Ethical Reasoning and the Use of Insider Information in Stock Trading

Author(s): Mohammad Abdolmohammadi and Jahangir Sultan

Source: Journal of Business Ethics, Vol. 37, No. 2 (May, 2002), pp. 165-173
Published by: Springer
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Ethical Reasoning and
the Use of Insider Mohammad Abdolmohammadi
Information in Stock Trading Jahangir Sultan

ABSTFJ\CT. The
cognitive developmental theory of by the DIT P-score indicated statistically significant
ethics suggests that there is a positive relationship effect on ethical behavior. The results have impor
between ethical reasoning and ethical behavior. In this tant implications for recruitment and training of
study,
we trained a
sample of accounting and finance professionals engaged in the use of financial markets
students in performing competitive stock trading in for securities
trading.
our state-of-the-art room. The then
trading subjects

performed trading of stocks under two experimental KEY WORDS: ethical reasoning, insider informa
conditions: insider information, and no-insider infor tion, stock trading
mation where significant performance-based financial
awards were at stake. We also administered the

Defining Issues Test

(DIT). Ethical behavior, as the
variable was measured in a binary scale: Introduction
dependent
whether the subjects used insider information for
trading of stocks or not. Ethical reasoning
as measured Stock trading is a highly complex task, one that
until recently was the sole domain of professional
Mohammad Abdolmohammadiis the John E. Rhodes stockbrokers. However, advances in the infor
Professor of Accountancy at Bentley College. Having mation have lead to the proliferation
technology
interest primarily in behavioral auditing and ethics of such as E
inexpensive stock trading firms
research, professor Abdolmohammadi has published in Direct. For a modest
Trade and DLJ fee, these
Accounting and Business Research, The
firms allow any individual investor to participate
Accounting Advances
Review, in Accounting,
in a competitive market trading that used to be
Auditing: A
Journal of Practice and Theory,
the domain of professional traders only several
Behavioral Research In Accounting,
years ago. A result has been the growth of the
Contemporary Accounting Research, Journal of
Business Ethics, Teaching Business Ethics, and so-called day traders who buy and sell stocks on
a daily basis; sometimes a given
Organizational Behavior and Human Decision they trade stock
Processes among others. multiple times in a single day. Various types of
Jahangir Sultan is a professor offinance at Bentley College. information, including real or perceived insider
His research interests cover various finance topics, information that can be traced to a variety of
including ethics. He has published numerous papers in sources, often permeate the trading. In this study,
Journal of Financial and Quantitative Analysis, we empirically investigate ethical behavior of
Journal of International Money and Finance, investors in the context a
individual of simulated
Journal of Financial Engineering, Journal of
stock market trading in a state-of-the-art
trading
Business Finance
and Accounting, Journal of
room. This research to the recent calls
responds
Applied Financial Economics, Open Economies
(e.g., Hosmer, 2000) for empirical research in
Review among others. In his position as the Founding
business ethics.
Director of theHughey Center for Financial Services,
Dr. Sultan has raisedfunds and has established a multi Recent research indicates that ethical problems
million dollar state-of-the-art trading room, which has exist in personal investing. For example, a study

provided a facility to investigate ethics in financial reported that managers traded clusters of the
markets. stocks of their own company after voluntary

JlA. Journal of Business Ethics 37: 165-173, 2002.

r 2002 Kluwer Academic Publishers. Printed in theNetherlands.
 166
Mohammad Abdolmohammadi and Jahangir Sultan

disclosures when
doing so resulted in more favor and
Background hypothesis
able stock prices for them (Noe, 1999). Similarly,
Mackenzie and Lewis (1999) reported the results Moral reasoning
of a qualitative study in which 20 investors were
interviewed. The authors found that while all of Moral dilemmas in business are
complex (Tansey,
the investors in the
study had ethical concerns, 1994). This
complexity requires not only the

they were not prepared to sacrifice their essen domain knowledge, but also moral expertise to
tial financial requirements to address them. The handle. For example, Gaa (1994, p. 135) argues
authors concluded that a compromise position of that auditors must achieve "moral expertise,
the investors was that they invested only a small defined as the ability to make audit judgments

proportion of their investments ethically, while in accordance with the "moral point of view".

they left the rest in non-ethical investment The "moral point of view" refers to acting
vehicles. according to accepted principles, moral such as
Individual investors, be it day traders or rights and justice principles. Baier (1958, p. 191)
occasional traders are not confined to any group states, "If one has adopted the moral point of
of people. Any investor regardless of age or view, then one acts on principle and not merely
educational background can participate. All is on rules of thumb to promote one's
designed
needed is a trading account and some funds aim."

