What Is an Insider?
"Insider" is a term describing a director or senior officer of a publicly-traded company, as well as any person or entity, that beneficially owns more than 10% of a company's voting shares. For purposes of insider trading, the definition is expanded to include anyone who trades a company's shares based on material nonpublic knowledge. Insiders have to comply with strict disclosure requirements with regard to the sale or purchase of the shares of their company.
- An insider is a director, senior officer, entity, or individual that owns more than 10% of a publicly-traded company's voting shares.
- In the United States, the Securities and Exchange Commission (SEC) has enacted stringent rules to prevent insiders from engaging in insider trading.
- Insider trading is when anyone buys or sells shares of a company based on material information not readily available to the general public.
Understanding an Insider
Securities legislation in most jurisdictions has stringent rules in place to prevent insiders from taking advantage of their privileged position for pecuniary gain through insider trading. Offenses are punishable by disgorgement of profits and fines, as well as incarceration for severe offenses.
Some investors pay close attention to heightened levels of insider buying as it can be a signal that a stock is undervalued and the share price is poised to increase.
In the United States, the Securities and Exchange Commission (SEC) makes rules concerning insider trading. While the term often carries the connotation of illegal activity, corporate insiders can legally buy, sell, or trade stock in their company if they notify the SEC. Insider buying is legal as long as the buyer is using information that is readily available to the public.
Types of Insiders
There are distinct groups of people the SEC considers insiders. Investors gain insider information through their work as corporate directors, officers, or employees. If they share the information with a friend, family member, or business associate and the person who receives the tip exchanges stock in the company, they are also an insider.
Employees of other companies in a position to gain insider information, such as banks, law firms, or certain government institutions can also be guilty of illegal insider trading. Insider trading is a violation of the trust investors place in the securities market, and it undermines a sense of fairness in investing.
In one of the first cases of insider trading after the United States formed, William Duer, secretary to the Board of Treasury, used information he gained from his government position to guide his purchases of bonds. Duer's rampant speculation created a bubble, which culminated in the Panic of 1792.
Albert Wiggin was a respected head of Chase National Bank who used insider information and family-owned corporations to bet against his own bank. When the stock market crashed in 1929, Wiggin made $4 million. In the fallout from this incident, the Securities Act of 1933 was revised in 1934 with stricter regulations against insider trading.
Martha Stewart was convicted of insider trading when she ordered the sale of 3,928 shares of ImClone Systems Inc. just days before the Food and Drug Administration (FDA) rejected the corporation's new cancer drug. By selling when she did, Stewart avoided losses of $45,673. For her role, Stewart was fined $30,000 and sentenced to five months in prison.
What Are Examples of Insider Trading?
Insider trading occurs whenever an individual uses nonpublic information about a company to buy or sell that company's stock in order to earn a profit or avoid a loss. For example, if a CEO mentions to their friend that the company is about to lose a lot of money due to a product recall in the next month, and this friend mentions that information to their son, and the son sells his shares in the company, that would be insider trading.
What Is an Insider of a Company?
An insider of a company, as defined by the Securities and Exchange Commission (SEC), is an officer, director, or 10% shareholder of a company that has inside information into the company because of their relationship to the company or with an officer, director, or principal shareholder of the company.
Is Insider Trading a Financial Crime?
Yes, insider trading is a financial crime. Whenever information that is not public is used by an individual to profit or avoid a loss, that is insider trading and is punishable with both fines or jail time.