A hot tip is a lucky bonus, right? In the share market, not so much.

If a person trades on information that hasn’t been released to the public, it’s called insider trading and it’s illegal.

For example, if you knew that a company was about to make a takeover offer and you bought shares before that was made public, you could be prosecuted for insider trading.

You’d make a profit because you knew for certain the offer would be made, so you know what the price should be.

Anyone can be prosecuted

Even if you pass on confidential information to someone who then trades on it, you can also be prosecuted.

While we commonly think of insiders as company directors, the reality is that the law views an insider as anyone with as-yet-unreleased information that will have an impact on the share price.

So why do we care about insider trading?

It’s like cheating at poker

Imagine a poker game, where your opponent can see not only their hand, but also yours. Essentially, they’re unbeatable. Insider trading is the same.

Shares are supposed to be priced on the basis of all public information, but a person with private information can accurately predict what the price will do – they have the advantage. They’ll know when to buy and when to sell.

The problem is that for one party to win, the other trader (who the insider bought from or sold to) must lose. If you think the game is rigged, you stop playing.

For share markets, this is serious stuff. Markets are most effective when they’re liquid, and liquidity depends on general investors being willing to trade. For that reason, regulators and law-makers try to stop illegal insider trading.

Penalties are getting higher

In New Zealand, law-makers have steadily increased the penalties for insider trading. It used to be a civil matter with a maximum penalty of three times what you’ve gained or the loss you avoided.

Then they added a NZ$1 million minimum fine to the civil penalties, and now insider trading’s a criminal offence, earning up to five years’ jail time.

It’s hard to prove

The problem is that we’ve increased penalties, but the regulators have struggled to detect and effectively prosecute insider trading.

So far, they’ve succeeded in court just once. If insiders don’t think they’ll get caught, does it really matter what the penalties are?

We’ve had some big court cases in New Zealand but very few wins. These are some of them:

· Seven investors in Tranz Rail agreed to repay NZ$27.5 million for trading before a massive price drop in 2002, but by selling they avoided losses of NZ$47.5 million, and no one admitted wrong-doing.

· Businessman Eric Watson repaid the gains he made from buying shares in a company in the six months prior to his company making a takeover offer, including nearly 400,000 shares on the morning of the announcement. His actions weren’t deemed to be insider trading by the securities commission, and he suffered no further penalty.

· Likewise, Kerry Hoggard, who was chief executive of Fletchers, bought shares in Fletcher on the eve of a major announcement. He repaid the gain he made, and resigned as CEO, which was arguably the biggest penalty suffered in these three cases.

· The only successful court case involves an employee of E-road, who texted a former employee advising him to sell due to poor sales. He pleaded guilty and received six months’ home detention, despite not trading. The former employee, who did trade, contested the criminal charge and the case recently resulted in a hung jury.

The FMA’s working hard

Despite New Zealand’s poor enforcement record, the laws themselves are just as tough as many other well-regulated countries.

And while illegal insider trading is hard to prove, especially to a criminal standard, the Financial Markets Authority is working hard to clean up the market.

However, without significant increases in resourcing, I believe it will always struggle to have the same success as Australia, one of the most successful countries for enforcement of insider trading.

First published 19 July, 2018

Story by Aaron Gilbert

Aaron Gilbert is an Associate Professor in Finance at Auckland University of Technology. He researches in a wide range of areas related to financial markets including law and finance, corporate governance, and KiwiSaver.

JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions. This story reflects the views of the contributor only. Content comes from sources that JUNO considers accurate, but we do not guarantee that the content is accurate.