Abstract
The purpose of this paper is to highlight the dangers faced by the public when trading in the stock exchange. The prices of stocks within the exchange can be manipulated in various ways in order to suit certain individuals. Manipulations are manifested in the form of insider trading, starting rumors among others. The economy of any country is a risk if its exchange is perceived to favor only certain individuals while locking out the majority. This paper highlights what the regulators are doing in order to mitigate any forms of manipulations that could be ongoing in the stock exchanges. The role of the stock in the exchange and how it operates is explained to readers as well as the mechanisms used to reduce instances of price volatility in exchange markets.
Introduction
Insider trading can be referred to as the trading by individuals or groups of persons with access to confidential information in the stocks of corporations and other securities and commodities in a manner that the confidential information grants them an advantage over the public. Examples of such individuals could be employees of the company, relatives or even directors of the listed company. Insider trading is illegal in most countries as it violates the relationship that other shareholders and trust that the public has on the company. In many instances insider trading warrants court actions and even jail time for persons found to have committed the offense. One of the most famous cases of high-ranking persons within the society being jailed was the acclaimed talk show host and Chef Martha Stewart who was jailed after investigations revealed that she had just sold shares in ImClone prior to its fall in share price. The Chef with the CEO, (Samuel Waksal) were found guilty of selling their shares a day, prior to the revocation of its drug (Erbitux) that at the time was being experimented by the FDA (Food and Drugs Administration). At the time, the only people privy to this information included high ranking members of staff within the company. The CEO had even sold his stakes in the company without alerting the Securities and Exchange Commission. He had even alerted friends and family about the share and advised everyone to ditch their shares in the company. On the day of the announcement, the shares of the company fell by a huge margin and news of the CEO’s behavior did not help to calm the markets as the prices of the shares continued to plunge. The perpetrators of the crime were later subjected to a court process that saw the CEO and his friends such as Martha Stewart jailed for a period of time. The list of persons found to have committed this grave offence are many bit it is not the scope of this paper to discuss them but rather it is for us to explain why it is an offence in the first place. Inner trading is detrimental to the growth of the stock exchange as it has the characteristics of chasing investors away after they lose confidence regarding unfair practices within the bourse. By extension this act can lead to a much smaller and less vibrant exchange meaning that it will get harder and harder for companies to seek for funding from the market. It is difficult to ascertain whether certain individuals such as security analysts and journalists have prior information to knowledge about company performance. It is the responsibility of such occupations to talk to corporate leaders and assess their companies. Security analysts offer tips and advise to traders on what stocks to pick and which one not to. Hence it becomes difficult to know whether they use this information to further heir interests in the stock exchange. Such occupations are regulated by a code of conduct that limits them from publishing or announcing non public information. Regulators in consultation with law makers have enacted the “STOCK Act” which is an acronym for Stop Trading on Congressional Knowledge Act. The act limits federal employees and law makers from applying information acquired in the course of their duties. The act also controls intelligence companies such as think tanks that have access to tons of information regarding companies in various countries.
Why is Insider Trading Illegal
The line between legal and illegal pertaining to insider trading is quite blurry as it is difficult to judge as to whether certain information was used for the purpose of trading in the stock exchange or the individual was just lucky. The law is against this practice as it can strongly influence the prices of stocks, commodities and other securities in a counter. This has the potential to disgrace the stock exchange and lead to loss of confidence among investors. The purchase and sale of stocks for members of staff of a company is not restricted but authorization from the regulatory body has to be approved first. For example, in the United States, CEOs and other members of staff have to notify the Securities and Exchange Commission during the purchase and sale of stocks that they may have prior information of. Rules and regulations regarding insider trading were tightened after the famous 1929 stock market crash that led to the loss of confidence by investors. At the time it was alleged that the market had collapsed due manipulation from forces both within and without the stock market. It was also claimed that when the majority of the individuals had lost all their life savings after the crash, there were a small group of individuals who had benefited thanks to hindsight from prior information from insiders within the market itself. It was perceived that the process of insider trading was facilitated by rogue stock brokers in collaboration with other groups of individuals who would lure the public by and encourage them to purchase stocks of certain companies they had prior knowledge of, this resulted in the price of the shares rising and this would have a domino effect in the fact that more people would be attracted to invest in the shares. After the price of the shares had risen, the insiders and their collaborators would then sell of the shares when the price is at its peak hence making a big profit margin. However the claims were unfounded at the time as it was difficult to investigate as who had actually had sold their shares as a result of having prior information regarding the stock. Since the collaborators and the stock brokers would have bought many shares, the price of the shares would drop once they decided to sell hence leaving majority of the new shareholders to suffer from their innocent actions. Insider trading is perceived to be practiced by individuals who already have wealth against the majority who have are looking for wealth through investing in the stocks exchange.
