Investing > What is Insider Trading?

What is Insider Trading?

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Making money on the stock market is one of the most quintessential parts of the American dream. At the time of this writing, over 55% of Americans are invested in the stock market. Over half of the population has historically invested since the 1970s.

While active stock trading might not be the most popular pastime, virtually everyone has 401(k)s or similar investments. Despite how common trading is, many people eventually wind up hearing the term insider trading and don’t know what it means.

What exactly is insider trading, they wonder, and does it apply to their own investment plans? The truth is that insider trading is necessarily a bit of a gray area.

Even apparently clear-cut cases of this illegal activity can drag out in court for months or years because of all the complexities. Today, let’s dive into what insider trading is and how you can avoid being charged with it as you buy and sell on the stock market.

What Insider Trading Is and Isn’t

In a nutshell, insider trading occurs when you trade company stock based on information that the rest of the public doesn’t have. If you know more about the stock you are buying or selling than the public at large, you can theoretically make smarter trades and earn money via information known only to business “insiders”.

This practice is mostly illegal. Technically, however, some insider trading is allowed under certain circumstances.

Another way to look at insider trading is buying or selling securities when you have information that can impact your decision on whether to buy or sell said security. It doesn’t matter what kind of stock (i.e. stock, option, mutual, common, preferred) you trade with, either. Trading any kind of stock with insider information is still illegal.

Information about the stock but which doesn’t necessarily impact your decision to buy or sell is not considered a component of insider trading.

However, insider trading doesn’t necessarily occur when a trader themselves provides information to another trader. Information that comes from an outside source, like an employee of a company, can also be given to a trader for the purpose of insider trading.

What is an insider? An insider is anyone who can access and provide valuable nonpublic information about a company or the ownership of stock (i.e. officers, directors, employees) and anyone who owns 10% of the company. A stockbroker who makes the trade isn’t necessarily an insider, but can still benefit from insider information.

This allows insiders to buy or sell shares, although those trades have to be registered with the SEC for fairness purposes. This is why you see headlines about CEOs buying back company shares or employees buying stock in their own companies.

Why is Insider Trading Illegal?

Originally, insider trading wasn’t illegal; the Supreme Court ruled it as one of the benefits of being an executive of a publicly-traded company. It only became banned in the 1920s when it became clear that insider trading afforded too many advantages to those already in power and created an unfair marketplace.

This was followed by the Securities Exchange Act of 1934, though it did little to stop insider trading for the time being. It did include a section that determined that any insider who makes a profit from buying company stock and selling it within six months must give those profits to the company itself.

In theory, this would eliminate the temptation for insider trading and make it difficult or impossible for insiders to make gains over the long-term from small market moves. Only later, when regulatory bodies grew real teeth, did insider trading game the consequences and legal ramifications that it is known for today.

The reason insider trading is classified as a largely illegal activity is because the SEC, or US Securities and Exchange Commission, constantly tries to provide a fair marketplace for all stock traders. If a few companies shared information about their operations with one another, traders associated with those companies could make big profits at the expense of others on the market.

Illegal insider trading can be intentional or accidental. For instance, a company CEO accidentally disclosing sensitive information about their quarterly earnings to the employee of a fast food shop counts as insider trading… if the employee uses that information to make a profit.

What About Legal Insider Trading?

Legal insider trading can occur often. CEOs, employees, or board members of a company organization can buy and sell shares of their own firm and any employing subsidiaries. So long as they register the trades to the SEC, they should be in the clear.

The big difference between the two types of insider trading is thus: the legal form has the insider making use of publicly available information to buy or sell stocks. The illegal form uses information that is not available to the public. This information is called “insider information”.

The Penalties for Insider Trading

In most insider trading cases, penalties include jail time and a monetary penalty. The amount for both depends on how severe the case is and how much of a profit was allegedly made based on the insider information. The SEC can also ban violators from becoming executives at any publicly traded companies in the future, issue bands the stock market traders, and more.

Even if you aren’t convicted of insider trading, the profits you make from unwittingly using insider information can be stripped from you if it was determined to be earned “unfairly”.

What’s the Difference Between Insider Trading and Insider Information?

The technicalities of what counts as insider information are the subject of intense debates in courtrooms and high-profile insider trading cases. In general, the SEC defines insider information as any information that:

  • is not publicly traded, or available to the public at large
  • provides an unfair advantage to the investor or trader

This keeps the definition somewhat broad, but it’s useful when the SEC needs to prosecute someone practicing insider trading. For instance, anyone overhearing sensitive financial information from a company CFO – when they would not normally be privy to such information – would have received insider information. Were they to use this to make a profit on the stock market, they would be committing insider trading.

