April 12, 2024

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Insider Trading: Impact and Legal Boundaries

8 min read

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  • 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.  
  • The SEC has put laws and safeguards in place to protect investors and ensure a more fair market.

Fair trading opportunities are necessary for people to feel like they can trust the price of securities and confidently participate in the stock market. This is why there are laws and regulations to eliminate market trades that aren’t conducted on a level playing field. 

Insider trading violates trust and fiduciary duty, leading to serious legal implications. The victims are often everyday investors — and the economy as a whole.

Insider trading has been a hot-button issue for many years. Although it’s common for people to discuss the stock market and make predictions, where you get that information matters. 

Here are the legal consequences of insider trading and how it is regulated by the SEC.

Check out Business Insider’s best stock trading apps>>

What is insider trading?

Insider trading is when you buy and sell securities based on material information that is inaccessible to the general public. Material non-public information (MNPI), is financial information about a publicly traded company or security that can influence an investor’s willingness to buy or sell certain assets, like stocks and ETFs.

Insider trading creates a culture of corruption that hurts the market’s liquidity and efficiency.

“The worry is that if this happens often, people won’t be as willing to buy stocks, and they’d be less trusting of the market in general,” says Robert C. Hockett, a lawyer and law professor at Cornell University. “Less investment money flowing into companies can mean fewer productive activities, wealth generation, and even employment opportunities.”

Ensure you understand when the information being exchanged is okay to inform your investing decisions. 

Let’s say an insider works at a company and owns some shares of its stock. This person receives private information about the company facing a major lawsuit. As a result, they opt to sell their shares before the news is made public. 

The person who buys the shares from this insider has no idea about the lawsuit and that the company’s value will soon decrease. The following week, the news breaks, and the stock value decreases. This is a prime example of illegal insider trading and how it can negatively impact everyday investors.

But then there are situations where insider trading may be legal. Legal insider trading is common since insiders can buy and sell shares of their own company as long as they follow specific timing guidelines and accurately report the trades to the Securities Exchange Commission (SEC).

Example of insider trading 

In 2014, a California attorney heard from his pharmaceutical client, Spectrum, that the company was about to experience a significant decline in revenue. One of the company’s best-selling drugs was underperforming. But this was confidential information that was not yet public. 

The attorney decided to sell all his shares of Spectrum within 48 hours. The lawyer tipped off his wife, who also sold her shares of stock, and together, they avoided $45,000 of losses before the bad news was made public. In this situation, insider information quickly turned into illegal insider trading.

Hockett explains that while situations like this one clearly violate the Securities Exchange Act, there could be a gray area regarding what counts as inside information. 

“Legitimate expertise is okay to trade on because insider trading rules weren’t established to punish people who do their research and make smart trades,” says Hockett. “If you’re an expert on solar power and do your due diligence, which allows you to make some profitable trades, there is nothing wrong with this.”

Hockett adds that it’s always wise to do your own research when making investment decisions. However, the key point is that insiders have unfair access to some information and shouldn’t be able to trade freely this way without disclosing it.

The legal consequences of insider trading could lead to a maximum fine of $5 million to jail time of up to 20 years. Companies can be fined up to $25 million. 

“There are two main ways to enforce insider trading laws,” says Hockett. “Someone can decide to sue the insider and say they defrauded them and took advantage of them by selling them securities that they knew would lose value shortly after.”

Hockett says that victims of insider trading can report insiders to the Securities and Exchange Commission; from there, the SEC could decide to pick up the case and begin the insider trading investigation process.

“The SEC has more resources than the average person, so it could be easier for them to pursue violators and gather evidence,” Hockett adds.

In civil suits, violators of insider trading laws could be ordered to give back the money they received from the sale and repossess stock ownership. The SEC could then add fines on top of this punishment. For example, the California attorney and his wife, who were both implicated in doing illegal insider trading back in 2014 agreed to pay a fine at the steep price of $90,000.

High-profile insider trading cases

Here are high profile examples of illegal insider trading. 

Ivan Boesky and Michael Milken

In the 1980s, American stock trader Ivan Boesky, who owned Ivan F. Boesky & Company, was found receiving insider tips from multiple corporate insiders, including Michael Milken (aka the junk bond king) and the investment firm Drexel Burnham Lambert. The SEC began investing Boesky in 1987 after a group of his corporate parents filed a lawsuit alleging that the legal agreements detailing their partnerships were purposefully misleading.

