Companies and regulators try to prevent insider trading to ensure the integrity of the markets and maintain reputations. However, not all insider trading is illegal. A company's directors, employees and management can purchase or sell the company's stock with special knowledge as long as they disclose those transactions to the Securities and Exchange Commission (SEC); those trades are then disclosed to the public.

Insider trading becomes illegal when a company's employees or representatives give out material nonpublic information to their friends, family or fund managers, for example. Another way that insider trading can occur is if non-company employees, such as those from government regulators or accounting firms, law firms or brokerages gain material nonpublic information from their clients and use that information for their gain.

How Regulators Prevent Insider Trading

The government tries to prevent and detect insider trading by monitoring the trading activity in the market. The SEC monitors trading activity, especially around important events such as earnings announcements, acquisitions and other events material to a company's value that may move their stock prices significantly. This surveillance can discover large, irregular trades around those material events and lead to investigations as to whether the trades were legitimate or the result of inside information being provided to those who instituted the trades.

Complaints from traders who lose substantial sums on large trades is another way that regulators prevent and commence investigations of insider trading. As inside traders often try to exploit their inside information to the maximum extent possible, they often turn to the option markets, where they can effectively leverage their trades and amplify their returns. If a trader has special knowledge that a company is being acquired, then that trader can buy a large number of call options on the stock; similarly, if a trader knows before any announcement that a company is going to report earnings well below Wall Street estimates, then that trader can take a large position in put options. Such trades before big events can signal to regulators that someone is trading on inside information; the big losses taken by investors without material nonpublic information on the other end of these trades also cause such investors to come forward and report the unusual returns.

Regulators also prevent and detect insider trading through insiders with knowledge of trades on material nonpublic information. The SEC gets tips from whistleblowers who come forward with knowledge that people are trading on such information. Whistleblowers can be employees of the company in question, or they can be employees of the company's suppliers, clients or service firms. Whistleblowers have incentives to come forward under law by receiving 10 to 30% of the fines collected from successful prosecutions of insider trading. The media or self-regulatory agencies, such as the Financial Industry Regulatory Authority (FINRA), can also be the initial sources for the SEC when it begins an insider trading investigation.

How Companies Prevent Insider Trading

Before it escalates to the government level, companies take several measures to prevent insider trading within their securities. Some companies have blackout periods when officers, directors and other designated people are barred from purchasing the company's securities, usually around earnings announcements. A company may also require officers, directors and others to clear their purchases or sales of the company's securities with its chief legal officer (CLO) to avoid any conflicts of interest or violations of securities laws.

In addition to these measures, companies usually implement an education program for their employees in which they learn how to avoid partaking in insider trading or sharing material nonpublic information. For example, employees may learn what is considered material and what is considered nonpublic, in addition to learning not to disclose information related to earnings, takeovers, security offerings or litigation to outsiders.

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