Understanding the Issue and Implications of Insider Trading

What is it? What are the penalties?

Businessman in suit behind bars in jail
GettyImages/Darrin Klimek

Insider Trading is a topic that has historically generated a great deal of news. When arrests are made for violating these rules, the world hears about it. In case you cannot recall any of the names of the executives and business professionals, remember that Martha Stewart was perhaps the best known celebrity to spend time behind bars for this particular crime.

The purpose of this article is to offer an overview of the concept of insider trading and explain some of the rules governing anyone who is deemed to have insider information.

Of course, this article is not intended to substitute for legal advice. Should you have questions about your status and the implications of potential actions, contact an attorney who specializes in this area of law. 

Insider Trading Defined:

Insider Trading is the trading in a security (buying or selling a stock) based on material information that is not available to the general public. It is prohibited by the US Securities and Exchange Commission (SEC) because it is unfair and would destroy the securities markets by destroying investor confidence.

What Makes Someone An Insider?

A company insider is someone who has access to important information about a company that might influence investor decisions in impact the firm's stock price or valuation. The important information is often described as material information. 

Company executives and general managers obviously have material information.

The Vice President of Sales, for example, knows how much the company has sold and whether it will meet the revenue estimates it has provided to investors. Others within the company also have material information. The accountant who prepares the sales forecast spreadsheet and the administrative assistant who types up the press release also are insiders because they have advance insight into income results.

Public companies typically control or restrict the number of people who have access to material information. They want to limit the number of insiders and improve their ability to monitor any questionable activity. They want to limit the likelihood that anyone will "leak" the information and they want to track the actual trades made by those designated as insiders. 

The company's senior management are insiders. So are some of the financial analysts. The top sales people usually also are insiders, although a regional sales manager who only sees his or her own region's results may not be one. The individuals in Investor Relations and/or Public Relations who prepare the public announcements also are insiders.

If the company is developing a new product that could be a big seller, the key people in the Research & Development team would also be considered insiders, provided the information they have is material, as defined above.

Publicly traded organizations have clear procedures for notifying those individuals deemed insiders and explaining the rules, limitations and potential penalties to them. 

Other individuals who are not employees, but with whom the company needs to share material information, are also insiders.

This list could include brokers, bankers, lawyers, etc.

You Can Be a Temporary Insider:

So does that mean you are not an insider unless you are on the company's management team, financial or development teams, or someone hired to handle the material information? In a word, "No".

The SEC includes in its definition of insiders those who have "temporary" or "constructive" access to the material information. If the president of a company tells you that the company's best hope for a breakthrough product isn't going to get regulatory approval, you are now every bit as much an insider as he is, given that information. It is illegal for him to trade based on that knowledge before it becomes public knowledge. It is equally illegal for you to do so because you are now a "temporary insider". This remains true regardless of how many times the information is passed.

If the president tells his barber, who tells his baby sitter, who tells her doctor, who tells you, the barber, baby sitter, doctor and you are all "temporary insiders".

Anyone who has material information is prohibited from trading, based on that knowledge, until the information is available to the general public. The US Supreme Court ruled that this even applies to someone with no ties to the company. Possession of material information makes you an insider, even if you stole the information.

Beware the Significant Penalties for Violating Insider Trading Rules:

Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 give the SEC the authority to seek a court order requiring violators to give back their trading profits. The SEC can also ask the court to impose a penalty of up to three times the profit the violators realized from their insider trading.

In addition to the financial penalties, there are criminal penalties. Many now feel those penalties are not strong enough and are working to increase them substantially. 

The Bottom Line:

Police your insiders yourself. Don't allow insider trading. Don't engage in it yourself. It is in your company's best interest to prevent insider trading so you don't have the SEC investigating you. Even if the company and all its officers eventually are cleared by the SEC of any wrong doing, the investigation itself can have lasting detrimental effects on the company.

Don't share material information with anyone who is not an insider. Make sure all insiders understand the responsibility this places on them. Make sure everyone in the company understands the circumstances under which they might become "temporary insiders' and how they must treat that situation.

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Updated by Art Petty