What is Insider Trading?
Insider trading involves trading in a public company's stock by someone who has non-public, material information about that stock for any reason. Insider trading can be either illegal or legal depending on when the insider makes the trade. It is illegal when the material information is still non-public, and this sort of insider trading comes with harsh consequences.
- Insider trading is the buying or selling of a publicly traded company's stock by someone who has non-public, material information about that stock
- Material nonpublic information is any information that could substantially impact an investor's decision to buy or sell the security that has not been made available to the public.
- This form of insider trading is illegal and comes with stern penalties including both potential fines and jail time.
- Insider trading can be legal as long as it conforms to the rules set forth by the SEC.
Understanding Insider Trading
The U.S. Securities and Exchange Commission (SEC) defines illegal insider trading as:
"the buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security."
Material information is any information that could substantially impact an investor's decision to buy or sell the security. Non-public information is information that is not legally available to the public.
The question of legality stems from the SEC's attempt to maintain a fair marketplace. An individual who has access to insider information would have an unfair edge over other investors, who do not have the same access, and could potentially make larger, 'unfair' profits than their fellow investors.
Illegal insider trading includes tipping others when you have any sort of material 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 has rules to protect investments from the effects of insider trading. It does not matter how the material nonpublic information was received or if the person is employed by the company. For example, suppose someone learns about nonpublic material information from a family member and shares it with a friend. If the friend uses this insider information to profit in the stock market, then all three of the people involved could be prosecuted.
The best way to stay out of legal trouble is to avoid sharing or using material nonpublic information, even if you overheard it accidentally.
Example: Martha Stewart and Insider Trading
Directors of companies are not the only people who have the potential to be convicted of insider trading. In 2003, Martha Stewart was charged by the SEC with obstruction of justice and securities fraud – including insider trading – for her part in the 2001 ImClone case.
Stewart sold close to 4000 shares of bio-pharmaceutical company ImClone Systems based on information received 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 made based on a tip she received about Waksal selling his shares, which was not public information. After a 2004 trial, Stewart was charged with lesser crimes of obstruction of a proceeding, conspiracy, and making false statements to federal investigators. Stewart served five months in a federal corrections facility.
Example: Amazon Insider Trading Case
In September 2017, former Amazon.com Inc. (AMZN) financial analyst Brett Kennedy was charged with insider trading. Authorities said Kennedy gave fellow University of Washington alumni Maziar Rezakhani information on Amazon's 2015 first quarter earnings before the release. Rezakhani paid Kennedy $10,000 for the information. In a related case, the SEC said Rezakhani made $115,997 trading Amazon shares based on the tip from Kennedy.
Legal Instances of Insider Trading
The term "insider trading" is generally has a negative connotation. 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 the legal disclosure of transactions of company stock. Directors and major owners of stock must disclose their stakes, transactions and change of ownership.
- 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 to declare earlier transactions or those that have been deferred.