Reasons for restrictions on the practice
It is after complaints from the public that financial regulators in most countries decided to inculcate restrictions that prevented the practice of insider trading, hence leading to a better and fairer playing ground for all. Courts and other legal processes have been used to enforce the regulations set out by the laws of the land. In the case between Dirk Versus the Securities Exchange Commission, the judge passed a land mark ruling against Dirk. At the time, Dirk was a tepee (Individual who receives information from insiders within an organization or stock exchange. Such insiders are referred to as tippers.) On receiving information, Dirk used this information to trade and gain profitably at the expense of other shareholders. The court argued that as long as the tepee (Dirk) was aware that the tipper (Insider) was breaking fiduciary laws then he himself was guilty for propagating the vice.
How Stock Markets operate i.e. the Business of Stock Markets
Stock markets operate as areas or markets where companies acquire money in order to run their businesses. This acquired money is mostly from the public when they purchase the company’s shares from the exchange. The public become part owners of the company on purchasing the shares. Shares are offered to the public through a process known as an Initial Public Offering (IPO). The individual may in future resell the shares back to other members of the public by going back to the exchange and selling it through brokers who are represented by stockbrokerage firms. There are also instances where the company may purchase back its own shares from the public at normally a higher rate than when it sold the shares to them. These instances are occasioned when the firm is seeking more control and authority in order to carry out its operations. There are also instances where the company may also do the opposite by selling moiré shares to the public. This could be occasioned when the company may be seeking more funds for long term investment initiatives. The exchange markets are driven by the mechanism of “willing buyer, willing seller.’ This means that the price of the shares is controlled by the amount the buyer is ready to pay for it.
There are also a number of securities that can be transacted in the stock exchanges such as company and treasury bonds. Derivatives and also commodities such as gold silver and other precious metals can also be traded. Examples of stock exchanges may be the New York Stock Exchanges, the NASDAQ. The stock exchanges allow buyer and sellers to come together in the establishment of the stock. The price of any stock is determined by demand-supply forces as stocks perceived to be attractive in terms of performance are priced higher than others. Stocks that are perceived to be unprofitable to investors are priced lowly as they do not attract investors into buying them. A high stock price is also favorable to company mangers and the employees of the form as they are given stock options hence acting as a motivation for them to increase their efforts towards making the company more profitable. Stock markets only operate within certain hours set by the regulatory body. The prices on the exchange are volatile and could change overnight as a result of happenings outside the firm such as change of government policies towards the company or even the death of the CEO or founder.
Stock Market Mechanisms
There are various mechanisms in place that guides the way the stock market operates in regard to volumes of stocks traded and the price. Apart from stopping market manipulations, market mechanisms are initiated in order to control price volatility. The effects of volatility in a market can lead to jittery investors leaving the market and this could lead to other detrimental effects on the market. Mechanisms against manipulations are geared towards public involvement as opposed to the notion that the market only served a select few. A volatile market can lead to a great impact in the long run as companies will have a hard time in raising funds to implement business operations. History has shown that we cannot completely eliminate volatility and the mechanisms can only mitigate the effects of volatility. Mechanisms may not be standard in all countries due to the different pace at which each stock market has developed. The most developed markets have integrated various mechanisms that enable traders to swap portfolios of assets and this virtually enables the trading of stock across all counters and across all exchanges. These mechanisms also have the ability to impede efforts by traders to take advantage of information that is pertinent to trading on the exchange and by extension mitigate volatility of stock prices as they allow re-balancing of portfolio. Recent advances in Information and technology have allowed traders to even submit multi price contingent orders, the specification by traders on varying parameters upon which trade will be executed and also the submission of orders that can be categorized as non standard type. Several mechanisms exist such as the two call auction trading mechanism which allows a vector of risky assets to be dealt among a range of informed speculators who may posses the characteristic of being risk averse. Trading of the risks can also be done by liquidity traders. In restricted environments, the demand by traders for assets is reliant on all equilibrium prices. The prices of stocks mirror the all the information that could be included on all order flows. This is the opposite of an unrestricted environment whereby demand from traders is reliant on asset price that is traded. These prices could mirror out the single order flow information. Both sets of mechanisms allow the trader to execute trades efficiently and fast. These mechanisms have also allowed investors in the stock markets flexibility when determining the number of assets that can be exchanged and in the right volume amounts this has negated the use of prior information on the stocks and has evened the “playing field.” Further investigations into better mechanisms such as the introduction of production in the model, that we have described above as restricted will allow enable the research among companies and their competition and the behavior of traders in the determination of stock prices. Recent happening within the New York Stock Exchange however showed us that the mechanisms in place still have to b tightened in order to avoid any instances of a stocks crash. Reforms bound to be effected by the stocks exchange across America include, exchange level erroneous order filters, limiting the size of market orders and the elimination of practices that show stub quotes never intended for execution.
