider uses the informational advantage caused by his (or her) privileged knowledge to participate in an anticipated rise in prices or, alternatively, to pre-empt an expected drop-off in prices. The term ‘insider’ originates from the discussion in the United States but many years ago also became an integral part of the European legal parlance. Insider dealing can happen in a multitude of different forms. Prohibitions against insider dealing are regularly supplemented by mandatory obligations for the issuers of financial instruments traded in a regulated market to promptly disclose to the public price-sensitive information regarding these instruments. This duty to disclose aims at keeping the time span as short as possible during which insider dealings could be carried out.
Under EU legislation insider dealing comprises one of the two forms of market abuse; the other one is market manipulation. They differ to the extent that a person engaging in market manipulation actively distorts the formation of prices of financial instruments, whereas the insider uses an already existing information asymmetry. In fact, insider dealing contributes to the accurate pricing of such instruments as it feeds important, so far undisclosed (inside), information into the market. In this way it enhances market efficiency. Accordingly, the prohibition of insider dealing is contested from an economic perspective.
The starting point of the discussion about the pros and cons of insider dealing and the usefulness of its prohibition was the publication of a treatise titled ‘Insider Trading and the Stock Market’ by the US economist Henry G Manne in 1966. At that time the US authorities had begun actively to curb insider dealing. In his highly contested but nevertheless groundbreaking economic analysis, Manne argued that insider trading is by no means harmful but, quite to the contrary, useful for the issuer and the financial markets, as it brings the prices of the pertinent securities closer to the level that would exist if the inside information were made public. At the same time, there are no direct victims of insider dealing, as the other market participants would have traded in the same way with third parties having no inside knowledge anyway. Furthermore, Manne regarded insider trading as an efficient means of compensating employed managers of public corporations, particularly the entrepreneurs among these individuals, for innovations they created that have the potential to increase the value of the firm after being disclosed. Thirdly, he emphasized the fundamental problem of implementing a prohibition that could hardly be effectively enforced.
Other early commentators added that the costs of a regulatory regime banning insider trading are likely to exceed its potential usefulness as the ban would mostly benefit professional market participants from the financial industries rather than the investing public in general. Also, history showed in their view that the uncovering of even spectacular insider scandals had no effect on trading activities in the affected markets. This should be taken as proof that the efficiency of financial markets does not depend on the prohibition of insider dealing.
The discussion started by Manne over 40 years ago continues. However, in the meantime a majority of economists seems to be in favour of a prohibition. They argue that insider trading does harm the investing public by causing adverse selection problems. By undermining the trust in the financial markets, transaction costs are likely to rise. Furthermore, the danger of increasing bid price spreads should be taken into account, as market makers would otherwise try to protect themselves against anticipated insider dealing. From the perspective of the principal-agent theory, allowing insider trading creates problems of moral hazard, perverse incentives and free-riding in the relationship between issuers (as principals) and their employed managers (as agents). These would by far outweigh any possible benefits of an entrepreneurial compensation for innovation. Seen from the perspective of modern property rights analysis, an insider trading prohibition can be regarded as an efficient means to protect an issuer’s property rights in information against a violation by its employees. Also, it should be noted that professional investors legitimately expect a modern financial market regulation to include an efficient and actively enforced insider regulation. Internationally competing financial centres therefore have to pay attention to this expectation.
From the legal point of view, guaranteeing fairness is a central aspect in advocating a prohibition of insider dealing. Information asymmetries caused by inside information would deny investors equal opportunities in the market if insiders were allowed to trade on their privileged information. In focusing the future regulatory discussion, differentiating between the type of exploited inside information might be desirable: the legal qualification may well differ depending on whether positive or negative information is (mis)used by an insider.
2. Insider regulation in an international and comparative perspective
By now almost all modern financial market regulations include a prohibition of insider dealing. Although its scope of application, its actual form and the sanctions attached to it differ somewhat depending on the individual jurisdiction, a continuous tightening of insider trading rules can be observed as an international trend. With respect to the enforcement of insider rules, however, differences between the national financial markets remain significant.