However, merely holding insider information is not a crime in and of itself. If someone were to discover sensitive financial information for a business on a slip of paper, or if they were to receive an email by accident from a company’s CFO, they aren’t committing a crime until they use that information proactively.

In theory, such a person could hold the insider information indefinitely until it was no longer of use. They’d have committed no crime.

Is Insider Trading a Conflict of Interest?

Insider trading can easily be considered a conflict of interest if the actions of the trader or insider directly go against the health of the company they allegedly serve. For instance, a CEO could theoretically purposefully change the direction of his company to better improve the stock market prices for his company’s securities. He could then sell the stocks he owned in that company, all while making cuts across other sectors of his company’s wellbeing, like employee benefits or product quality.

The above example constitutes a conflict of interest. The CEO demonstrably active in his own self-interest despite ostensibly being in business to better help his company succeed. His profits directly worked against the long-term image and quality of his company.

An even simpler example might involve a company insider providing insider information to a family member or friend. In this case, the insider is acting in a conflict of interest against the company they have a fiduciary duty to in order to make a profit for their family or friends. All in all, insider trading can and often is a conflict of interest for the insider. This sometimes includes the trader, if the two people are one and the same.

Examples of Insider Trading

There are plenty of small examples of insider trading further down this guide. But one particularly recent and high-profile case involves United States Senators Richard Burr and Kelly Loeffler, Republicans from North Carolina and Georgia, respectively. The pair of Senators allegedly sold off a large number of stocks at the beginning of the Coronavirus pandemic.

The Coronavirus has resulted in severe economic upheaval. It’s easy to imagine how early information about the pandemic’s effects could lead to predictions about how certain industries or companies would perform over the next few months.

Crucially, the selling of stocks occurred almost immediately after several confidential briefings that the Senators were privy to but the public (and thus the broader market) was not.

Sen. Loeffler raised a common political defense, citing that her stock portfolio decisions were made by several third-party advisors that have most or complete control over her investment decisions. This is a legal activity per SEC guidelines (it’s called a qualified blind trust), but most politicians or lawmakers don’t use this, leading many to suspect her defense. Loeffler is (at the time of this writing) attempting to pin it on her broker.

Meanwhile, Sen. Burr has raised the defense claiming that his stock trades were based only on news reports rather than the information he received based on his position as chairman of the Senate Intelligence Committee. Indeed, many others on the stock market were making trades by February based on publicly available news information. But many dispute this; the U.S. Court of Appeals has said that material information, “cannot lay idle in the human brain”.

At this time, the SEC via the Ethics in Government Act of 1978 requires that congressmen and senior staffers must report securities transactions no later than 45 days after execution. But it appears that this is not enough to prevent insider trading, particularly given that government officials are usually privy to material and nonpublic information frequently.

Ultimately, the above controversy is an excellent example of what is likely a clear-cut case of insider trading, and by U.S. politicians, no less!

Who Has Been Convicted of Insider Trading?

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There are so many pertinent examples of insider trading convictions that it’s hard to count.

For instance, The Wall Street Journal columnist R. Foster Winans was convicted of insider trading in 1985 when he gave information to two stockbrokers about specific securities he was going to write about on his upcoming column. Thus, the stockbrokers made money and provided some of the profits to Winans. He was sentenced to 18 months in prison.

The former CEO of the investment bank Keefe, Bruyette & Woods, James McDermott Jr., was convicted in 2000 of insider trading. He provided information about upcoming mergers between bank industry companies to Kathryn Gannon, his then-mistress and adult movie star. McDermott Jr. was sentenced to eight months in prison and fined $25,000.

A more well-known case involves Jeffrey Skilling, the former president of Enron. He was convicted on 19 counts including insider trading in 2006. He was sentenced to 24 years in prison and fined $45 million.

There are even more examples below as we tackle the best ways to avoid insider trading, as well as understand the limitations of the SEC.

How Can You Avoid Insider Trading?

Avoiding insider trading is something that takes both forethought and control of one’s greed. Additionally, there are several legal technicalities and loopholes you need to avoid in order to avoid being accused of insider trading, regardless of your intention.

You Can Be Guilty Even If You Don’t Trade Stocks Yourself

Firstly, you can be guilty of insider trading even if you don’t trade the stocks yourself. The guidelines concerning insider trading only demand that a profit needs to be paid – not that the profit needs to be made by you. Therefore, if you give insider information to a person with the power to buy or sell stock and make a profit based on that information, you’ve committed insider trading even though you don’t see it.

This caveat also means that giving the order to use insider information – for instance, if you ordered your online stock broker to make a sale based on that information – you still performed insider trading. It doesn’t just matter who pulls the trigger. It also matters who made the ethical breach occur in the first place.

