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Are insider trading laws effective enough?

Insider trading in the US may have taken place in 41% of the takeovers. However, the prohibition of insider trading has become quite common. Of the world’s 103 markets 87 have laws against insider trading, but like the US many are ineffective

In the United States the concept of insider trading has been part of the markets for close to 75 years. The concept is that if you have information that is not generally available to the rest of the market you should either disclose the information or refrain from trading. The idea was that trading on private information acted as a fraud on other investors.

Even though the rule has been around for many years and is actively prosecuted, does not necessarily mean that it is totally effective. It has been estimated that insider trading in the United States may have taken place in 41% of the takeovers and in 24% of British takeovers.
 
Nevertheless, the prohibition of insider trading has become quite common. Of the world's 103 markets 87 have laws against insider trading, but like the United States many are ineffective.

Even in developed markets the concept is often quite new. Germany did not enact an insider trading law until 1994. Japan has had an insider trading law only since 1996. While the US has prosecuted tens of thousands of cases, the Japanese have prosecuted less than 50. In the past year there have been accusations of insider trading in connection with significant stock price drops before 20 new share issue announcements.
 
Across almost all emerging markets the issue of insider trading usually has nothing to do with the law itself, but with the enforcement of law. In Russia the law is quite new. It was just passed this year after several years of consideration, but without adequate enforcement it is doubtful whether it will have any effect.
 
Brazil made use of inside information illegal in 2001. It does carry a prison sentence, but, of course, no one has yet been sent to prison. Over the past three years only 10 investors have been punished. The securities watchdog, the exchange, the Bovespa, and the legislators are trying, but enforcement will require a much greater effort. Presently insider trading is so common in M&As that amateur traders use it as part of their strategy.
 
In high-tech India the local watchdog, the Securities and Exchange Board of India (SEBI), has invested in an Inter-Market Surveillance System. This expensive piece of hardware was supposed to identify potential insider trading and manipulation. So far the effects have not been promising. In a recent incident a new de-merged company opened at Rs598.80 on the National Securities Exchange (NSE) and plunged to Rs86, a stunning 85% loss in just one hour. Not only are there huge price swings but there are different prices quoted depending on whether the trade takes place on the Bombay Stock Exchange or the NSE.
 
The Chinese market has often been compared with a casino. Since so many of the companies are government owned, it is riddled with insider trading, market manipulation and government interference. Often there is no correlation between the growth of the company and its share price.
 
In fact charges of insider trading could be used as a weapon against would be oligarchs. Huang Guangyu, founder and chairman of Gome, China's largest electronics retailer, was one of China's richest men. He arrested and convicted for vaguely defined "economic crimes" including insider trading. 
 
Hong Kong stands out among its peers as having a relatively good record for prosecuting securities violations. Prior to 2003 insider trading in Hong Kong was not considered an offense. Even then there were no prosecutions until 2008. Since then Securities and Futures Commission (SFC) has been on a roll with nine criminal convictions for insider trading including a former managing director of Morgan Stanley.
 
According to the Asian Corporate Governance Association, Singapore also has a high ranking for investigating insider trading and corporate governance. It scores a 67 out a possible100. The US and UK using these criteria would score about 80. Other countries didn't do quite as well, Japan scored 57, Thailand a 55, Indonesia a 40 and the Philippines in last place with a 30.
 
The real question is why bother? Some noted economists including Milton Friedman have argued that insider trading should not even be illegal, because the act of buying and selling by insiders communicated sufficient information. True, but the information comes too late to be of value.
 
The real reason has to do with the law of fraud. The reason insider trading and fraud are illegal is because they are economically inefficient. If each trade had to be preceded by a lengthy investigation, then high transaction costs would inhibit trades. The process of raising capital would be far more difficult and expensive. The market would be limited to family and government owned companies that are so prevalent in emerging markets.
 
Finally it has to do with trust. Studies of monkeys show they understand the concept of fairness very well. Perhaps the reason why fewer and fewer retail investors participate in these markets is the accurate perception that something is very wrong.
 
(The writer is president of Emerging Market Strategies and can be contacted at [email protected] [email protected])
 

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