Outside the European Union, no internationally unified rules regarding insider dealing exist. The only at least partially supranational regulation is the Convention on Insider Trading of 20 April 1989, open to signature by the Member States of the Council of Europe, that went into force on 1 October 1991. But the Convention only provides for mutual assistance through the exchange of information between the national supervisory agencies, and does not harmonize any substantial rules. A first important step in the direction of setting up a regime of uniform international regulatory standards are the (non-binding) recommendations of the Emerging Markets Committee of the International Organization of Securities Commissions (IOSCO). The Committee had worked out these recommendations on the basis of a comprehensive comparative analysis of existing national insider trading rules and their respective enforcement practices. It published its findings in 2003 in a report titled ‘Insider Trading: How Jurisdictions Regulate It’. The recommendations are aimed at national legislatures and offer a catalogue of criteria for setting up new, or improving already existing, insider regulation.
Turning to the level of national law, the developments in the United States deserve special attention. The formation of insider rules as an increasingly important part of the capital markets regulation started there. The first decision of the pertinent federal supervisory authority, the Securities and Exchange Commission (SEC), prohibiting insider trading in the context of exchange (open market) transactions dates from 1961, was Cady, Roberts & Co (40 SEC 907). The first court decision qualifying insider trading as a violation of the general antifraud provision followed in 1968 (SEC v Texas Gulf Sulphur Co 401 F.2d 833 (2d Cir. 1968)). This landmark judgment coined the famous phrase ‘disclose or abstain’, and quickly became the leading decision in these matters. It also gained international attention. Various other important decisions followed, but differed in their reasoning for prohibiting insider trading. Some courts stressed the need of equal access to price-sensitive information for all investors (equal access theory). Others demanded, in a more narrow approach, a finding of a violation of fiduciary duties by the insider (fiduciary duty theory). Later decisions emphasized a misappropriation of the pertinent information by the insider (misappropriation theory). But, whatever the reasoning, the point of reference was always the general antifraud provision laid down in section 10(b) of the Securities and Exchange Act (SEA) of 1934 and rule 10b-5 thereunder. Another pertinent regulation can be found in section 14(e) SEA and rule 4e-3 thereunder, which prohibits insider trading in the context of tender offers. Furthermore, section 17(a) of the Securities Act of 1933 stipulates a general prohibition of fraudulent behaviour and of the dissemination of misleading information when offering securities. This prohibition includes the selling of securities by an insider.
A highly differentiated and flexible catalogue of graded administrative, penal and civil sanctions characterizes the US securities regulation. These range from supervisory administrative (disciplinary) measures such as, for example, suspension of one’s professional licence, to the surrender of profits, civil penalties or criminal sanctions (fines or imprisonment of up to 10 years). The Insider Trading Sanctions Act of 1984 introduced civil penalties of up to three times the amount of the profits realized by the insider. Responding to a series of insider scandals, the Insider Trading and Securities Fraud Enforcement Act of 1988 significantly tightened the criminal sanctions. The various kinds of sanctions may be applied partly alternatively, partly cumulatively. Furthermore, regardless of actions by the authorities, the victims of insider dealing have either express or implied private actions to sue an accused insider for damages.
This complex regulatory setting and the strict enforcement of the insider trading rules by the US authorities and courts influenced jurisdictions as far apart as Switzerland or Japan, as well as the pertinent developments within the European Union. The judicial conflict of the early 1980s between the United States and Switzerland, for example, caused by the Swiss refusal to provide judicial assistance in the context of an insider case, acted as a catalyst for introducing a prohibition of insider dealing in Art 161 of the Swiss Penal Code in 1988 shaped along the lines of the US model. Based on that provision an insider can be fined and/or sentenced to imprisonment of up to three years. Additionally, the beneficiary of insider trading may be required to surrender any profits obtained.
