Insider trading is the practice of buying or selling shares of a company’s stock (or some other security) based on knowledge that was acquired by an insider as an officer of the company, and that is not available to the general public. Such use of this knowledge is illegal because it gives an unfair advantage to one set of investors.
Insider trading is illegal trading done by insiders on the basis of classified insider information. Insider trading prevention is regarded as a primary activity of securities regulatory authorities. This is particularly true of US financial markets.
The basic purpose of an ideal securities market is the proper allocation of capital resources in an economy. It is expected that securities markets will be characterised by the existence of ‘market efficiency’. Market efficiency implies a situation where the market price of a security truly reflects its future risk-return matrix. When company insiders indulge in insider trading in secondary markets, it leads to information flow and price forecasting.
Company insiders, due to their accurate information about the risk-return profile of company bonds and shares, can often truly gauge whether market prices are high or low. Insider trading is, however, distinct from market manipulation. While manipulators lead to a decline in market efficiency, insiders augment market efficiency. Market manipulation leads to a movement of market prices away from their fair values. Insider trading brings market prices closer to their fair values. However, insider trading is considered unfair by speculators, who are outside traders. Since they do not possess that relevant information, which is possessed by inside traders,. Hence, both fund managers and individual speculators stand to lose from insider trading.
Insider trading benefits the economy at large by increasing market efficiency, but it hurts the economic interests of a section of economic agents. Corporate officers, employees, and directors of companies indulge in insider trading. Other categories of inside traders are found among government employees and employees of printing firms, brokerage firms, law firms, and banking services. The United States has been the first country to effectively tackle insider trading. The Securities and Exchange Commission is the concerned US regulatory authority in this respect. Under the Insider Trading Sanctions Act, 1984, the Securities and Exchange Commission in the USA can impose civil as well as criminal proceedings for insider trading. Most nations have suitable legislation for the containment of insider trading.
To avoid charges of insider trading, insiders usually cannot trade their company’s stock on the basis of major news until the news has been made public. The traditional definition of public is appearance on the Dow Jones broad ticker.
As publicly traded companies prepare to report their quarterly earnings, a quiet period exists during which executives cannot discuss earnings until they are released to the public.
The Securities and Exchange Commission is in charge of making sure market participants are playing by the rules. Company “insiders” aren’t the only ones who can be charged with insider trading. A friend or relative who gets tipped off by the CEO about an impending bankruptcy filing and trades on this information could be guilty. Other people who come into contact with private information, whether or not they work for the company, are also prevented from trading based on that information, even if knowing it by itself is not illegal.
Insider trading is also a more general term that includes legal buying and selling by insiders. Insiders can’t be shut out of trading their own stock, and their trading is legal as long as they are on a level playing field with everyone else.
Many investors watch the trades insiders are making, which are filed on Form 4 with the SEC, as one measure of whether a company is headed up or down. Conventional wisdom holds that if insiders (who know the company best and presumably want to profit from it) buy, that’s a signal of strength. Conversely, if insiders are selling, that might be a signal of weakness.
However, buying and selling by insiders could have nothing to do with their company’s health. Maybe there are tax reasons; maybe the insider needs a large sum of money for something personal; maybe the CEO sells shares but retains options.
Peter Lynch once said: “Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.”
Insider trading is the trading of a corporation’s stock or other securities (e.g. bonds or stock options) by corporate insiders such as officers, key employees, directors, or holders of more than ten percent of the firm’s shares. Insider trading may be perfectly legal, but the term is frequently used to refer to a practice, illegal in many jurisdictions, in which an insider or a related party trades based on material non-public information obtained during the performance of the insider’s duties at the corporation or otherwise misappropriated.
All insider trades must be reported in the United States. Many investors follow the summaries of insider trades, published by the United States Securities and Exchange Commission (SEC), in the hope that mimicking these trades will be profitable. Legal “insider trading” may not be based on material, non-public information. Illegal insider trading in the US requires the participation (perhaps indirectly) of a corporate insider or other person who is violating his fiduciary duty, misappropriating private information, trading on it, or secretly relaying it.
Insider trading is believed to raise the cost of capital for securities issuers, thus decreasing overall economic growth.
Illegal Insider Trading
Rules against insider trading on material non-public information exist in most jurisdictions around the world, though the details and the efforts to enforce them vary considerably. The United States, the United Kingdom, and Canada are viewed as the countries that have the strictest laws and make the most serious efforts to enforce them.