(generally with aminimum of $2000). Our target To have moral point of view, one has to have
group was a sample of accounting the ability to engage in moral reasoning to solve
undergraduate
and finance students, who can be assumed to be moral dilemmas. The most and
recognized
among the most knowledgeable day traders due widely used measure of moral reasoning is the
to their technical knowledge of accounting and P-score generated from the Defining Issues Test
finance. They also were trained in the mechanics (DIT) as described in Rest (1994). The DIT
of stock trading in our state-of-the-art trading instrument is grounded in the cognitive devel
room.
opmental theory of moral development advanced
The objective of this study is to investigate the by Kohlberg (1981, 1984) from Piaget's (1965)
ethical behavior of these individuals when they theory of cognitive
development in children.
engage in personal stock trading in a simulated Kohlberg proposed three levels of moral devel
stock we into two
competitive trading market. Specifically, opment with each level subdivided
investigate whether ethical reasoning has any stages. Each of the six stages is cognitively and
effect on
choosing to use insider
information, morally at higher levels than the previous stages.
which is illegal and unethical, or not to use The first level of moral development, called the
insider information, which is legal and ethical, Pre-conventional level, relates to self-centered
for personal stock trading. ethics of convenience, where the individual obeys
The remainder of this paper is organized as the rules to avoid punishment (Stage 1) and seeks
follows. The next section briefly discusses the personal rewards through manipulation of others
literature as a means of developing (Stage 2). The second level of moral cognition
background
the study's research hypothesis. A section then is called the Conventional level. It relates to the
and on
describes the research method by the followed ethics of conformity, group focuses
results. The final section provides a summary as loyalty and seeking acceptance by members of
well as the limitations and implications of the the group as a "nice" person (Stage 3), and the

study. ethics of national law and order (Stage 4). Stage

4 is where theindividual obeys civic and/or
laws, as
as well professional codes and
religious
commonly accepted social role-expectations. The
third level of moral cognition is called the Post
conventional level where one achieves the

principled-centered ethics of conviction. At this

 Ethical and the Use of Insider. Information in Stock Trading 167
Reasoning

level, the individual is attracted to the ethics of The Securities and Exchange Act of 1934 (the
social contract, natural law and utilitarianism ACT) makes it illegal for insiders to trade in

5) and the ethics of unwritten global securities of their own firm while in possession
(Stage
ethical of justice, duties and human of "material information." Naturally, insider
principles
that may be linked to such material
rights (Stage 6). The six-stage theory predicts trading
that individual progress throughout life from a information advantage is the focus of the SEC's

stages in accordance with efforts to detect and punish insider trades.

lower stage to higher illegal
their moral and development. To deter illegal insider trading, the SEC routinely
propensities
The full version of the DIT instrument is a monitors trading by all insiders using market
with six ethical surveillance programs and penalizes violators with
multiple-choice questionnaire
dilemmas. Each ethical dilemma is accompanied fines, imprisonment, disgorgement of profits, and

by twelve questions (for a total of 72) that "were by barring them from securities trading. Finally,
to represent the different considerations the enactment of the Insider Trading Sanctions
designed
that are diagnostic of different schemes of Act (ITSA) in 1984 and the Insider Trading and
fairness." 1986, p. 196). The Securities Fraud Enforcement Act of 1988 has
(Rest, subject
indicates the importance of each item in the made illegal trading more
insider costly in terms
resolution of the dilemma a 4-level scale of legal costs, fines, and loss of reputation (Bris,
by using
some, little or none), and 2001). An important outcome of these harsh
(much importance,
then answers an overall of what one is that corporations now routinely
question penalties
to do The P-score,
in the circumstances. monitor insider trading to avoid costly legal
ought
P standing for "principled moral (Rest, battles as well as to improve corporate image in
thinking"
1994, p. 13) is a measure between 0 and 95, and the marketplace.
it is "based on the relative that a Academic research on insider trading has
importance
a number of issues the
subject gives to items representing Stages 5 and investigated including
6" the P-score effects of insider on abnormal stock
(Rest, 1994, p. 13). Thus, trading
measures an individual's standing
on Kohlberg's returns, the welfare impact of insider trading, and
Post-conventional level ethics of conviction. The the efficacy of the insider trading laws and sanc

