Insider Trading

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What is 'Insider Trading'

Insider trading is the buying or selling of a security by someone who has access to material nonpublic information about the security. Insider trading can be illegal or legal depending on when the insider makes the trade. It is illegal when the material information is still nonpublic; trading while having special knowledge is unfair to other investors who don't have access to such knowledge.

BREAKING DOWN 'Insider Trading'

Illegal insider trading includes tipping others when you have any sort of nonpublic information. Legal insider trading happens when directors of the company purchase or sell shares, but they disclose their transactions legally. The Securities and Exchange Commission (SEC) has rules to protect investments from the effects of insider trading.

Martha Stewart and Insider Trading

Directors of companies are not the only ones who have the potential to be convicted of insider trading. Brokers and clients can be found guilty of insider trading. For example, Martha Stewart was found guilty of insider trading in 2003.

Stewart sold her shares of biopharmaceutical company ImClone Systems based on a tip from Peter Bacanovic, a broker at Merrill Lynch. Bacanovic's tip came after ImClone Systems' chief executive officer (CEO), Samuel Waksal, sold all his shares of the company. 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 done based on a tip she received about Waksal selling his shares, which was not public information. Stewart served five months in prison and also months of house arrest and probation. Waksal was convicted and sentenced to a seven-year prison term.

Legal Insider Trading

The term "insider trading" is generally negative. Legal insider trading happens in the stock market on a weekly basis. The SEC requires transactions to be submitted electronically in a timely manner. Transactions are submitted electronically to the SEC and also must be disclosed on the company’s website.

The Securities Exchange Act of 1934 was the first step to legal disclosing transactions of company stock. Directors and major owners of stock must disclose their stakes, transactions and ownership changed. Form 3 is used as an initial filing to show a stake in the company. Form 4 is used to disclose a transaction of company stock within two days of the purchase or sale. Form 5 is used earlier transactions or those that have been deferred.

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