Definition Of “insider”
According to the U.S. SEC, corporate insiders are a company’s officers, directors, and any beneficial owners of more than ten percent of a class of the company’s equity securities. These insiders are breaking their fiduciary duty to the shareholders when they make trades in the company’s own stock based on material non-public information, which is considered fraudulent. The corporate insider, simply by accepting employment, has made a contract with the shareholders to put the shareholders’ interests before their own in matters related to the corporation. When the insider buys or sells based upon company-owned information, he is violating his contract with the shareholders.
For example, illegal insider trading would occur if the chief executive officer of Company A learned (prior to a public announcement) that Company A would be taken over and bought shares in Company A, knowing that the share price would likely rise.
Liability For Insider Trading
Liability for insider trading violations cannot be avoided by passing on the information in an “I scratch your back, you scratch mine” or quid pro quo arrangement, as long as the person receiving the information knew or should have known that the information was company property.
For example, if Company A’s CEO did not trade on the undisclosed takeover news but instead passed the information on to his brother-in-law, who traded on it, illegal insider trading would still have occurred.
Misappropriation Theory
A newer view of insider trading, the “misappropriation theory,” is now part of US law. It states that anyone who misappropriates (steals) information from their employer and trades on that information in any stock (not just the employer’s stock) is guilty of insider trading.
For example, if a journalist who worked for Company B learned about the takeover of Company A while performing his work duties and bought stock in Company A, illegal insider trading might still have occurred. Even though the journalist did not violate a fiduciary duty to Company A’s shareholders, he might have violated a fiduciary duty to Company B’s shareholders (assuming the newspaper had a policy of not allowing reporters to trade on stories they were covering).
Proof Of Responsibility
Proving that someone has been responsible for a trade can be difficult because traders may try to hide behind nominees, offshore companies, and other proxies. Nevertheless, the U.S. Securities and Exchange Commission prosecutes over 50 cases each year, with many being settled administratively out of court. The SEC and several stock exchanges actively monitor trading, looking for suspicious activity.
Trading On Information In General
Not all trading on information is illegal inside trading, however. For example, while dining at a restaurant, you hear the CEO of Company A at the next table telling the CFO that the company will be taken over, and when you buy the stock, you wouldn’t be guilty of insider trading unless there was some closer connection between you, the company, or the company officers.
Tracking Insider Trades
Since insiders are required to report their trades, others often track these traders, and there is a school of investing which follows the lead of insiders. This is, of course, subject to the risk that an insider is making a buy specifically to increase investor confidence or for reasons unrelated to the health of the company (e.g., a desire to diversify or buy a house).
As of December 2005, companies are required to announce times to their employees as to when they can safely trade without being accused of trading on inside information.
American Insider Trading Law
The United States has been the leading country in prohibiting insider trading made on the basis of material, non-public information. Thomas Newkirk and Melissa Robertson of the SEC summarise the development of U.S. insider trading laws.
Common-Law
U.S. insider trading prohibitions are based on English and American common law prohibitions against fraud. In 1909, well before the Securities Exchange Act was passed, the United States Supreme Court ruled that a corporate director who bought that company’s stock when he knew it was about to jump up in price committed fraud by buying while not disclosing his inside information.
Section 17 of the Securities Act of 1933 contained prohibitions against fraud in the sale of securities, which were greatly strengthened by the Securities Exchange Act of 1934.
The Securities Exchange Act of 1934’s Section 16(b) forbids corporate directors, officers, or stockholders who own more than 10% of a company’s shares from making short-swing profits (from any purchases and sales within any six-month period). Under Section 10(b) of the 1934 Act, SEC Rule 10b-5 prohibits fraud related to securities trading.
The Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 provide for penalties for illegal insider trading to be as high as three times the profit gained or the loss avoided from the illegal trading.
SEC Regulations
S.E.C. regulation FD (“Full Disclosure”) requires that if a company intentionally discloses material non-public information to one person, it must simultaneously disclose that information to the public at large. In the case of an unintentional disclosure of material non-public information to one person, the company must make a public disclosure “promptly.
Under the Williams Act’s regulations on takeovers and tender offers, the SEC also regulates insider trading or similar practices.
Court Decisions
Much of the development of insider trading law has resulted from court decisions.
In SEC v. Texas Gulf Sulphur Co. (1966), a federal circuit court stated that anyone in possession of inside information must either disclose the information or refrain from trading.
In 1984, the Supreme Court of the United States ruled in the case of Dirks v. SEC that tippees (receivers of second-hand information) are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information and the tipper received any personal benefit from the disclosure. (Since Dirks disclosed the information in order to expose fraud rather than for personal gain, nobody was liable for insider trading violations in his case.)