higher the P-score, the closer is the person to the tions. For example, early research by Ball and
principled stages (Stages 5 and 6 in Kohlberg's Brown (1968) andMuelbroek (1992) report that
ethics model). The trades by corporate insiders prior to earnings
cognitive developmental
instrument is scored at the Center for the Study announcements or
corporate
events contain

of Ethical at the University of information to the market. This was evident in

Development
Minnesota. price run-ups prior to actual release of corporate
earnings.
The extent to which insider trading affects
on insider information market efficiency has also been a hotly debated
Trading
issue. Proponents of insider trading hold the view
Insider is defined as trading corpo that prohibiting insider trading allows markets to
trading by
rate officers with authority and perform efficiently by encouraging fairness and
decision-making
with to the shareholders. liquidity. In contrast, Leland (1992) found
fiduciary obligations
Not all trading by insiders is illegal. What con support for the hypothesis that insider trading
stitutes illegal insider trading is that these trades makes security prices more efficient as markets
-
are information driven because of access to impound insider's information into security
"material information." Material information is prices. The
explanation is that
trading insider
defined as private information that an investor conveys information about future performance of
could utilize to enhance wealth the firm and therefore stock price reacts to the
personal by
the firm's ahead of the release information content of these trades. Seyhun
trading security
of corporate events such as merger announce (1992) also found that insider trading predicts
ments or
surprises.
future aggregate returns.
earnings
 168
Mohammad Abdolmohammadi and Jahangir Sultan

Do insider-trading laws deter illegal insider Research hypothesis

trading? The evidence is mixed. Several
researchers have examined whether or not insider The literature is rich with studies of ethical

trading is affected by the passage of the 1988 reasoning, using the DIT instrument. A general
ITSA. For example, empirical research reported finding is that ethical reasoning and ethical

by Seyhun (1998) indicates that despite the recent behavior have a positive correlation. For example,

legal restrictions, insider

trading continues to be reviews of prior studies indicate that ethical

profitable practice.In contrast, Bris (2001) found reasoning explains 10% to 15% of the variation
that while toughness of insider trading laws does in ethical action (Thoma, 1994, p. 201).
matter, from insider trading in 52 coun expectwe ethical reasoning as
profits Consequently,
tries have actually risen in recent years. measured by the DIT P-score to have a positive
Nevertheless, the effect of insider trading might and significant effect on avoiding to trade on
have lessened as a result of tougher laws in some insider information. Thus,
cases. For
example, Garfinkel
(1997) found that
the passage of the ITSA in 1988 has affected Ht: On average insider information non-users
insider trading to the extent that there appears to will have a significantly higher level of
be less information content in insider trading the P-score than the insider information
around announcements or earnings users.
earnings
surprises. Similarly, recent studies by Bettis et al.

(2000) and Roulstone (2001) offer support for

the hypothesis that firms restricting insider Research method
the earnings earn lower
trading around surprises
returns to the trades made. Ethical judgment instrument
The literature reviewed above relates to the
of trading on insider information by The full version (i.e., six cases, and 72 questions)
illegality
company management. A broader issue is of the DIT instrument was used to collect data
whether insider trading by company insiders or on subjects' ethical reasoning. The test-retest
as unethical. Limited P-score is in or
other investors is viewed reliability for the the high 0.70s
research is available to answer this question. For low 0.80s (Davison and Robbins, 1978), making
Ekin and Tezolmez (1999) a it a reliable instrument for measuring ethical
example, reported
a sample of Consistent with the we used
study in which corporate mangers reasoning. literature,
rank ordered 11 scenarios (e.g., environmental the P-score as a summary measure of ethical

pollution, using office supplies, insider trading) judgment. The higher the P-score, the higher the

by their unethical nature. Insider trading was level of ethical reasoning

ranked next to the last item (which was giving

gifts/favors) in terms of it being considered

unethical. However, authors generally agree that Stock trading simulation
insider trading "unfairly shifts the risk burden
in favor of the insider trader We the subjects in a stock trading
disproportionately engaged
contrary to utility (Cho
theory." Shaub, and simulation in our state-of-the-art trading room.