Another example is the Japanese legislature which also followed the US model and made insider dealing a criminal offence in 1988. Insider dealing can be sanctioned with a fine and/or imprisonment of up to five years (Arts 166, 167, 197-2 of the Financial Instruments and Exchange Law). Also, a dual punishment of the insider as well as of his or her employer is allowed (Art 207 of the Financial Instruments and Exchange Law). However, it is widely acknowledged that certain deficits exist when it comes to enforcing the prohibition.
3. Genesis and core elements of the European regulatory regime on insider dealing
Within the European Union the first attempts to create a common regulatory regime on insider dealing date back to the 1970s. The European best practice rules for securities transactions published in 1977 already contained some, albeit non-binding, recommendations on insider dealing. After lengthy preparatory works the Council Directive Coordinating Regulations on Insider Dealing (Dir 89/592) was adopted in 1989—a milestone in the history of insider dealing rules in Europe. Previously, only very few Member States had national legislation banning insider dealing. One early example is the United Kingdom, which had amended its Company Code in 1980 to make insider dealing a criminal offence. In the course of drawing up uniform regulations to fight market manipulation within the EU, the European Commission also revised the rules of the Insider Dealing Directive and integrated the amended rules together with a new mandatory rule for timely disclosure of inside information alongside the regulations on market manipulation in the Market Abuse Directive (Dir 2003/6). This directive, slightly amended in 2008 (Dir 2008/26), replaced the Insider Dealing Directive.
The Market Abuse Directive was one of the first directives drafted within the framework of the simplified legislative proceedings introduced in 2002 (the so-called comitology or Lamfalussy procedure). According to the directive’s character as a framework directive, it only regulates the basic principles and leaves technical issues to be addressed by implementing measures on the second level of the comitology procedure. In 2003 and 2004 the Commission adopted three implementing directives (Dir 2003/124, 2003/ 125, 2004/72). Also in 2003, the Commission adopted a regulation implementing the Market Abuse Directive (Reg 2273/2003) that supplements these three directives. On the third level of the comitology procedure, the (former) Committee of European Securities Regulators (CESR) has published three sets of guidance and information on the common operation of the Market Abuse Directive to the market.
This highly structured regulatory regime in regard to the ‘prohibition of insider dealing’ aims at creating a framework for ensuring the integrity of Union financial markets and enhancing investor confidence in those markets as an integrated and efficient financial market requires integrity and public confidence (recitals 2 and 12). The new regulation is designed to ensure that the insider dealing rules are consistent with the legislation against market manipulation and to avoid loopholes in Union legislation in this area (recital 13). According to Art 2(1) of the Market Abuse Directive, the Member States have to prohibit persons regarded as primary insiders, who possess inside information, from making use of that information by directly or indirectly acquiring or disposing of financial instruments to which that information relates for their own account or for the account of a third party. It was a controversial question whether ‘using’ had to be interpreted objectively without the necessity that the insider intentionally used his inside information, or whether a presumption of innocence held such that the authorities had to prove in the course of an indictment that he had acted purposely on that information. In December 2009 the European Court of Justice (ECJ) clarified that the directive had to be interpreted objectively: ‘[T]he fact that a primary insider who holds inside information trades on the market in financial instruments to which that information relates implies that that person “used that information” within the meaning of Article 2(1) of Directive 2003/6’ (ECJ Case C-45/08 – Spector Photo Group  ECR 0000). In the view of the ECJ only such a broad interpretation takes into account the ‘essential characteristic of insider dealing [that] consists in an unfair advantage being obtained from information to the detriment of third parties who are unaware of it’. However, the court also emphasized the right of the alleged insider to rebut this presumption.
