What Is Insider Trading?

Definition & Examples of Insider Trading

Businesswoman whispering secrets into a businessman's ear

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Insider trading is buying or selling stocks or other securities based on information that is not known to the public. It involves a direct breach of fiduciary duty or other violation of trust. The trader in these cases uses inside knowledge to profit. This act breaks key rules that are meant to keep the market fair for all parties.

There have been many high-profile cases that involve insider trading. But many investors are still unsure about what it is. You may not know how it works or why it's such a big deal. Let's break it down.

What Is Insider Trading?

Insider trading happens when someone makes a trade based on "material" information that's not available to the public. In market terms, material information is any detail that could affect a company's stock price. In a more broad sense, in legal terms, it is any fact that if known, would have an effect on the outcome of a choice, mainly to buy or sell.

Having these facts gives the investor an edge when it comes to buying or selling shares. Since few others have that same edge, it creates an unfair advantage.

In most cases, the trader must be a person with a fiduciary duty to another person, institution, corporation, partnership, firm, or entity. Many people acting in the market have such duties, such as brokers, or other agents that make trades on a client's behalf. If you have a fiduciary duty to someone else, you can get into trouble if you buy or sell shared based on info that no one else has access to.

A fiduciary duty exists when one person is supposed to act in another's best interest. Fiduciaries have duties of care, loyalty, good faith, confidentiality, prudence, and disclosure.

How Insider Trading Works

Insider information lets a person profit in some cases and avoid a loss in others. In either case, it's an abuse of that person's knowledge or power.

It's illegal because it gives an unfair advantage. Investors who are "in the know" have a chance to make more money. But others who don't have access to these secret tips don't have the same chance.

The list of those who have been tried and found guilty of insider trading includes corporate officers, employees, and government officials. Any person who tips off someone else with insider information can also be charged and found guilty.

Insider trading can also happen where no fiduciary duty is present. In these cases, the crime often comes to light because another crime has been committed.

One such type of crime might be corporate espionage. For example, an organized crime ring might use certain financial or legal institutions to gain access to private information. If they are found out, the people involved might be found guilty of insider trading. They may also be convicted of other charges for related crimes.

Not all insider trading is actually illegal. Many factors go into whether the Securities and Exchange Commission (SEC) will bring charges against a person for insider trading.

The main issues the SEC must prove are that:

  • The defendant had a fiduciary duty to the company; and
  • They planned to personally gain from buying or selling shares based on inside info.

What Are the Penalties for Insider Trading?

Insider trading penalties often involve fines and jail time. The outcome can include one or the other, but often both. The exact penalty depends on how severe the case is. There may be other outcomes to a case as well. These can be financial or professional, or again, often both. The SEC has moved to ban those who engage in trading violations from serving on the boards at publicly traded companies.

The History Behind Insider Trading

Insider trading didn't always have a bad rap. In the early 20th century it was not against the law, or even looked down upon. In fact, a Supreme Court ruling once called it a “perk” of being an executive.

After the stock market crash in 1929 and the Great Depression that followed, trading practices came under more scrutiny. A number of court cases and new laws chipped away at insider trading, even setting severe penalties were set for those who engaged in the practice.

It wasn't until 1934, with the creation the SEC and the passing of the Securities Exchange Act, that there was a legal body in charge of creating actual laws around the issue. The Act didn't fully forbid insider trading. Nor did it even really define it. But in a series of new rules, the SEC was able to criminalize certain actions, one by one. For instance, any fraud that occurred during the sale of a stock was against the law, so a rule was added to extend to purchases as well. The effect was a piecemeal set of rules that were tricky to navigate. As a result, there were limits of what the SEC could do to enforce the new rules.

That has since changed. In recent years, the SEC reports that it has filed insider trading complaints against hundreds of people financial professionals. These complaints have also been filed against lawyers, corporate insiders, and hedge fund managers.

Notable Events

There have been a number of high-profile insider trading cases. Many of them have happened over the past few decades.

SEC vs. Switzer

Barry Switzer was Oklahoma's football coach in 1981. He was prosecuted that year by the SEC after he and his friends purchased shares in Phoenix Resources, an oil company.

Switzer was at a track meet when he heard executives from Phoenix talking about their plans to liquidate the business. He bought the stock at around $42 per share and later sold it at $59 per share. He earned about $98,000 in the process.

The charges against him were later dismissed by a federal judge due to a lack of evidence. In a way, he got off easy. Switzer might have been fined and served jail time if one of his players was the son or daughter of the executives and if they mentioned the tip to him.

In this case, The Supreme Court found that the tipper had not breached their fiduciary duty for personal gain.

U.S. vs. O'Hagan

James O'Hagan was a lawyer with the firm of Dorsey & Whitney in 1988. The firm began representing Grand Metropolitan PLC. At the time, Grand Metropolitan planned to launch a tender offer for Pillsbury.

At that point, and with this knowledge, O'Hagan bought a large number of options in the company. He knew that the options would soar in value after the tender offer was made public.

O'Hagan later sold his options at a prime moment. He made $4.3 million.

He chose to acquire the options based on facts that weren't available to the public. He also did so without informing his firm. He was found guilty on 57 charges. His conviction, though, was overturned on appeal.

The O'Hagan case found its way to the Supreme Court. There, the verdict was reinstated in a 6-3 ruling. The Court found that O'Hagan was guilty of "employing a deceptive device...in connection with the purchase of a security."

Recent Cases

Insider trading made major headlines in 2003. This was during the Martha Stewart ImClone scandal. The firm's stock price fell drastically in a single day, and Stewart came under suspicion when the public learned that she had sold thousands of ImClone shares just the day before. In court she was cleared of fraud charges, but she was found guilty of obstruction of justice and lying to investigators, and sent to federal prison.

Insider trading was front-page news again in 2011. Hedge fund manager Raj Rajaratnam was sentenced to a record 11 years in prison. He had traded stocks based on the receipt of confidential information.

Safeguards Against Insider Trading

Many rules have been created to control this issue, and even some that allow it—to a degree. Section 16 of the Securities and Exchange Act of 1934 requires that when an "insider" buys a corporation's stock and sells it within six months, all of the profits must go to the company. In this case, all officers, directors, and 10% owners count as insiders.

The theory is that much of the lure of this type of trading is removed when insiders can't gain from small moves.

Company insiders also must disclose any changes in the ownership of their positions. This includes all shares that are bought and sold.

Key Takeaways

  • Insider trading involves purchasing or selling stocks or shares based on private information through a breach of fiduciary duty or other types of trust.
  • The SEC can charge both those who receive information and those who gave it with insider trading.
  • If found guilty, penalties can include heavy fines and jail time.