Insider trading is the buying and selling public securities using material, nonpublic information.
For such a short answer, it raises a lot of questions. What constitutes material information? Does it matter how you came to access the data? Why is insider trading illegal? What happens if you get caught? This post will address all these questions and more.
Defining Insider Trading
Let’s start with the basics – breaking down the definition of insider trading.
Illegal insider trading is based on the use of “material, nonpublic information”.
In this context, material information can impact the price of a company’s stock, either positively or negatively. For example, one company purchasing another could cause the value of a stock to shoot up, such as when Amazon bought Whole Foods. Another example could be that a successful, long-time CEO of a publicly-traded company is stepping down, leading to the price of that company’s stock dropping.
The other defining characteristic of insider trading information must be nonpublic. In theory, this seems straightforward; either the information has been released or not, but it’s not always that clear. For example, you’re at a baseball game and happen to overhear two strangers discussing an upcoming merger at the publicly-traded company they work for. The company has not yet announced this information to the public. If you trade on this information, is it insider trading?
In this instance, you could legally trade on the information. That’s because insider trading requires that you have a duty to keep the information private. Specifically, the SEC’s definition of illegal insider trading includes the description that the trading must be “in breach of a fiduciary duty or other relationship of trust and confidence.” The relationship between a company and its employees falls within this definition. Therefore, if an employee who works at a publicly-traded company overhears material, nonpublic information while at work and trades on that information, that would constitute illegal insider trading. Those working within publicly traded companies may have more opportunities to access material, nonpublic information, but insider trading is not limited to those within a company.
The required “relationship of trust and confidence” could be between a publicly-traded company and a third-party provider or consultant the company hires. The relationship could also be between an insider and someone with no affiliation to the company, such as a friend or family member. Even if a friend or a family member has no association with the company, that friend has a relationship with the insider and cannot trade on confidential information the insider provides.
An individual who breaches their duty of confidentiality and shares nonpublic, material information may be charged with illegal insider trading, even if the individual did not personally profit from the data. Examples of insider trading have involved:
- Employees, directors, and corporate officers of publicly traded companies
- Employees of firms whose roles have given them access to material nonpublic information about a company, including law, brokerage, and banking firms
- Employees of the government whose positions gave them access to material, nonpublic information, and the political intelligence consultants who work with them.
- Friends, family, and business partners of the above. There is typically a “tipper” and a “tippee” in these situations. The tipper has material information that’s not available to the public. The tippee is the person who receives the information.
As we can see, examples abound of relationships that have been exploited for the use of illegal inside trading.
Before going any further, it’s worth pausing to make a quick note on terminology. You may have noticed the continued use of “illegal insider trading”. Though the term may sound redundant, it’s not. Typically, when people refer to insider trading, they refer to illegal insider trading, but not all insider trading is illegal.
Legal vs. Illegal Insider Trading
Legal insider trading is when someone inside a company makes a trade on that company’s stock. For example, an employee may purchase many shares in her company. This is perfectly legal.
The difference between legal and illegal insider trading is the use of nonpublic information. If that same employee purchased those same shares, knowing that information would soon become public, that would cause the stock price to increase, and the purchase would become illegal insider trading.
Even though most people mean illegal insider trading when referring to insider trading, it’s worth discussing legal insider trading because it helps explain why it is so hard to catch. Insiders making trades is perfectly legal. Prosecuting insider trading, which we’ll touch on more later in this post, requires proving that the individual based the trade on material, nonpublic information.
Why Is Insider Trading Illegal?
The obvious reason trading on material, nonpublic information is illegal is because it provides an unfair advantage to those with the data.
When someone has nonpublic, material information about a publicly-traded company, they can use that information to make a profit. The average investor does not have this ability and is at a disadvantage. The rules created by the Securities and Exchange Commission (SEC), the agency responsible for policing insider trading, aim to create a fair marketplace. Besides giving insiders a clear advantage, scholars also argue that insider trading is socially undesirable. The argument is that economic growth is negatively impacted since traders must spend more on capital.
The History of Insider Trading
Profiting off material information that’s not yet public is illegal, but it hasn’t always been. Up until the 1930s, all insider trading was legal. Insider trading helped fuel the roaring 1920s, and at the time, few had any issue with it. In the Massachusetts Supreme Court case, Goodwin v. Agassiz, the court ruled that profiting from material, nonpublic information was “a perk of being an insider”.
But public sentiment shifted during the Great Depression. The public lost faith in the markets after the stock market crash of 1929, and the idea of federal regulation became considerably more appealing. This led to Congress passing the Securities Exchange Act of 1934, which created regulations to help protect investors and created the SEC to enforce the act.
Though the act was arguably the beginning of federal regulation of the markets and is still the backbone of fraud and insider trading cases today, it included neither a definition of insider trading nor concrete wording making it illegal. Specifically, the act had a significant loophole. The law prohibited “fraud and misstatements in the sale of securities”, but it did not prevent fraud or misstatements when purchasing securities. This essentially meant insider trading remained legal.
In 1942, the SEC updated the language of the Securities and Exchange Act of 1934, at which point insider trading officially became illegal. Later further updates to the act were made, broadening the language even more. Section 10b of the Securities and Exchange Act of 1934 prohibits any fraudulent or deceptive practice and has been broadly interpreted in cases ranging from negligence to failure to stop others from participating in securities fraud.
Though the Securities and Exchange Act of 1934 is one of the most well-known and wide-reaching acts relating to insider trading, it is far from the only one. Various other laws and regulations have also been passed related to insider trading, including the Insider Trading Sanction of 1984 and the Insider Trading and Securities Exchange Act of 1988. Much of insider trading prosecution today is based on these two acts.
