U-M Report: Confusing Penalties for Illegal Insider Trading Don’t Work


Ambiguous wording of penalties for illegal insider trading prevents laws from working correctly, harming investors and eroding confidence in public markets, says a new study released by the University of Michigan.

"Increasing civil and criminal penalties does not work as a successful deterrent if there is substantial ambiguity about what is illegal insider trading," says Cindy Schipani, a business law professor at U-M and a co-author of the study. "This ambiguity allows insiders to not only trade successfully but also to fend off attempts by the U.S. Securities and Exchange Commission and the U.S. Justice Department to discipline them after the fact."

Schipani says she and co-author and U-M finance professor Nejat Seyhun looked at decades of trades filed by registered insiders. From 1975 to 1984, for example, the researchers found 60,000 transactions that showed almost immediate abnormal profitability. Over the next three decades, that number shot up. From 2005 to 2014, more than 200,000 large-volume transactions show immediate profitability by day five.

"Our evidence indicates that insiders are taking advantage of this vagueness of the law to exploit their material, nonpublic information," Seyhun says.

Seyhun says a recent ruling from the Second Circuit Court of Appeals makes it even more difficult for prosecutors to establish quid pro quo (an exchange of goods or services, where one transfer is contingent upon the other) between people who share nonpublic information and then trade on it.

In the study, titled Defining 'Material, Nonpublic:' What Should Constitute Illegal Insider Information, Schipani and Seyhun propose that for an insider trading case, investigators need to establish that the kind of information giving rise to the trade is significant enough to require disclosure on an 8-K form (a report companies must file with the SEC to announce major events that shareholders should know about), the announcement leads to abnormal stock returns, and the alleged insider trading must have occurred two months before announcing the information.

"The benefit of this additional clarity should enable courts to separate routine insider trading from opportunistic trading and increase the confidence in the public equity markets," Seyhun says.

The study is published in the Fordham Journal of Corporate and Financial Law.