What Is Insider Trading?
An insideris a person who possesses either access to valuable non-public information about a corporation or ownership of stock equalingmore than 10% of a firm's equity. This makes a company's directors and high-level executives insiders.
Top 3 Most Scandalous Insider Trading Debacles
Key Takeaways
- Aninsideris someone with either access to valuable non-public information about a corporation or ownership of stock equalingmore than 10% of a firm's equity.
- Insidersarelegally permitted to buy and sell shares, but the transactions must be registered with the SEC.
- Legal insider trading happens often, such as when a CEO buys back company shares, or when employees buy stock in the company where they work.
- Illegal use of non-publicmaterial information is generally used for profit.
- The SEC monitors illegal insider trading by looking attrading volumes, which increase when there is no news released by or about the company.
Understanding Insider Trading
Legal Insider Trading
Insidersarelegally permitted to buy and sell shares of the firm and any subsidiaries that employthem. However, these transactions must be properly registered with the Securities and Exchange Commission (SEC) and are done with advance filings. You can find details of this type of insider trading on the SEC's EDGAR database.
Legal insider trading happens often, such as when a CEO buys back shares of their company, or when other employees purchase stock in the company in which they work. Often, a CEO purchasing shares can influence the price movement of the stock they own.
A good example is whenever Warren Buffett purchases or sells shares in the companies under the Berkshire Hathaway umbrella.
Illegal Insider Trading
The more infamous form of insider trading is the illegal use of non-publicmaterial information for profit. It's important to remember this can be done by anyone including company executives, their friends, and relatives, or just a regular person on the street, as long as the information is not publicly known.
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.
The SEC is able to monitor illegal insider trading by looking at the trading volumes of any particular stock. Volumes commonly increase after material news is issued to the public, but when no such information is provided and volumes rise dramatically, this can act as a warning flag. The SEC then investigates to determine precisely who is responsible for the unusual trading and whether or not it was illegal.
A common misconception is that all insider trading is illegal, but there are actually two methods by which insider trading can occur—one is legal, and the other is not.
Insider Trading vs. Insider Information
Insider informationis knowledge of material related to a publicly-traded company that provides an unfair advantage to the trader or investor. For example, say the vice president of a technology company's engineering department overhears a meeting between the CEO and the CFO.
Two weeks before the company releases its earnings, the CFO discloses to the CEO that the company did not meet its sales expectations and lost money over the past quarter. The vice president of the engineering department knows their friend owns shares of the company and warns the friend to sell their shares right away and look to open ashort position. This is an example of insider information because earnings have not been released to the public.
Suppose the vice president's friend then sells their shares and shorts 1,000 shares of the stock before the earnings are released. Now itis illegal insider trading.However, if they trade the security after the earnings are released, it is not considered illegal because they do not have a direct advantage over other traders or investors.
FAQs
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 insider trading and why is it illegal? ›
Insider trading is the trading of a company's securities by individuals with access to confidential or material non-public information about the company. Taking advantage of this privileged access is considered a breach of the individual's fiduciary duty.
What is insider trading in simple words? ›
Definition: Insider trading is defined as a malpractice wherein trade of a company's securities is undertaken by people who by virtue of their work have access to the otherwise non public information which can be crucial for making investment decisions.
Why insider trading is both unethical and illegal? ›
Obviously, the reason insider trading is illegal is because it gives the insider an unfair advantage in the market, puts the interests of the insider above those to whom he or she owes a fiduciary duty, and allows an insider to artificially influence the value of a company's stocks.
How often is insider trading caught? ›
These estimates also imply that there is at least four times more actual insider trading than there are prosecution cases. We estimate that the probability of detection/prosecution of insider trading in both M&A and earnings announcements is approximately 15%.
How do people get caught insider trading? ›
Regulators also work to prevent and detect insider trading through insiders with knowledge of trades on material nonpublic information. The SEC gets tips from whistleblowers who come forward with the knowledge that people are trading on such information.
Is insider trading always unethical? ›
According to Rawls' theory of justice, insider trading is largely unethical; however, there are no guarantees and no absolutes in evaluating ethical decisions from a justice theory perspective.
What is a real example of insider trading? ›
Ivan Boesky is an American stock trader who became infamous for his role in an insider trading scandal during the 1980s. This scandal also involved several other corporate officers, employed by major U.S. investment banks, who were providing Boesky with tips about upcoming corporate takeovers.
What is a famous example of insider trading? ›
Martha Stewart was accused of insider trading after she sold four thousand ImClone shares one day before that firm's stock price plummeted. Although the charges of securities fraud were thrown out, Ms. Stewart was found guilty of four counts of obstruction of justice and lying to investigators.
What is the best example of insider trading? ›
Hypothetical Examples of Insider Trading
A government employee acts upon his knowledge about a new regulation to be passed which will benefit a sugar-exporting firm and buys its shares before the regulation becomes public knowledge.
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.
Who is guilty of insider trading? ›
A person is liable of insider trading when they have acted on such privileged knowledge in the attempt to make a profit. Sometimes it is easy to identify who insiders are: CEOs, executives and directors are of course directly exposed to material information before it's made public.
What is the difference between legal and illegal insider trading? ›
Legal insider trading is when insiders trade the company's securities (stock, bonds, etc.) and report the trades to the authorities such as Securities Exchange Commission (SEC). Illegal insider trading is a form of trading securities using price-sensitive information which is not available to public.
Can you go to jail for insider trading? ›
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.
What is a red flag for insider trading? ›
For example, a red flag for insider trading is an insider's abnormal trading pattern, going from inactivity to trading, or from buying and selling to abruptly aggressively buying or selling a significant position in the stock.
What is the highest fine for insider trading? ›
Along with a hefty $1.8 billion fine, several individual traders found themselves headed to jail. To date, this is the largest fine for insider trading in U.S. history. Of that amount, half was set aside for criminal fines and the other half for civil fines related to money laundering and forfeiture actions.
What is an example of legal insider trading? ›
Examples of insider trading that are legal include: A CEO of a corporation buys 1,000 shares of stock in the corporation. The trade is reported to the Securities and Exchange Commission. An employee of a corporation exercises his stock options and buys 500 shares of stock in the company that he works for.
What are the 2 types of insider trading? ›
There are two types of insider trading, legal and illegal.
In the illegal kind, one breaches the company's trust by trading based on the inside information while others remain ignorant. In legal cases, an insider buys or sells securities of their corporation based on the inside information.
Why is insider trading harmful? ›
Insider trading adversely affects market liquidity and makes transaction costs higher, reducing investor returns. And since a lot of people have a stake in financial markets – about half of U.S. families own stocks either directly or indirectly – this behavior hurts most Americans.