The directive does not expressly use the terms ‘primary’ and ‘secondary’ insider, but it obviously maintains that distinction first developed under the Insider Dealing Directive. There are four categories of primary insiders: (a) company insiders like, for example, executive, non executive or supervisory directors of the issuer; (b) (large) shareholders who possess inside information ‘by virtue of their holding of capital in the issuer’; (c) professional insiders who gain the information in the context of their business; and (d) criminal insiders who obtain it by criminal activities (Art 2(2)). According to Art 3 of the Market Abuse Directive, the Member States have to prohibit primary insiders from disclosing the inside information to third parties or recommending or inducing other persons on the basis of such information to acquire or dispose of the pertinent financial instruments. Article 4 of the directive requires the Member States to make sure that the prohibitions of Arts 2 and 3 also apply to persons who are not primary insiders, but who are in possession of inside information and who knew or ought to have known that it is inside information (secondary insiders). From a comparative doctrinal perspective, the underlying concept of the directive seems to be somewhat similar, though wider, to the approach developed by the US courts under the equal access theory mentioned above.
The definition of the central term ‘inside information’ is supplied by Art 1(1) of the Market Abuse Directive in connection with Art 1 of the implementing directive of the Commission of 23 December 2003 (Dir 2003/124) and is explained in the second set of the CESR guidance and information on the common operation of the directive of July 2007 (CESR/06-562b). It consists of four elements that illustrate the rationale underlying the concept of the insider dealing prohibition: (i) the information must be sufficiently precise (rumours are not covered); (ii) it must not have been made public and thus already been known to the public; (iii) it must directly or indirectly relate to issuers of financial instruments (corporate information) or to such instruments (market information); (iv) it must be price-sensitive, ie if made public it must be likely to have a significant effect on the prices of those financial instruments or the price of related derivative instruments. The term ‘financial instrument’ is broadly defined in Art 1(3) of the directive and comprises, besides transferable securities traded in a regulated market in one of the Member States, various other instruments such as, for example, swaps, derivates in commodities and money market instruments.
Several other measures support the prohibition of insider dealing. As a preventive regulation with the purpose of reducing the potential for insider trading, issuers are made to inform the public as soon as possible about inside information concerning them (Art 6(1)). Furthermore, they have to draw up a list of those persons working for them who have access to inside information (Art 6(3)). Also, persons discharging managerial responsibilities within an issuer and those closely connected with them are obliged to notify the competent authority about transactions conducted on their own account in the issuer’s financial instruments (Art 6(4)). Persons professionally arranging transactions in financial instruments who reasonably suspect that a transaction might constitute an insider dealing have to notify the competent authority without delay (Art 6(9)).
According to Art 14 of the Market Abuse Directive, the Member States have to ensure that—without prejudice to their right to impose criminal sanctions—appropriate administrative measures can be taken or administrative sanctions can be imposed against persons responsible for a non-compliance with any of the directive’s provisions. The measures have to be effective, proportionate and dissuasive. The important issue of private actions by the victims of insider dealing for damages is not dealt with in the Market Abuse Directive.
Henry G Manne, Insider Trading and the Stock Market (1966); Klaus J Hopt and Eddy Wymeersch (eds), European Insider Dealing (1991); Klaus J Hopt, ‘Ökonomische Theorie und Insiderrecht’  Die Aktiengesellschaft 353; Stephen M Bainbridge, ‘Insider Trading’ in B Bouckaert and G De Geest (eds), Encyclopedia of Law and Economics, vol III (2000) 772; The Emerging Markets Committee of the International Organization of Securities Commissions, Insider Trading (2003); Guido A Ferrarini, ‘The European Market Abuse Directive’ (2004) 41(3) CMLR 711; Mark Stamp and Tom Jaggers (eds), International Insider Dealing (2005); Daniela Koenig, Das Verbot von Insiderhandel. Eine rechtsvergleichende Analyse des schweizerischen Rechts und der Regelungen der USA und der EU (2006); Barry Rider, Kern Alexander, Lisa Linklater and Stuart Bazley, Market Abuse and Insider Dealing (2nd edn, 2009); Lars Klöhn, ‘The European Insider Trading Regulation after Spector Photo Group’ (2010) ECFR 347; William KS Wang and Marc I Steinberg, Insider Trading (3rd edn, 2010).