One of the Biggest Red Flags is a Large and Profitable Trade Right Before Big News Drops

If you make money on the stock market, it’s almost always a good thing. But if you make a huge profit right before big news drops about a company or an organization in which you are invested, it’s an easy flag for the SEC to see. You can be sure they’ll come investigating.

For instance, the former Equifax technology executive Jun Ying was charged with securities fraud in March 2018. This occurred after he had allegedly used information about Equifax’s recent hack attack in 2017 to sell almost $1 billion in shares before the public at large knew of the breach. The SEC gathered lots of information to support their case, including his browser history.

Another example follows Raj Rajaratnam, who founded the hedge fund Galleon Group. Rajaratnam made several huge trades in 2017 right before Hilton Hotels was taken over by the Blackstone Group; the SEC later proved that he had insider information to tip himself off to this winning strategy.

Sometimes, Insider Trading Tips Can Be Given In Strange or Unusual Ways

You have to be very careful when trading with any information, as insider information can appear at your doorstep in unusual ways. For instance, a waiter or waitress at a restaurant might find a napkin with insider trading information written on it as part of a code passed between individuals planning on insider trading. The waiter or waitress could then take this information and become an insider trader themselves.

Another infamous SEC case from 2017 saw a licensed therapist charged with insider trading. In the case, the therapist claimed that he’d received nonpublic information about an upcoming merger via his patient’s admissions during a therapy session. This violated not only insider trading laws but also therapy laws, which usually prevent therapists from revealing information shared by their patients in confidentiality.

SEC Investigators Are More Skilled than Ever at Flagging Trades They Believe Are Suspect

In general, the SEC monitors illegal insider trading by looking at the trading volumes for certain stocks. In most cases and with a fair market, volumes for stocks increase when material news is provided to the public. As an example, a coffee company planning to open up 1000 stores in China will likely accompany a significant stock volume increase.

If a stock volume increase occurs but there is no material news accompanied by the change, the SEC may be suspicious. They then dive deeper to determine who’s responsible for the trading and to investigate whether it was illegal.

These days, it’s a lot easier for the SEC to spot transactions that are suspect for insider trading. Regulatory partners, like the Financial Industry Regulatory Authority, Inc. or FINRA, and various stock exchanges are big helps. Additionally, new software improvements have made it easier for the SEC to track smaller insider trading deals because of better data flow and comprehension.

No one is safe from the SEC; CEOs, board members, politicians, and even world government leaders can be investigated by this organization for insider trading. All the SEC needs to prove is that the person in question has or had access to insider information. 

They can also use relatively innocent information to link people together and prove cause or opportunity to conspire. SEC investigators have gone on record using the timestamps of subway cards in New York City or Facebook photos in order to prove that insider trading was not only possible but probable.

For instance, William Walters, a gambler who was friends with the former chairman of Dean Foods, made tons of money in 2017 based on information he obtained from the latter. The SEC was able to easily track down this case of insider trading based on his “sudden” run of luck.

Proving Securities Fraud is Very Difficult for Federal Prosecutors

This all being said, it is difficult for the SEC, and any federal prosecutors, to prove that you’ve committed securities fraud via insider information you overheard in a relatively innocent manner. For instance, it’s a lot easier for the SEC to prove you committed insider trading if you have an email chain demonstrating the scoop you received out of turn. It’s a lot harder for them to prove that you heard insider information while at the movies.

This is because prosecutors must not only prove beyond a reasonable doubt that the person they accuse is guilty but also that the accused knew the information they were acting on was obtained illegally. In theory, a person could technically commit insider trading without knowing that the information was “insider”. This could feasibly be because of ignorance of the market.

An example can be seen in a 2014 case when Anthony Chiasson and Todd Newman, hedge fund managers, were released from their insider trading convictions and freed from prison. Their appeal case found that the SEC did not prove beyond a reasonable doubt that the two had performed insider trading.

In the aforementioned case with William Walters, he also gave Phil Mickelson, a World Gold Hall of Fame recipient, information about the Dean Foods stock. Yet the SEC did not find Mickelson himself guilty of insider trading because they could not prove that he was aware of how Walters had received the insider information or why he was suggesting profitable trades. Thus, Mickelson got to avoid going to jail but did have to relinquish his profits in 2012 (nearly $1 million plus interest!).

When Proving an Insider Trading Charge, Prosecutors Have to Show that Something of Material Value Was Expected

The SEC faces an additional difficulty. They have to prove that the insider trading activity either led to material gain or was expected to.

As mentioned before, merely having insider information isn’t enough to qualify as a crime. This means that the SEC often needs to dive quite deeply into a case or a person’s activities in order to acquire the requisite evidence for a conviction. 

