What Is Insider Trading and Why Is It Illegal?

The desire to make money causes some people to ignore the rules

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Insider trading made major headlines in 2003 as a result of the Martha Stewart/ImClone scandal that ultimately sent the domestic diva to federal prison. It was front page news again in 2011 when hedge fund manager Raj Rajaratnam was sentenced to a record 11 years in prison for trading stocks based on the receipt of confidential information.

But many investors are still unsure about what insider trading is, how it works, and why it's such a big deal, despite all the coverage. In simplest terms, some investors' desires to make money are strong enough to cause them to ignore key rules and regulations that are designed to keep the market fair for all investors.

The History Behind Insider Trading

Insider trading wasn't considered illegal at the beginning of the 20th century. In fact, a Supreme Court ruling once referred to it as a “perk” of being an executive. It was banned with serious penalties being imposed on those who engaged in the practice after the excesses of the 1920s, however, bringing on a decade of deleveraging and a shift in public opinion.

The U.S. Securities and Exchange Commission (SEC) became involved after the Securities Exchange Act was passed in 1934, but the Act didn't actually prohibit such trading. Nor did it even really define it, so the SEC was limited when it came to taking enforcement actions.

That's changed significantly in the millennium. The SEC reports that it has filed insider trading complaints against hundreds of financial professionals, attorneys, corporate insiders, and hedge fund managers.

The Definition of Insider Trading

Insider trading happens when someone makes a trade of stock based on information that's not available to the general public. In other words, that individual has an edge that few others have.

The trader must typically be someone who has a fiduciary duty to another person, or to an institution, corporation, partnership, firm, or entity. You can get into trouble if you make an investment decision based upon information that's related to that fiduciary duty if that information isn't available to everyone else.

A fiduciary duty exists when one individual or entity has an obligation to act in another's best interest. Fiduciaries have duties of care, loyalty, good faith, confidentiality, prudence, and disclosure.

Insider information allows a person to profit in some cases and to avoid loss in others, such as in the Martha Stewart/ImClone scandal.

When No Fiduciary Duty Is Present

Insider trading can also arise in cases where no fiduciary duty is present but another crime has been committed, such as corporate espionage. For example, an organized crime ring that infiltrated certain financial or legal institutions to systematically gain access to and exploit and use non-public information might be found guilty of such trading, among other charges for the related crimes.

Punishable and Non-Punishable Insider Trading

Many factors must be considered before the Securities and Exchange Commission (SEC) will prosecute someone for insider trading. The main issues the SEC must generally prove are that the defendant had a fiduciary duty to the company and/or they intended to personally gain from buying or selling shares based upon the insider information.

An Example: 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, which planned to launch a tender offer for Pillsbury. Mr. O'Hagan subsequently acquired a large number of options in the company, knowing that the options would soar following the announcement of the tender offer.

Mr. O'Hagan eventually sold his options and realized a $4.3 million gain. He chose to acquire the options based on information that wasn't available to other investors. He did so without informing his firm. He was found guilty on 57 charges, but his conviction was overturned on appeal.

The case eventually found its way to the Supreme Court where the conviction was reinstated in a 6-3 decision. The Court found that O'Hagan was guilty of "employing a deceptive device...in connection with the purchase of a security."

The Case of Barry Switzer

Barry Switzer, the then-Oklahoma football coach, was prosecuted by the SEC in 1981 after he and his friends purchased shares in Phoenix Resources, an oil company.

Switzer was at a track meet when he overheard a conversation between executives concerning the liquidation of the business. He purchased the stock at around $42 per share and later sold it at $59 per share, earning about $98,000 in the process.

The charges against him were later dismissed by a federal judge due to a lack of evidence. Switzer probably would 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 off-handedly. The Supreme Court found that the tipper had not breached their fiduciary duty for personal gain.

The line between "criminal" and "lucky" is admittedly blurred in some insider trading cases.

What Are the Penalties for Insider Trading?

Insider trading penalties generally consist of a monetary penalty and jail time, depending on the severity of the case. The SEC has moved to ban trading violators from serving as executives at publicly-traded companies.

Section 16 Requirements: Safeguards

Section 16 of the Securities and Exchange Act of 1934 requires that when an "insider"—defined as all officers, directors, and 10% owners—buys the corporation's stock and sells it within six months, all of the profits must go to the company. The theory is that much of the temptation of this type of trading is removed when it's impossible for insiders to personally gain from small moves.

Company insiders are also required to disclose changes in the ownership of their positions, including all purchases and dispositions of shares.

Article Sources

  1. Securities and Exchange Commission Historical Society. "Fair To All People: The SEC and the Regulation of Insider Trading." Accessed March 9, 2020.

  2. U.S. Securities and Exchange Commission. "SEC Enforcement Actions." Accessed March 9, 2020.

  3. Oyez.org. "United States vs. O'Hagan." Accessed March 9, 2020.

  4. University of Pennsylvania Journal of Business Law. “The SEC’s Neglected Weapon: A Proposed Amendment to Section 17(A)(3) and the Application of Negligent Insider Trading.” Page 276-277. Accessed March 9, 2020.

  5. U.S. Securities and Exchange Commission. "Officers, Directors and 10% Shareholders." Accessed March 9, 2020.