Boesky entered a guilty plea and was convicted of insider trading. He was sentenced to 3.5 years of jail time with a $100 million fine. He was also permanently banned from working with securities. As part of the guilty plea, Boesky became an informant for the SEC and provided information on a case against Milken. 

Martha Stewart

In 2001, Martha Stewart sold around 4,000 shares of ImClone stock just a few days before the FDA announced that it would not approve ImClone’s new cancer drug, Erbitux. The stock dropped 16% in one day. Stewart made about $250,000 on the sale. 

Although she claimed that the sale was a pre-existing order with her broker, the SEC charged Stewart with obstruction of justice and securities fraud. It is believed that Steward received an insider tip from Peter Bacanovic, a broker at Merrill Lynch. Stewart was convicted of insider trading in 2004 and was sentenced to a minimum of five years in prison with a $30,000 fine. 

R. Foster Winans

Wall Street Journal columnist J. Foster Winans wrote a business-oriented newspaper column called “Heard on the Street” from 1982 to 1984 where he analyzed specific stocks and offered his opinion. Winan’s had arranged a deal with a group of stockbrokers who would purchase the stock Winans was going to feature in his column. In return, the brokers gave Winan a portion of their earnings. 

Eventually, Winans was caught by the SEC and convicted of insider trading and mail fraud. Winans pleaded not guilty, claiming his actions were unethical but not illegal. In 1988, he was found guilty of 59 separate counts of securities fraud and served nine months in Federal prison.

Regulatory measures to combat insider trading

The SEC is the primary regulator and central authority in the US for ensuring fair and transparent market trading. It is responsible for preventing insider trading in corporations and other stock traders.

Here are some of SEC regulations on insider trading: 

  • Rule 10b-5: Under the Exchange Act, rule 10b-5 is anti-fraud provision that makes it unlawful for anyone to directly or indirectly use misleading statements, manipulative devices, or omit essential information to buy or sell securities. 
  • Section 16(b) of the Securities Exchange Act of 1934: Section 16(b), otherwise known as the short-swing profit rule, prevents individuals from earning short-term gains on company stock using non-public material information within a six-month period. Any gains earns earned in this timeframe are considered disgorgement and have to be forfeited to the company. 
  • Insider Trading Sanctions Act of 1984: Federal legislation that allows the SEC to charge people found guilty of illegal insider trading up to three times the amount of profit or loss. The Insider Trading and Securities Fraud Enforcement Act of 1988 revised the original 1984 act.

Individual brokers and companies must uphold regulatory measures and insider trading policies to ensure employees are not in violation of illegal insider trading practices. Public companies must disclose holdings and transactions of company stock. 

Even if the individual with insider trading knowledge does not personally trade, sharing non-public material information to others is still illegal. This is referred to as “tipping”.

Insiders must also fill out Form 4 detailing what they bought, when, and for how much. The information on this form is made public through the Electronic Data Gathering, Analysis, and Retrieval system (EDGAR). In some cases, the insider may have to refrain from trading (often until the non-public information becomes public) and can trade during a specific trading window in the future.

Insider trading FAQs

Insider trading causes regular people to have a pessimistic view of the market due because of the unfair advantage insider trading have by using non-public material information. As a result, ordinary people are less likely to participate in the market, which decreases overall market liquidity and efficiency. 

Insider information is defined as material, non-public information about a company that could influence someone’s opinion to buy or sell certain securities. Insider information can include a company’s financials, earning reports, failing products, pending mergers, shift in company ownership, and much more. 

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. 

To avoid being implicated in insider trading, investors should avoid using non-public material information to influence stock trades for themselves or others. Make sure to comply with SEC regulatory rules and regulations to ensure ethical trading practices and guidance on how to handle sensitive information that may impact the market. 

Regulatory bodies, mainly the SEC, detect insider trading by analyzing trading patterns and investigating suspicious trading activity. Before making any major announcements or convictions, the SEC thoroughly investigates suspicious trading activity suspected that may indicate illegal insider trading took place. 

The penalties and legal consequences of insider trading are a maximum fine of $5 million and up to 20 years of jail time. The severity of these penalties depends on how substantial the loss or gains of profit in each case it, and the specific actions that took place during the event. 

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