1991, pp. 85-86). it is important Most of the

subjects had already participated in
Consequently,
to identify the ethical attributes that foster ethical an orientation to the trading room. However,
decision behavior in stock trading in the presence given the complexity of the trading mechanics,
of insider information. As in the final we provided up to one hour of hands-on training
explained
section, these attributes have implications for until every subject felt comfortable with the

recruiting and training of professional stock mechanics and was ready to participate in the
brokers. actual game. The were given
competitive subjects
a case in which two companies with various
levels of economic characteristics were to be
 Ethical Reasoning and the Use of Insider Information in Stock Trading 169

traded. The cases specified the market environ sections of the courses, explained the project and
ment, economic events and financial informa compensation, and recruited volunteers. The
tion. The cases also
specified a situation in consisted of 57 32 of whom
legal sample subjects,
which each company had sued the other for 50 were to the controlgroup
randomly assigned
million dollars for dumping radioactive material (i.e., no insider information treatment), while the
in its property. As explained later, a settlement of remaining 25 students were in the insider infor
this lawsuit was presented to the experimental mation treatment
group.2 The control group had
group of subjects as insider information. a mean age of 20.61 years as compared with the
Each subject was given a
hypothetical fund experimental group mean age of 20.08 years,
of $10,000 to use for investing. However, the which are different
by approximately V2 year.
magnitude of the portfolio could be significantly This difference was
statistically significant at the
than this amount because the 0.07 level =
greater subjects (T-statistic 2.82).
could engage in margin buying and short sales. The two groups did not differ in their Grade
one = =
After session of this competitive simula Point Averages (i-stat 0.29, P 0.78), religious
= P = 0.93),
tion, we provided
a folder to each subject con affiliations (Chi-squared 0.15,
cerning insider information about the two whether they had taken an ethics course or not
one of = = or class rank
companies. Approximately half the (Chi-squared 0.60, P 0.44),
= P =
subjects, selected randomly, were told that there standing (Chi-squared 2.40, 0.12).
was no new information, while the other half However, there was a difference
significant
was given specific insider information (settlement between the academic majors of these subjects.
of the law-suit shortly before it was revealed to While relatively more accounting majors were
the public). We presented the following sentence allocated to the experimental group, more
to the subjects to make sure that they knew that finance majors were
among the groupcontrol
on is illegal = = not
trading insider information and may (Chi-squared 7.70, P 0.02). We do have
be unethical. any theory to predict whether this difference and
the age difference should influence the results in
Note: For a public
insiders of company (i.e.,
any way. In fact, as discussed later there were no
persons with fiduciary obligations to the company's
significant differences in ethical reasoning
shareholders), trading on insider information is
between the control and experimental
in the United States and is to groups.
illegal subject pun
All students received $6 per hour for partici
ishment. Also, most people view trading on insider
information as unethical it is unfair to pating in the study. The monetary compensation
because
other investors.
was necessary because of the length of the study
- it
required up to 3V2 hours of subjects' time.
Upon the completion of the second compet In two experimental sessions, we finished within
itive simulation, we asked the subjects whether three hours, while session took approx
the third
they used the insider information to make stock imately 3V2 hours.
In addition, the students
trading in the second simulation. We classify received a significant monetary bonus of respec
these subjects as having committed an unethical tively $100, $75, and $50 for placing first, second
behavior if they used the insider information for or third in the stock market performance. This
their trading and ethical behavior if they did not.1 performance was measured based on the cash
value of all securities owned at the end of the
simulation, the higher the amount the better the
The subjects performance. Since there were three simulation
sessions, there were nine subjects who received
The subjects were
junior business students these bonuses.
enrolled in the first
intermediate accounting
(required of accounting or a financial
majors)
statement analysis (required of finance majors)
course. One of the authors went to several
 170
Mohammad Abdolmohammadi and Jahangir Sultan

Results information for its stock trading on average had

a significantly lower level of the P-score than the
Table I presents the results of our statistical group that did not use insider information in its

analysis. Panel A shows the P-scores of the stock trading.

control group and the experimental group of We investigated the effects of a number of

subjects. The means and standard deviations of demographic variables on the results as well and
the P-scores are not different found no effects. For the
significantly significant example,
the control = and own
between group (P-score 34.80) subjects assessed the strengths of their
= at from to very
the experimental group (P-score 33.50) honesty and ethics excellent bad.
= not
conventional levels of significance (T-statistic This variable did indicate any significant
0.45, which is This result indicates differences on the P-score. The assessed
insignificant). subjects
that the random assignment of subjects to the percentage of the society that they deemed

experimental groups was effective in the sense to be unethical. This variable showed no
signif
that the subject groups had approximately the icant effects on the P-score either. Similarly, the
same level of ethical had an insignif
reasoning. strength of one's religious belief
A conclusion from
the insignificant difference icant effect on the P-score. Thus, the difference
between the control
and experimental groups is in ethical reasoning based on the use or non-use
that any P-score difference within the experi of insider information can be as
interpreted
mental group is due to the experimental insider robust because it is not confounded by demo
information treatment, which is the focus of the graphic variables.
research hypothesis (H^. To formally test for this

