What Is Insider Trading and Why Is It Illegal?

Definition, History, and Punishment

Insider Trading
Insider trading is a crime that results when, under certain circumstances, a person uses non-public information in an attempt to generate a profit or avoid a loss. Though it was legal at one time in the United States, it has long been against the law due to the incentives it creates in the financial system, pitting managers and executives against owners, as well as the lack of confidence and corruption it can breed in and within the financial system.. Comstock / Stockbyte / Getty Images

Insider trading is nothing new and, yet, from time to time, scandals erupt that cause it to re-enter the public consciousness in a major way.  When I first penned this article on May 23rd, 2003, insider trading talk was all the rage as a result of the Martha Stewart - ImClone insider trading scandal that had been on-going in the months prior to publication and which, ultimately, sent the domestic diva to Federal prison.

Despite all of the coverage, many investors were still unsure about what insider trading was, how it worked, why it was such a big deal, and how it is punished.  

More than a dozen years later, this quick overview still serves to give you the background on all of that so you have better familiarity with the topic.  

What Is Insider Trading?  Here's a Basic Definition of Insider Trading To Help Your Remember What Constitutes This Crime.

Insider trading occurs when someone who has a fiduciary duty to another person, institution, corporation, partnership, firm, or entity makes an investment decision based upon information related to that fiduciary duty that is not available to the general public. In some cases, the information allows them to profit, in others, avoid a loss. (In the Martha Stewart - ImClone scandal, the latter happened to be the case.)  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 non-public information, perhaps through the use of computer viruses or recording devices, might be found guilty of insider trading among other charges for the related crimes.

Insider trading was not considered illegal at the beginning of the twentieth century; in fact, a Supreme Court ruling once called it a “perk” of being an executive. After the excesses of the 1920’s, the subsequent decade of deleveraging, and the resulting shift in public opinion, it was banned, with serious penalties being imposed on those who engaged in the practice.

What Are the Penalties for Insider Trading?

Depending upon the severity of the case, insider trading penalties generally consist of a monetary penalty and jail time. In recent years, the Securities and Exchange Commission (SEC) has moved to ban insider trading violators from serving as an executive at any publicly traded company.

What Constitutes Criminal Insider Trading?

What, exactly, constitutes insider trading? The question is much trickier than it might seem on the surface. In order for the SEC to prosecute someone for insider trading, it must prove that the defendant had a “fiduciary duty” to the company and / or intended to personally gain from buying or selling shares based upon the insider information.

This test of duty was significantly weakened by the Supreme Court's United States vs. O'Hagan ruling. In 1988, James O'Hagan was a lawyer at the firm of Dorsey & Whitney. After the firm began representing Grand Metropolitan PLC, which planned to launch a tender offer for Pillsbury, Mr. O'Hagan acquired a large number of options in the company. Following the announcement of the tender offer, the options soared, resulting in a four million dollar gain. After being found guilty on fifty-seven charges, the conviction was overturned on appeal. The case eventually found its way to the Supreme Court where the conviction was reinstated.

Barry Switzer, 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 meeting when he overhead a conversation between executives concerning the liquidation of the business. He purchased the stock at around $42 per share, and later sold at $59, making around $98,000 in the process. The charges against him were later dismissed by a federal judge on a “lack of evidence”.

On the other hand, based on precedence in other cases, Switzer probably would have been fined and served jail time if one of his players was the son or daughter of the executives, and mentioned the tip to him off-handedly. The line between "criminal" and "lucky", it seems, is almost entirely blurred in such insider trading cases.

Section 16 Requirements: Safeguards Against Insider Trading

In order to prevent illegal insider trading, 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. By making it impossible for insiders to gain from small moves, much of the temptation of insider trading is removed. Company insiders are also required to disclose changes in the ownership of their positions including all purchases and dispositions of shares.

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