Regulatory authorities often lack a "smoking gun" (i.e., hard evidence such as a note or a memorandum) when prosecuting individuals for illegal insider trading. As a result, many insider trading cases depend solely on circumstantial evidence, which is usually obtained by associating trades with "unusual" price moves. However, insiders with the most accurate information (the ones most likely to possess "material, non-public" information) are the ones best able to modify their trading strategy in response to prosecution strategies based on price moves. This is a major obstacle to the efficacy of insider trading regulation. Thus, if legislation discourages strategic insiders with relatively precise information from trading, then in all likelihood any investor who is prosecuted will possess only the weakest (most imprecise) information. Stratetgic behavior by insiders in response to insider trading regulations can thereby lead to a situation where the pool of prosecuted traders contains a large fraction of innocent individuals (i.e., individuals with relatively poor information).
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