The Dirks case also defined the concept of “constructive insiders,” who are lawyers, investment bankers, and others who receive confidential information from a corporation while providing services to the corporation. Constructive insiders are also liable for insider trading violations if the corporation expects the information to remain confidential, since they acquire the fiduciary duties of the true insider.
In United States v. Carpenter (1986), the U.S. Supreme Court cited an earlier ruling while unanimously upholding mail and wire fraud convictions for a defendant who received his information from a journalist rather than from the company itself. The journalist R. Foster Winans was also convicted.
It is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principle for any profits derived therefrom.
However, in upholding the securities fraud (insider trading) convictions, the justices were evenly split.
In 1997, the U.S. Supreme Court adopted the misappropriation theory of insider trading in United States v. O’Hagan, 521 U.S. 642, 655 (1997). O’Hagan was a partner in a law firm representing Grand Metropolitan while it was considering a tender offer for Pillsbury Co. O’Hagan used this inside information by buying call options on Pillsbury stock, resulting in profits of over $4 million. O’Hagan claimed that neither he nor his firm owed a fiduciary duty to Pillsbury so that he did not commit fraud by purchasing Pillsbury options.
The Court rejected O’Hagan’s arguments and upheld his conviction.
The “misappropriation theory” says that someone breaks 10(b) and Rule 10b-5 when they use confidential information for trading securities without giving credit to the source of the information. This is considered fraud “in connection with” a securities transaction. Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.
The Court specifically recognised that a corporation’s information is its property: “A company’s confidential information…qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty…constitutes fraud akin to embezzlement—the fraudulent appropriation to one’s own use of the money or goods entrusted to one’s care by another.
In 2000, the SEC enacted Rule 10b5-1, which defined trading “on the basis of” inside information as any time a person trades while aware of material non-public information—so that it is no defence for one to say that she would have made the trade anyway. This rule also created an affirmative defence for pre-planned trades.
Security Analysis And Insider Trading
Security analysts gather and compile information, talk to corporate officers and other insiders, and issue recommendations to traders. Thus, their activities may easily cross legal lines if they are not especially careful. The CFA Institute, in its code of ethics, states that analysts should make every effort to make all reports available to all the broker’s clients on a timely basis. Analysts should never report material nonpublic information except in an effort to make that information available to the general public. Nevertheless, analysts’ reports may contain a variety of information that is “pieced together” without violating insider trading laws, under the mosaic theory. This information may include non-material nonpublic information as well as material public information, which may increase in value when properly compiled and documented.
In May 2007, a bill entitled the “Stop Trading on Congressional Knowledge Act, or STOCK Act,” was introduced that would hold congressional and federal employees liable for stock trades they made using information they gained through their jobs and also regulate analysts or “Political Intelligence” firms that research government activities. The bill has not passed.
Arguments For Legalising Insider Trading
Some economists and legal scholars (e.g. Henry Manne, Milton Friedman, Thomas Sowell, Daniel Fischel, and Frank H. Easterbrook) argue that laws making insider trading illegal should be revoked. They claim that insider trading based on material, nonpublic information benefits investors in general by more quickly introducing new information into the market.
Milton Friedman, laureate of the Nobel Memorial Prize in Economics, said: “You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that.” Friedman did not believe that the trader should be required to make his trade known to the public because the buying or selling pressure itself is information for the market.
Other critics argue that insider trading is a victimless act: A willing buyer and a willing seller agree to trade property which the seller rightfully owns, with no prior contract (according to this view) having been made between the parties to refrain from trading if there is asymmetric information.
Legalisation advocates also question why activity that is similar to insider trading is legal in other markets, such as real estate, but not in the stock market. For example, if a geologist knows there is a high likelihood of the discovery of petroleum under Farmer Smith’s land, he may be entitled to make Smith an offer for the land and buy it without first telling Farmer Smith of the geological data. Nevertheless, circumstances can occur when the geologist would be committing fraud if he did not disclose the information, e.g. when he had been hired by Farmer Smith to assess the geology of the farm.
Advocates of legalisation make free speech arguments. Punishment for communicating about a development pertinent to the next day’s stock price might seem to be an act of censorship. If the information being conveyed is proprietary information and the corporate insider has contracted to expose it, he has no more right to communicate it than he would to tell others about the company’s confidential new product designs, formulas, or bank account passwords.
There are very limited laws against “insider trading” in the commodities markets if, for no other reason, the concept of an “insider” is not immediately analogous to commodities themselves (e.g., corn, wheat, steel, etc.). However, analogous activities such as front-running are illegal under U.S. commodity and futures trading laws. For example, a commodity broker can be charged with fraud if he or she receives a large purchase order from a client (one likely to affect the price of that commodity) and then purchases that commodity before executing the client’s order in order to benefit from the anticipated price increase.