hypothesis, the experimental group is divided

into two sub-groups of insider information users Summary, limitations, and implications
and insider information non-users and their
P-scores are compared. Panel 2 of Table I In this study we provide data from
experimental
presents the results. The mean P-score of the a competitive stock trading simulation. An exper
insider information users (31.22) was significantly imental group was introduced to a piece of
lower than the insider information non-users insider information in the middle of the simula
(37.30) at the 0.08
level of significance using the tion while the control group did not receive this
=
two sample -test (T-statistic 1.87). Thus, in information. The experimental group was told
support of Ht the group that used the insider that the use of insider information is illegal, and

TABLE I
Panel A: P-score difference between control group and experimental group

Ethical reasoning Control group Experimental group T-stat. Signifiance

= =
(n 31) (n 24)

Mean P-score 34.80 33.50 0.45 0.65

(Standard deviation) (12.00)(8.57)

Panel B: P-score difference between inside information users and insider information non-users within the
Experimental Group

Ethical reasoning Insider info users Insider info non-users T-stat. Signifiance
= =
(n 15) (n 9)

Mean P-score 31.22 37.30 1.87 0.08

(Standard deviation) (8.84)
(6.94)
 Ethical Reasoning and the Use of Insider Information in Stock Trading 171

may be unethical. All subjects were paid hourly only difference is that the portfolio money in the
to participate in the study. The top stock per simulation was not real money,
although the
formers were also given a significant amount of bonuses were. One argue can
that a day trader
cash award. We also measured the subjects' who uses his/her own money in the market may
ethical reasoning using the full version of the behave differently than the subjects in our study.
DIT. For example, there is evidence indicating that a
The results indicated that the experimental "competitive game" [a game of sharing and using
group and the control
group did not differ in common resources] produces more inconsisten
their P-scores. However, the experimental sub cies in subjects' moral reasoning than the non
group that used the insider information in its game ethical reasoning (Reall et al., 1998). Our
stock trading had a significantly lower level of the view of the context of our study is that the day
P-score than the experimental sub-group that did trader who risks his/her own money in a real
not use the insider information in its stock market portfolio may be even more susceptible
trading. to lapses in ethical behavior than the subjects in
The study had a few
First, limitations. the our simulation study. This is because insider

sample size for the experimental group was small. information presents real chances for financial
This limitation was due to a financial constraint gain in the real market place
as compared with
(we paid for subject participation), the trading the simulated market in our study. Thus, our
room capacity constraint, and the of results may be conservative. However, future
availability
subjects. Although the sample sizes for the insider research is needed to investigate the extent of this
information users and non-users were sufficient possible difference.
from a statistical perspective, larger samples in The results of the study also have significant
future studies are desirable. A related issue here implications for ethics training in general, and
is that we randomly assigned the subjects to ethics in stock trading in particular. For example,

experimental and control groups. However, we can

stockbrokers be trained in ethical
professional
ended up with a larger sample for the control issues and the trading room simulation to discuss

group than for the experimental group. This was areas in which they may have potential for
due to subject attrition or demo unethical lapses in investing. This
implication is
incomplete
graphic information. As reported earlier, com important for brokerage firms who might want

parative analysis of demographic information to consider extensive ethical training for their
between the two samples indicated no differences brokers. Bebeau (1994) reported that significant
for most variables, except for age and academic gains could be achieved from extensive training
major. The control group was older by approx in professional settings such as dentistry.

imately one half of one year than the experi The results indicate that people with higher
mental group. Also, while there were relatively levels of ethical reasoning are less likely to use
more finance majors in the control group, there insider information in stock the
trading, signaling
were more accounting in the of firm recruits
majors experi importance screening brokerage
mental group. These minor
differences should for ethical reasoning. Since the DIT instrument
not have any major effects on the results, and has been found to be a reliable instrument to
we found that there were no significant differ measure ethical it can be used as a
reasoning,
ences between the
experimental and control device to identify recruits with
screening high
groups concerning ethical reasoning. levels of ethical reasoning. The P-score from the
The subject group was selected from juniors instrument is a simple linear measure that can
in a business college. We assumed that these be helpful to accomplish this task.
subjects represented the individual investors

engaged in day trading in the current market

environment. The simulation game used in the
study is completely similar to the technology
used by brokerage firms and day traders. The
 172
Mohammad Abdolmohammadi and Jahangir Sultan

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