Insider Trading

Definition

Insider trading refers to the buying or selling of a publicly traded company’s stocks by someone who has non-public, material information about that company. The term often refers to illegal conduct, but it can also apply to legal trading by corporate insiders such as officers, key employees, directors, or shareholders. Insider trading is regulated by securities laws and is considered illegal when it breaches fiduciary duty or any other relationship of trust and confidence.

Phonetic

Pronunciation in phonetics: /ˈɪnˌsaɪdər ˈtreɪdɪŋ/

Key Takeaways

1. Illegal vs Legal Insider Trading: Insider trading generally refers to buying or selling securities based on material non-public information. When done properly and in accordance with SEC regulations, it’s legal and common. However, the term is usually associated with illegal conduct, where insiders use their access to confidential information for their own advantage or pass this information to others.
2. Insider Trading Regulations: The Securities Exchange Act of 1934 established the rules for insider trading. The act restricts any person who has non-public, material information about a company from buying or selling its stock or other securities. It also prohibits sharing such information to others who will then trade based on it.
3. Penalties for Insider Trading: Illegal insider trading is taken very seriously by the U.S. Securities and Exchange Commission and other financial regulators worldwide. Penalties can range from heavy fines to imprisonment. For example, in the U.S., individuals are subject to a penalty of up to $5 million and 20 years in jail, and corporations can be fined up to $25 million.

Importance

Insider trading is a crucial concept in the world of business and finance because it pertains to the legality and ethics of certain trading activities. Primarily, insider trading refers to buying or selling a publicly-traded company’s stock by individuals who have access to non-public, material information about the company. While the term is often associated with illegal conduct, both legal and illegal forms of insider trading exist. If conducted fairly, it can efficiently incorporate new information into the marketplace. However, illegal insider trading, where non-public information is used for personal profit, holds the potential to undermine investor confidence in the fairness and integrity of the securities markets because it puts the general public at an unfair informational disadvantage. Consequently, insider trading is monitored and regulated by financial authorities to maintain a level playing field for all investors.

Explanation

Insider trading in the world of finance and business refers primarily to the trading of a public company’s stock or other securities (bonds, stock options, etc.) by individuals with access to non-public, material information about the company. This practice exists with the fundamental intent of leveraging key undisclosed information to gain an unfair advantage in the marketplace, potentially securing profitable trades before the information becomes public knowledge.The purpose behind insider trading is not to contribute to the fairness or health of the market, but to potentially gain significant personal financial benefit. When actionable insider information becomes available to these individuals, they can make buying or selling decisions based on this knowledge before the rest of the market has a chance to react. However, it’s important to note that insider trading is heavily regulated and often illegal due to its harmful effects on market integrity, and these activities are closely monitored by regulatory bodies, like the Securities and Exchange Commission (SEC) in the United States.

Examples

1. Martha Stewart Case: The notable lifestyle mogul, Martha Stewart, was involved in an insider trading case in 2004. Stewart sold stocks of ImClone Systems based on a non-public, insider tip that the FDA was going to decline the company’s new drug. Stewart was convicted for lying about the reason for selling the stock, rather than insider trading itself, but it is one of the most famous insider trading cases.2. Raj Rajaratnam and the Galleon Group: Back in 2009, billionaire Raj Rajaratnam and his hedge fund, the Galleon Group, were charged by the SEC for an insider trading scheme that generated more than $25 million in illicit gain. They gathered confidential information about corporate earnings or takeover activity from a network of insiders at various public companies. Rajaratnam was convicted in 2011 and sentenced to 11 years in prison.3. Jeffrey Skilling and Enron: A well-known insider trading case is the financial scandal involving Enron Corporation in 2001. Key company executives, including CEO Jeffrey Skilling, sold off their company stocks based on their inside knowledge about the company’s impending bankruptcy, without informing shareholders of the company’s dire financial situation. The Enron scandal led to more stringent regulations related to insider trading and greater scrutiny of company financials.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Securities Exchange Commission (SEC)
• Material Nonpublic Information
• Trade Restrictions
• Shareholder Trust
• Corporate Governance

Sources for More Information

• Investopedia: Insider Trading
• U.S. Securities and Exchange Commission: Insider Trading
• Legal Information Institute: Insider Trading
• Corporate Finance Institute: Insider Trading