Insider Trading: What It Is and Why It’s Illegal

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Updated on Wednesday, February 6, 2019

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Insider trading sounds like one of those things that’s always illegal, but in fact it’s often perfectly fine — and savvy investors can even benefit from it. Still, there are certain forms of insider trading that are strictly forbidden. Here’s a breakdown of what insider trading is and why it’s sometimes illegal.

Insider trading explained

Insider trading is the purchase or sale of securities by an insider of a publicly traded company. Insiders are those who have or are assumed to have material, nonpublic information about a company’s operations.

The term “insider” includes the following groups:

  • Corporate executives with privileged access to information
  • Directors
  • Investors owning 10% or more of the company’s stock
  • Any other person who receives material, nonpublic information from an insider

When an insider buys or sells stock, that transaction generally must be reported to the Securities and Exchange Commission on a Form 4 filing. The filing lists the transaction price, the number of shares traded and the insider’s total stake in the company.

Is insider trading illegal?

There are both legal and illegal forms of insider trading, and the distinction depends on whether the insider has traded on material information that has yet to be made public. That is, the information must be nonpublic, and it must be important, or material.

Someone commits illegal insider trading when:

  1. A trade has been made that …
  2. Uses material, nonpublic information with the …
  3. Understanding that the information is important and …
  4. The person breaks a fiduciary duty to the company by trading or tipping that information

But there’s at least one more important instance of illegal insider trading:

  • A tippee who trades on material, nonpublic information received from someone who has a fiduciary duty to the company — and the tippee knows (or should have known) that information belonged to the company

In this instance, the law assumes that a tippee who receives material, nonpublic information has the same duty as an insider to avoid trading on that information.

So when is insider trading legal?

Insiders can trade stock legally when information is not material or has already been made public, and this kind of insider trading happens all the time. Insiders then report the trade to the SEC, and investors can see when insiders have traded the stock and at what price.

There’s one other way insiders may trade while in possession of material, nonpublic information. The SEC allows an insider to set up a special plan (called a 10b5-1 plan) that lets them trade in the security. The plan specifies that the insider will trade (usually sell) a certain amount of stock at regular intervals over a specific time frame. However, the plan must be set up when the insider is not in possession of material, nonpublic information.

Legal insider trading can be a strong signal for investors about how the people who know the company best view its prospects. Strong insider buying, for example, is one of the best signals that a stock is likely to perform well in the near future. Investors also are on the lookout for a string of sales by company insiders, as they may hint at a decline for the stock.

Why is insider trading illegal?

Insider trading is illegal for a few reasons, but perhaps the biggest is that the officers and directors of a company have a fiduciary duty to the company. By trading against their company or giving tips to others who may trade, insiders hurt the ability of their company to raise money effectively.

Another main reason for making certain kinds of insider trading illegal is that it harms the integrity of the markets. Illegal insider trading allows insiders to profit at the expense of outsiders, discouraging outsiders from participating in the market. So it hurts the ability of the markets to raise capital from outside investors if outsiders think they’re always going to be taken advantage of by insiders.

Illegal insider trading also transfers wealth from outsiders to insiders, robbing outsiders of the full value of their stock. If insiders know of a nonpublic, positive development and can buy stock from less knowledgeable outsiders, then outsiders aren’t getting all the value they could from their stock.

Examples of illegal insider trading

Insider trading can occur in any number of scenarios. Here are a few examples:

  • A CEO buys stock in his company because he’s about to negotiate a takeover of his firm.
  • An executive tells a friend about an unannounced new product that the stock market will love, and the friend buys stock on the tip.
  • As part of their regular work auditing a company, an auditor finds material, undisclosed breaches in a company’s accounting and decides to short sell the stock in order to make money when it declines.
  • An employee of a company hears from the CFO that the company won’t meet Wall Street’s earnings estimates next quarter, and that puts the company’s stock in danger. The employee sells his own stock before the announcement.

One of the most famous criminal cases of insider trading involved Michael Milken, also known as the Junk Bond King. Milken used nonpublic knowledge of debt deals to tip associates, and while he was not convicted of insider trading, he pled guilty to other securities violations. In total, Milken paid $600 million in criminal fines and, in a related suit, another $500 million in civil penalties. He was sentenced to 10 years in prison and community service.

Another high-profile case involved style maven Martha Stewart, who sold nearly 4,000 shares of a stock after she heard from her broker that the company’s CEO was selling because of an imminent adverse ruling from the Food and Drug Administration. By selling, Stewart avoided losses of nearly $46,000. In the end, Stewart was not convicted for insider trading but for obstruction of justice and lying to investigators and received a five-month term in prison. She had to pay a $30,000 criminal fine as well as nearly $200,000 in civil penalties.

Penalties for insider trading

While high-profile cases often get the headlines, the SEC takes on many cases of insider trading each year, including ones that are much smaller. Nevertheless, the penalties can be quite stiff:

  • Up to $5 million in fines in a criminal trial as an individual
  • Up to $25 million in fines in a criminal trial as a business
  • Up to 20 years of imprisonment

Those are just the punishments for insider trading and not the related crimes that often occur as part of insider trading, such as other fraud-related offenses.

On top of these penalties, there is the possibility of further fines in civil trials. If the SEC prosecutes successfully, it can demand treble damages — three times what the defendant obtained from the activity. Treble damages were applied as part of the fine Stewart had to pay. Other penalties may include bans from the securities industry or bans on managing outside money.

States may be able to add further penalties, often allowing the affected company to recover damages from the defendant.

Bottom line

Illegal insider trading is something that law enforcement takes seriously and monitors closely. Policing the markets for this kind of activity helps keep the markets fair for outside investors who do not have privileged knowledge of a company’s operations. But it’s important to remember that some forms of insider trading are legal and that savvy investors often watch what insiders do in order to gain further insight into whether the company might be a good investment.