In the aforementioned Rajaratnam case, Raj’s brother, Rengan, was not convicted of insider trading even though he was a portfolio manager at the same company his brother worked at. There wasn’t enough physical evidence to convict. 

How is Insider Trading Proven?

The SEC has to consider tons of factors before they can prove that insider trading occurred. In brief, the SEC has to prove that the defendant:

  • had some kind of fiduciary duty to the company or organization (i.e. they had a business relationship)
  • they intended to gain from buying or selling shares based on the insider information

Additionally, the SEC only cares about insider information that is “material” – that is, information that is pertinent to the company’s operations and which has a realistic effect on the stock market. For instance, insider information about a CEO’s favorite sandwich does nothing for the stock market but information about his health certainly does.

The “materiality test” is broad by design. Anything that can reasonably be proven to matter to a trade can count if the case is convincing. 

For instance, James O’Hagan, a lawyer in 1988 for the firm Dorsey & Whitney, acquired a large number of stock options in Grand Metropolitan PLC: a company that the firm had recently begun representing. He used the knowledge that the company was going to make a tender offer to Pillsbury. He then sold those options for over $4 million of profit.

The SEC proved that he made those choices based on information that was not available to other investors or the public at large. In this case, both a relationship to the companies affected by the trade and a desire for personal profit were easy to prove.

But an alternative example shows how slippery the line between insider trading and honest lucky profit can be. In 1981, and Oklahoma football coach named Barry Switzer was prosecuted by the SEC after he purchased several shares in an oil company named Phoenix Resources. He also had some of his friends purchase shares based on information he heard at a track meet between business executives.

Switzer earned about $98,000, but the charges for insider trading were dismissed when there is no evidence that Switzer personally knew about how valuable the information was. Additionally, the SEC found that the executives who gave the tips unwittingly had not done so for personal gain.

Lying to the FBI is Just as Much a Criminal Offense as Insider Trading

You should be aware that lying to the FBI is a criminal offense just like insider trading is. It also makes you look more suspicious even if you don’t have anything to hide.

Lying to any law enforcement officer is a felony even if you aren’t under oath, which means you could go to jail. If you have insider information or what you suspect is insider information, it’s always best to disclose it immediately if the SEC or federal officers come investigating.

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You don’t want to end up like Martha Stewart, the former Chief Executive Officer and founder of her titular company Martha Stewart Living Omnimedia. In 2001, she was indicted on charges of security fraud and obstruction of justice. Stewart was not convicted for insider trading charges, but she was convicted based on her lying to the FBI.

Why Do People Practice Insider Trading?

Ultimately, it’s always about making more money.

Someone playing the stock market game fairly doesn’t have more information than they can reasonably acquire from news sources, understanding of economic trends, or outward understanding of certain markets or industries. A fisher or farmer, for instance, could use their knowledge of the El Niño weather phenomenon to determine their investment strategy for the next few years. This is all fair game, as it’s ostensibly something anyone can learn.

But insider trading provides an explicit advantage to those with the insider knowledge. If you know that one of the companies you hold stock in is about to make a big play that is practically guaranteed to raise their stock price… the smart idea is to buy more of that stock to sell it once the price is at a record high level. This potential advantage is what drives the greed at the heart of all insider trading.

More insidiously, insider trading is almost impossible for some key individuals to avoid unless they take the proper precautions. For instance, Bill Gates holds the keys to one of the biggest software and computer companies in the world.

Any decision he makes about Microsoft is likely to alter the stock market massively. But he can’t automatically turn off his brain when he makes stock market choices; he always knows what his decision will probably be due to the software industry as he buys or sells.

In this way, many business executives or politicians practice insider trading without directly meaning to… or at least without taking pains to stop themselves. Insider trading is almost assuredly more rampant and damaging than the SEC or any federal body can control or predict. As a result, the federal regulations and criminal charges are something of a band-aid solution.

Insider trading will likely never go away so long as the stock market is set up as it is. This being said, anyone looking to make their money and keep it will do their best to avoid insider trading. The stock market is certainly lucrative enough if you have the know-how and economic sense to make a profit in the first place.

Summary

Insider trading is a largely illegal activity that almost never pays off in the long term. Even if you were to get away with it, you’d likely have to pay out hundreds of thousands or millions of dollars in legal or federal fees, or even give away any of the money you made from insider information.
There’s a reason that insider trading is frowned upon: it’s not good business sense.

Beyond that, it’s definitely immoral!Even with COVID-19 still making waves in the economy, some people are looking to make more money than they could ever need through insider trading methods. Remember what we’ve discussed and you’ll be much less likely to accidentally be accused or convicted of insider trading as you try to ride out the market instability over the course of the future.

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on TheTokenist.io. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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