What is Insider Trading?

Insider trading is like seeing the test a day before taking it…

While all the other students must study all of the material, you have inside information about what you need to know and which areas to focus on. That advantage lets you position yourself much better than any of your peers. It wouldn’t be surprising if you ended up with the best grade in the class. But your classmates would probably complain if they knew about your unfair advantage. It undermines the integrity of the test, as insider trading undermines the perceived fairness and integrity of the securities market.

While the term insider trading has negative connotations as it's generally used, not all insider trading is illegal. People inside companies, and connected to companies business operations, buy and sell stock in their companies all the time — With proper disclosure and oversight from the Securities and Exchange Commission (SEC). And just knowing something about a company is not illegal. But using confidential information to gain an advantage over the rest of the market could be a misappropriation of that non-public information, which is illegal.

An insider is anyone in possession of material information about a company, which is not available to the rest of the market. It is most commonly a reference to a company’s executives, board members, and substantial owners. But it also extends to accountants, lawyers, and anyone else with information that is likely to result in a change to a company’s market value.

Insiders are not strictly prohibited from buying and selling stock in their own companies. But their trades must be disclosed to the SEC.

For example, if a company CFO decides to sell some of their stock to pay for their child’s college tuition, there is nothing wrong with that. But if that CFO knows that the company missed its earnings target, selling the stock just before the announcement of the earnings report likely would be illegal. The SEC would likely investigate the trade and determine whether or not to pursue charges of insider trading.

Likewise, if the CFO told their cousin, friend, barber, or random person on the subway about the poor earnings report, it would be illegal for that person to act upon the information. A person does not have to be an insider to be guilty of insider trading. Any person trading based on inside information for personal gain can be convicted of insider trading. This is often the case when a person with a fiduciary duty, such as an employee at a law firm, gains information about the company. Using such information to trade shares of the company could be considered a breach of a fiduciary duty, which could land them in jail.

Trading based on inside information formally became illegal with the passage of the Securities Exchange Act of 1934. Section 10 of that act contains the language related to securities fraud. The SEC further defined the law by adopting Rule 10b-5, which expanding the definition to include purchasing stocks.

However, some forms of insider trading have always been illegal under common law. In 1909, the U.S. Supreme Court ruled that a corporate director could not sell stock to someone without disclosing information about a pending action that would devalue the stock. In Strong v. Repide, the highest court determined that such an action was deceitful and fraudulent under common law.

One of the goals of the Securities and Exchange Commission (SEC) is to maintain fairness in the securities markets. If people with inside information are able to act on that information, it provides that person with an advantage over the rest of the traders. The SECs mission is to "protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation."

Imagine a person doing hours of research, crunching numbers, and building financial models. That person makes an investment decision to purchase or sell a stock based on all available information. Another person happens to be friends with an accountant at the company in question. After playing a tennis match, this person gets a tip about the company’s earnings. Without doing any research, this second person has more insight into the direction the share price is about to move.

The same goes for someone working at a brokerage who might gain information other traders don’t have. Or, imagine a government employee who shorts a company stock just before denying a permit. There are lots of ways that a person could make a profit based on asymmetric information. For most investors, that doesn’t seem like a fair system. The SEC views the detection and prevention of insider trading as one of its core functions.

SEC rule 17 CFR § 240.10b5-1, often referred to as rule 10b5-1, prohibits trading on the basis of material non-public information. If someone violates this law, they could be subject to criminal and civil penalties. The person can be fined up to three times their gains or avoided losses, or up to $5 million, by using insider information. They could also face a criminal sentence ranging from probation to 20 years in prison. A corporation can also be fined up to $25 million for insider trading violations.

Insider information is something that a person connected to the business dealings of a company knows, but the rest of the world doesn’t. This non-public information is only material if the release of the information will change the market’s perception of the company’s value — and illegal insider trading doesn’t occur unless that insider information is used to trade to make a gain or avoid a loss.

The term insider trading has negative connotations. But insider trading occurs whenever someone inside a company buys or sells their own company’s stock. There is nothing wrong with trading by insiders, so long as it is properly disclosed and isn’t using insider information to make a profit or avoid a loss. However, using insider information to gain an advantage over the rest of the traders is illegal insider trading.

In the strongest sense, insider trading could be avoided by prohibiting all trades by corporate officers in their own company. But even this does not reach far enough to prevent all cases. The prohibition would need to extend to family members of executives as well. But, even then, friends, relatives of friends, and even passing acquaintances could still use non-public information obtained from these executives.

Further, owners of a company are likely to know things about the direction of the corporation that others do not. But preventing the sale of equity in a company would undermine the entire idea of the stock market.

Traders are constantly evaluating information for several sources and must weigh the credibility of the information. Some people, including the late economist Milton Freidman, have argued that there should not be any insider trading laws. From his perspective, allowing insider trading would lead to the faster disclosure of information to the public — Which he viewed as a positive outcome.

Others argue that oversight can help prevent large scale deception and fraud that hurts the fairness of the marketplace. Insiders can protect themselves from accusations of illegal insider trading by putting together a stock sale plan and filing it with the SEC.

For example, if a chief executive officer (CEO) is nearing retirement, he or she might plan to cash in their stock options over several years on a set schedule. To protect themselves, they can disclose that plan to the public. Then, if a sale happens to coincide with a major market event, the plan can help defend against accusations of insider trading.