Legal Differences Among Jurisdictions
The US and the UK vary in the way the law is interpreted and applied with regard to insider trading.
In the UK, the relevant laws are the Financial Services Act 1986 and the Financial Services and Markets Act 2000, which defines an offence of Market Abuse. It is not illegal to fail to trade based on inside information (whereas without the inside information, the trade would have taken place), since from a practical point of view, this is too difficult to enforce. It is often legal to deal ahead of a takeover bid, where a party deliberately buys shares in a company in the knowledge that it will be launching a takeover bid.
Japan enacted its first law against insider trading in 1988. Roderick Seeman says: “Even today, many Japanese do not understand why this is illegal. Indeed, previously, it was regarded as common sense to make a profit from your knowledge.”
In accordance with EU directives, Malta enacted the Financial Markets Abuse Act in 2002, which effectively replaced the Insider Dealing and Market Abuse Act of 1994.
The “Objectives and Principles of Securities Regulation,” published by the International Organisation of Securities Commissions (IOSCO) in 1998 and updated in 2003, states that the three objectives of good securities market regulation are (1) investor protection, (2) ensuring that markets are fair, efficient, and transparent, and (3) reducing systemic risk. The discussion of these “Core Principles” states that “investor protection” in this context means “investors should be protected from misleading, manipulative, or fraudulent practices, including insider trading, front-running or trading ahead of customers, and the misuse of client assets.” More than 85 percent of the world’s securities and commodities market regulators are members of IOSCO and have signed on to these Core Principles.
The World Bank and International Monetary Fund now use the IOSCO Core Principles in reviewing the financial health of different countries’s regulatory systems as part of these organisations’s financial sector assessment programmes, so laws against insider trading based on non-public information are now expected by the international community. The enforcement of insider trading laws varies widely from country to country, but the vast majority of jurisdictions now outlaw the practice, at least in principle.
Insider trading refers to the buying or selling of a publicly traded company’s stock by someone who has access to material, non-public information about the company.
In most jurisdictions, insider trading is illegal because it undermines the integrity of the financial markets and gives unfair advantages to individuals with privileged information.
An insider is typically someone who has access to confidential information about a company that has not been disclosed to the public. This can include company executives, directors, employees, and other individuals with access to sensitive information.
Material information is information that could significantly impact a company’s stock price if disclosed to the public. Non-public information refers to information that has not been made available to the general public.
Penalties for insider trading can vary depending on the jurisdiction and the severity of the offense but may include fines, imprisonment, disgorgement of profits, and civil penalties. Individuals found guilty of insider trading may also face civil lawsuits and regulatory sanctions.
Insiders can legally buy or sell stock in their own company, but they must comply with strict regulations and disclose their transactions to the appropriate regulatory authorities. Failure to do so can constitute insider trading.
Legal insider trading involves buying or selling stock in a company while complying with all relevant securities laws and regulations. Illegal insider trading occurs when individuals trade on material, non-public information in violation of securities laws.
Insider trading can be detected and investigated through various means, including market surveillance, analysis of trading patterns, whistle-blower tips, and cooperation with regulatory agencies such as the Securities and Exchange Commission (SEC) or Financial Conduct Authority (FCA).
Insider trading can occur in other financial markets, such as options, bonds, and commodities, whenever individuals trade on material, non-public information to gain an unfair advantage over other market participants.
This site contains general legal information but does not constitute professional legal advice for your particular situation. Persuing this glossary does not create an attorney-client or legal adviser relationship. If you have specific questions, please consult a qualified attorney licensed in your jurisdiction.
This glossary post was last updated: 9th April 2024.
To help you cite our definitions in your bibliography, here is the proper citation layout for the three major formatting styles, with all of the relevant information filled in.
- Page URL:https://dlssolicitors.com/define/insider-trading/
- Modern Language Association (MLA):Insider Trading. dlssolicitors.com. DLS Solicitors. May 18 2024 https://dlssolicitors.com/define/insider-trading/.
- Chicago Manual of Style (CMS):Insider Trading. dlssolicitors.com. DLS Solicitors. https://dlssolicitors.com/define/insider-trading/ (accessed: May 18 2024).
- American Psychological Association (APA):Insider Trading. dlssolicitors.com. Retrieved May 18 2024, from dlssolicitors.com website: https://dlssolicitors.com/define/insider-trading/
Our team of professionals are based in Alderley Edge, Cheshire. We offer clear, specialist legal advice in all matters relating to Family Law, Wills, Trusts, Probate, Lasting Power of Attorney and Court of Protection.
All author posts