Hypothetical Examples of Insider Trading
Let’s look at a hypothetical example to put what we’ve discussed thus far into more concrete terms. Let’s say Company A has a quarterly earnings announcement on Friday. At that time, Company A will report the release of a new product that is expected to sell incredibly well and allow Company A to increase profits dramatically. Once this news is released, it is likely that investors will respond favorably to the press, and the price of Company A’s stock will rise.
An employee of Company A knows about the announcement occurring on Friday. On Wednesday, the employee purchases 100,000 worth of Company A stock. On Friday, when the new product was announced, Company A’s stock increased by 10%. The employee then sells his shares for 110,000 – a $10,000 profit made only two days. The employee in this example profited from his use of material nonpublic information and therefore is guilty of insider trading.
This is an obvious example of insider trading. Let’s look at another example that’s slightly more complicated.
Let’s say that instead of making the trades, the employee of the company tells a friend about the upcoming new product announcement and suggests that the friend purchase stock in Company A. On Wednesday, the friend purchased $100,000 worth of Company A stock. When the new product was announced on Friday, Company A’s stock increased by 10%. The friend sells his shares the same day. In this instance, both the employee and the friend are guilty of illegal insider trading, even though the employee did not make a profit. The employee had a relationship with his employer, Company A, which he exploited by tipping his friend. The friend had a relationship with the employee, which he utilized to make a profit.
While cases like these do occur, most examples of real-life insider trading are even more complicated. To see how insider trading can play out in the real world, we’ll look at the famous example of Martha Stewart.
Martha Stewart and Insider Trading
One of the most publicized examples of insider trading was in 2003, when the SEC charged Martha Stewart with securities fraud. This case is an excellent example of how an individual may profit, even if they’re not an insider in the publicly-traded company in question, and how complicated insider trading cases may be.
The charges against Stewart concerned a company called ImClone. ImClone had a drug called Erbitux, but the drug had not yet received approval from the Federal Drug Administration (FDA). Erbitux was an essential product for ImClone, and if approved, it could be used to treat cancer. The CEO of ImClone, Samuel Waksal, knew the FDA was about to reject Erbitux’s approval. Since he knew this would negatively impact the company’s stock price, Waksal instructed his Merrill Lynch broker, Peter Bacanovic, to sell all of the ImClone shares he held at Merrill Lynch.
Bacanovic was not supposed to share the information relating to Waksal’s trade. Employees at Merrill Lynch were not allowed to discuss with clients trades other clients had made. They could not use the information they gained from client trades to benefit another client. But Bacanovic did share this information.
Stewart was another one of Bacanovic’s clients. Stewart had his assistant tell Stewart that Waksal had sold all of his shares of ImClone. Based on this information, which was not publicly known, Stewart chose to sell all of her shares of ImClone. ImClone announced that the FDA had denied Erbitux’s application the following day, and the share price dropped. By selling when she did, Stewart avoided a loss of $45,673.
Stewart and Bacanovic, her broker, were charged with insider trading. When an investigation began, Stewart attempted to cover up the illegal insider trading. Due to the attempted coverup, she was also charged with obstruction, conspiracy, and making false statements, which often accompany insider trading charges. Stewart served five months in a federal corrections facility for these charges, not the insider trading charges.
Stewart was one of many high-profile insider trading cases in the last two decades, but convictions are relatively rare even though insider trading charges are highly publicized. This is because insider trading is often tough to prove.
Proving Insider Trading
The SEC works with stock exchanges and other regulatory bodies such as FINRA to help catch those involved in insider trading, but proving insider trading is often incredibly tricky.
The SEC keeps an incredibly close eye on the directors and owners of publicly traded companies since these individuals often have more to gain. Directors and owners not only have access to information others may not, but their roles within the company mean their actions may create material, nonpublic information. For example, the CEO of a company can impact the company’s stock price if he chooses to leave the company. This is why a company must report who owns the company and the percentages they hold. When ownership changes occur, they must be reported to the SEC.
Furthermore, under Section 16 of the Securities and Exchange Act of 1934, when a director or officer of a publicly-traded company, or anyone with a 10% or higher stake in the company, buys company stock and then sells it within six months, any profit from that trade is required to go to the company. This makes it more complicated, though certainly not impossible, for directors and officers of publicly traded companies to profit from inside information.
The SEC does not limit its scope to directors or owners of publicly traded companies because, as we’ve seen, anyone can become involved in insider trading. This is why all insiders must report their trading activity to the SEC. The SEC then uses software to review trades and flag suspicious-looking trades. This should make it relatively simple to catch insider trading, but this isn’t necessarily the case.
Trading history can highlight red flags, such as making a significant trade right before the information is released, which causes substantial movement in the stock price, but profiting from trade is not illegal. Even though the SEC has many tools and partners that can help it find suspected insider trading, proving insider trading is still incredibly problematic. A conviction of insider trading requires proof beyond a reasonable doubt that the person making the trade had access to nonpublic material information and knew it was confidential.
If insider trading is proven, the penalty is often relatively high. According to the Insider Trading Sanction of 1984 and the Insider Trading and Securities Exchange Act of 1988, the financial penalties for insider trading may be up to three times as much as the profit made on the trade. But the penalties for financial trading are not only financial. Insider trading is also punishable by up to 20 years of jail time.
The Bottom Line
Even with the potential penalties, the temptation to profit from insider information will likely always tempt some insiders. But as tempting as insider trading may be, the potential of fines and jail time means that insiders should think twice before trying to compound capital criminally.