What Is Insider Trading and When Is It Legal? (2024)

What Is Insider Trading?

Insider trading involves trading in a public company's stock or other securities by someone with non-public, material information about the company. Insider transactions are legal if the insider makes a trade and reports it to the Securities and Exchange Commission, but insider trading is illegal when the material information is still non-public.

Those who commit insider trading face harsh consequences, so it's important to know what it is and how to avoid it if you own company shares and have information that can affect other investors.

Key Takeaways

  • Insider trading is buying or selling a publicly traded company's stock by someone with non-public, material information about that company.
  • Non-public, material information is any information that could substantially impact an investor's decision to buy or sell a security that has not been made available to the public.
  • This form of insider trading is illegal and has stern penalties, including potential fines and jail time.
  • Insider transactions are legal as long as you conform to the rules set forth by the SEC.

What Is Insider Trading and When Is It Legal? (1)

Understanding Insider Trading

The U.S. Securities and Exchange Commission (SEC) defines illegal insider trading as:

The buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, non-public information about the security.

Material information is any information that could substantially impact an investor's decision to buy or sell the security. Non-public information is information that is not legally available to the public.

The question of legality stems from the SEC's attempt to maintain a fair marketplace. An individual with access to insider information would have an unfair edge over other investors, who do not have the same access and could potentially make larger, and thus unfair, profits than their fellow investors.

Legal vs. Illegal Insider Trading

The Securities Exchange Act of 1934 was the first step in requiring the disclosure of company stock transactions. Directors, executives, or anyone else who has information or who holds more than 10% of any class of a company's securities are considered insiders by the SEC.

Anyone who becomes an insider must file SEC Form 3, Initial Statement of Beneficial Ownership of Securities, within 10 days of assuming an insider role.

If an insider makes a transaction, they must file Form 4, Statement of Changes in Beneficial Ownership, within two business days of making the transaction. This form serves to notify the public that an insider acted on a security.

SEC Form 5, Annual Statement of Changes in Beneficial Ownership Of Securities, is required no later than 45 days after a company's fiscal year ends. The SEC requires its filing only if one or more transactions exempted from Form 4 were not reported during the year.

If you meet the definition of an insider and file the forms, trading your company shares is called an insider transaction. It is only considered illegal insider trading when you don't follow the rules.

Illegal insider trading includes an insider (by SEC definition) not submitting the required forms after making a transaction. It also includes passing along material non-public information before it is made publicly available. For example, suppose you work for XYZ Company and learn that it is about to post losses in its quarterly report, which can affect investors.

You tell a friend who owns shares in the company, and they sell their shares a few days before the report is published—and share prices drop right after it is. You and your friend may be guilty of insider trading even though neither of you is classified as an "insider" by definition. You acted on information that could affect other investors when they didn't have the information.

Examples of Insider Trading

Insider trading is nothing new—it has been going on for as long as stock markets have existed. However, there are some notable recent examples worth mentioning.

Martha Stewart

Directors of companies are not the only people who have the potential to be convicted of insider trading. For example, in 2003, Martha Stewart was charged by the SEC with obstruction of justice and securities fraud—including insider trading—for her part in the 2001 ImClone case.

Stewart sold close to 4,000 shares of biopharmaceutical company ImClone Systems based on information from Peter Bacanovic, a broker at Merrill Lynch. Bacanovic's tip came after ImClone Systems chief executive officer (CEO), Samuel Waksal, sold all his company shares. This came around the time ImClone was waiting on the Food and Drug Administration (FDA) for a decision on its cancer treatment, Erbitux.

Shortly after these sales, the FDA rejected ImClone's drug, causing shares to fall 16% in one day. The early sale by Stewart saved her a loss of $45,673. However, the sale was made based on a tip she received about Waksal selling his shares, which was not public information. After a 2004 trial, Stewart was charged with lesser crimes of obstruction of a proceeding, conspiracy, and making false statements to federal investigators. Stewart served five months in a federal corrections facility.

Amazon

In September 2017, former Amazon.com Inc. (AMZN) financial analyst Brett Kennedy was charged with insider trading. Authorities said Kennedy gave fellow University of Washington alumni Maziar Rezakhani information on Amazon's 2015 first-quarter earnings before the release. Rezakhani paid Kennedy $10,000 for the information. In a related case, the SEC said Rezakhani made $115,997 trading Amazon shares based on the tip from Kennedy.

Has Insider Trading a Negative Connotation?

The term "insider trading" generally has a negative connotation based on the perception that it is unfair to the average investor. Essentially, insider trading involves trading in a public company's stock by someone with non-public, material information about that stock. Insider trading is illegal, but if an insider trades their holdings and reports it properly, it is an insider transaction, which is legal.

When Is Insider Trading Illegal?

Insider trading is deemed illegal when the material information is still non-public and comes with harsh consequences, including potential fines and jail time. Material non-public information is defined as any information that could substantially impact that company's stock price.

