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 illegal? ›

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 Quizlet? ›

Insider trading. the buying or selling of company stock or securities for a profit based upon information that is not readily available to the public.

What is insider trading and why is it illegal reddit? ›

Insider trading laws prevent employees in a company from trading in that stock other than at specified times and with advance notice. This is to prevent employees with privileged information from manipulating the stock price, quickly buying low or selling high before informing the general public of good/bad news.

Why is insider trading unethical and illegal? ›

The main argument against insider trading is that it is unfair and discourages ordinary people from participating in markets, making it more difficult for companies to raise capital. Insider trading based on material nonpublic information is illegal.

What is insider trading legal examples? ›

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.

How do you prove insider trading? ›

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.

What is an example of insider trading simple? ›

Hypothetical Examples of Insider Trading

A publicly traded company executive learns that the upcoming earnings report will be substantially better than anticipated. The executive buys many shares before the report's release knowing that this information will probably cause the company's stock price to soar.

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.

What are the two 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.

What is insider trading for dummies? ›

Insider trading occurs when someone from within or outside the publicly-traded company obtains privileged unpublished material information and uses it to trade the company's stock.

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 the penalty for insider trading? ›

The SEC imposes a variety of fines and penalties for making illegal insider trades based on MNPI. The maximum criminal fine for individuals is $5,000,000. The maximum fine for a business entity whose securities are publicly traded is $25,000,000. The maximum prison sentence for an insider trading violation is 20 years.

Is insider trading ever legal? ›

Yes. Insider trading can be considered legal if corporate insiders (such as directors, executives, and employees) trade company stock without exploiting confidential material information. To do so, corporate insiders must file certain regulatory reports to the SEC and receive approval.

Why is insider trading so hard to stop? ›

Although the Securities and Exchange Commission (SEC) has rules to protect investments from the effects of insider trading, incidents of insider trading are often difficult to detect because the investigations involve a lot of conjecture.

What are the three prohibitions of insider trading? ›

If you have 'inside information' relating to the Company, it is illegal for you to: • apply for, acquire, or dispose of, securities in the Company; or • procure another person to apply for, acquire, or dispose of, securities in the Company; or • directly or indirectly, communicate the information, or cause the ...

What is insider trading a violation of? ›

SEC Rule 10b-5 prohibits corporate officers and directors or other insider employees from using confidential corporate information to reap a profit (or avoid a loss) by trading in the Company's stock.

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.

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