Role of Regulators in Fighting Insider Trading
Stock exchange regulators in most countries have come up with various initiative sin combating the vice. Most require the full disclosure of any trades by persons deemed to be in possession of information that is likely to alter the price of the stock in question. Individuals mostly targeted by this requirement are directors, CEOs, big shareholders among others. This creates a fair trading ground for all and hence reduces chances of manipulation. Regulators have also been given powers to inspect and scrutinize cases that may be deemed to have gone against the law. They have also been given powers to act against individuals or companies found to have aided and abetted the crime. Action may be through restraining the individuals from trading again or the striking off of rogue stock brokers from the exchange in question. Regulatory bodies have also introduced bounties and other rewards to whistleblowers who alert authorities on the spread of the practice both within and without the organization. In some countries regulators have enough muscles to fight the big corporations found to have breached the insider trading rules or firms that do not have a code of conduct top restrict their employees from engaging in the vice. In America, companies have to set out dates and announce periods in which their staff can deal in trades without breaching any laws be accused of trading while utilizing inside information.
Prevention Measures against insider trading Practices
Prevention against the vice is mostly driven by regulators. In most stock exchanges, firms listed on the stock exchange are required by law to comply with acts and laws that have been set up the law makers against engaging in this practice. Listed firms are also required by law to educate the public and their shareholders on the importance of the contents of the regulations that ban the practice. This is especially significant in conclusion of contracts that are related to investments management. The efforts are also geared towards encouraging employees’ within the company to re think before proceeding with the sale of the firm’s stock. If caught committing the crime, they will be liable to a number of consequences that may include being fired from the job, receiving penalties through fines or even jail time for the employee. The rate at which employees and other insiders come across confidential information is very high and this is why regulations against insider trading are mostly geared to curtail their efforts in trying to benefit from the stock exchange. Due to efforts from regulators, most companies have a code of conduct that looks after shareholders and investors while guaranteeing the integrity of the exchange markets. Another way that the practice has been prevented in the past is through direct monitoring of the shares by coming up with proper mechanisms that scrutinize the volumes being traded against individual brokers and also in regard to the time the sale is being done. Penalties and fines against individuals found to have practiced insider trading continues to be increased. In some countries such as India, the individual is fined about three times the amount he has been found to have profited from insider trading. Most developed countries have laws that restrict high ranking officials within an organization from trading in securities such as derivatives and other forms of company securities.
Other Trading Manipulations
Manipulation of stock prices through insider trading is paled and has been shadowed by other forms of stock manipulations. With the advent of the World Wide Web, it is getting easier for share prices to be manipulated as information can be relayed on a real time basis. Manipulation through insider trading has been made even easier as it just requires information to be sent to external persons and brokers via email. Never has it been easier for crooks to take advantage of the public as the utilization of the internet is making it hard for regulators to keep tabs on every trade that goes on in the stock exchange. Instances have been found of how companies doctor documents such as profit earnings hence luring the unsuspecting public to buy the shares. Examples of companies that have collapsed due to such manipulations techniques include ENRON, World Com among others. These actions are normally perpetrated by the company, Brokerage Company or persons wanting to gain financially by misinforming the public. This form of manipulation can involve many “actors” in order to make it more plausible to the public. Promoters can be hired to release fake press releases.
The second way that the stock prices can be manipulated is through rumor mongering by mangers. This is where investment managers could decide to create a rumor about certain stocks. Price movements can be greatly determined from such rumors as liquidity within the company can be created from a rumor about a new invention that the company could be embarking on. After the public has bought into the shares is when it becomes evident that there are no new inventions and that they were duped into buying the shares. Such manipulation techniques are subtle and very difficult to spot out as investors normally place high credibility to fund managers. It is also very difficult to track the origins of certain rumors as no trail can direct investigators back to the fund managers. This technique is only short term as the truth is spread also as fast as the rumor was formed. Market manipulations have been with us and it is unfortunate that it is still very difficult in tracking down these manipulators. The only way that we can successfully deal with the menace of manipulation is through education programs and initiatives geared towards imparting knowledge to the masses on how to spot manipulations and how to deal with them. The public also has to be aware that despite the manipulation techniques being employed by these malicious individuals, it is still possible to make money in the stock exchange by employing sound investment strategies. These strategies could be in the form of diversification of risks through spreading portfolio of ones shares to researching deeply before committing one’s resources into buying a particular stock.
Conclusion
The practice of insider trading and other manipulation techniques can have detrimental effects on the shares and the general health of the economy. An environment that fosters such practices only serves to chase away investors and thus hurting local companies looking for funds. It is imperative that all the employees, brokerage firms and investors know on the laws governing trading on stock exchange. Such knowledge can only be shared through initiatives by the regulators in conjunction with the listed firms on how to trade without breaching the laws of the country. It is unfortunate that the public has always been the ones who are hurt whenever such malpractices are committed in the market. Such malpractices lead to depressed prices in the bourse and this hurts the economy in the long run. With concerted efforts from all the stakeholders in the financial industry, insider trading and other manipulation techniques can be mitigated to a point that is not detrimental to investors.
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