When Is Insider Trading Legal?

Legal insider transactions happen in the stock market all the time.The question of legality stems from the SEC's attempt to maintain a fair marketplace. It is legal for company insiders to trade company stock as long as they report these trades to the SEC on time.

The Bottom Line

Insider trading is when non-published information from a company is used to make a trading decision by someone with an invested interest in that company. It is illegal to engage in insider trading, but it is legal to trade your company shares as long as you follow the guidelines set by the SEC.

What Is Insider Trading and When Is It Legal? (2024)

FAQs

What Is Insider Trading and When Is It Legal? ›

Essentially, insider trading involves trading in a public company's stock by someone with non-public, material information about that stock. Insider trading is illegal, but if an insider trades their holdings and reports it properly, it is an insider transaction, which is legal.

What is insider trading and when is it illegal? ›

Insider trading is the selling or purchase of stocks and other securities based on non-public, material insider information. People found guilty of Illegal insider trading can receive up to 20 years of jail time and a $5 million fine.

What is the common law definition of insider trading? ›

Insider trading is the trading of a company's securities by individuals with access to confidential or material non-public information about the company.

Why is insider trading unethical and illegal? ›

To recap: insider trading is bad or illegal, for the most part, as it creates an unfair advantage for a select group of insiders (and individuals they share insider information with) by artificially tipping the scales on company stock prices by suddenly unloading or buying up massive amounts of stock.

What is an example of insider trading? ›

Illegal Insider Trading

For example, suppose the CEO of a publicly traded firm inadvertently discloses their company's quarterly earnings while getting a haircut. If the hairdresser takes this information and trades on it, that is considered illegal insider trading, and the SEC may take action.

How do you prove insider trading? ›

Burden of Proof in Insider Trading Cases

Prosecutors must prove that the defendant actually received information, that the information was both “material” and “nonpublic,” and that the information directly influenced the defendant's trade.

Is it insider trading if you overhear? ›

The individual charged with insider trading must have been aware that the information was material and nonpublic. For example, if you overhear a conversation on a train but have no knowledge that it is insider information, you cannot be convicted if you act on this information.

What is the legal theory of insider trading? ›

The classical theory of insider trading is a form of insider trading where a corporate insider—i.e. an employee, director, or officer—commits securities fraud under Rule 10b-5 by trading in securities of their company on the basis of material non-public information.

What is the new law on insider trading? ›

—It shall be unlawful for any person, directly or indirectly, to purchase, sell, or enter into, or cause the purchase or sale of or entry into, any security, security-based swap, or security-based swap agreement, while aware of material, nonpublic information relating to such security, security-based swap, or security- ...

How do people get caught for insider trading? ›

The Securities and Exchange Commission plays a pivotal role in detecting and prosecuting insider trading. The agency monitors trading activities and investigates unusual spikes in trading volume or price changes that precede significant corporate events, such as mergers or earnings reports.

What is insider trading in simple words? ›

Insider trading is buying or selling a publicly traded company's stock by someone with non-public, material information about that company. Non-public, material information is any information that could substantially impact an investor's decision to buy or sell a security that has not been made available to the public.

How does the IRS catch insider trading? ›

Market surveillance activities: This is one of the most important ways of identifying insider trading. The SEC uses sophisticated tools to detect illegal insider trading, especially around the time of important events such as earnings reports and key corporate developments.

Who is hurt by insider trading? ›

It also victimizes everyday investors who don't have access to the same information as the insiders.

How long do you go to jail for insider trading? ›

Under Section 32(a) of the Securities Exchange Act of 1934, as amended by the Sarbanes-Oxley Act of 2002, individuals face up to 20 years in prison for criminal securities fraud and/or a fine of up to $5 million for each "willful" violation of the act and the regulations under it.

What are the three types of insider trading? ›

Classic Insider Trading: Buying or selling assets based on important non-public information. Tipper-Tippee Trading: An insider gives others access to confidential information so they can trade using it. Trading During Blackout Periods: Insider trading during times when particular people are barred from trading.

What are the four scandalous insider trading incidents? ›

Cases of insider trading often capture the attention of the media, particularly if the accused party is a public figure. Four cases that captured a significant amount of media coverage in the U.S. are the cases of Albert H. Wiggin, Ivan Boesky, R. Foster Winans, and Martha Stewart.

How do people who insider trade get caught? ›

The Securities and Exchange Commission plays a pivotal role in detecting and prosecuting insider trading. The agency monitors trading activities and investigates unusual spikes in trading volume or price changes that precede significant corporate events, such as mergers or earnings reports.

What type of crime is insider trading? ›

Insider trading charges (usual charged Federally as Securities Fraud under Title 18, United States Code, Section 1348) involve the intentional trade (sale or purchase) of any security based upon material, non-public information.

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