What Is Insider Trading?

Businesswoman whispering secrets into a businessman's ear
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DEFINITION

Insider trading is the act of buying or selling stocks or other securities based on information that's not known to the public. It involves a direct breach of fiduciary duty or other violation of trust.

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

Many high-profile cases over the years have involved 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.

Definition and Example of 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 legal terms, it's any fact that, if known, would have an effect on the outcome of a choice to buy or sell.

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

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

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 or avoid a loss. It's an abuse of that person's knowledge or power in either case.

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

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. An organized crime ring might use certain financial or legal institutions to gain access to private information. The people involved might be found guilty of insider trading if they're found out. They may also be convicted on 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 information.

What Insider Trading Means for Investors

Insider trading penalties often involve fines and prison time. The outcome can include one or the other, but it often includes 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. It wasn't against the law in the early 20th century, or even looked down upon. In fact, a Supreme Court ruling once called it a “perk” of being an executive.

Trading practices came under more scrutiny after the stock market crash in 1929 and the Great Depression. A number of court cases and laws chipped away at insider trading, even setting severe penalties for those who engaged in the practice. It wasn't until 1934, with the creation of 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 the SEC was able to criminalize certain actions, one by one, in a series of rules. 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. There were limits to what the SEC could do to enforce the rules as a result.

That has since changed. The SEC reports that it has filed insider trading complaints against hundreds of people and financial professionals, including lawyers, corporate insiders, and hedge fund managers.

Notable Insider Trading Events

There have been a number of high-profile insider trading cases.

SEC vs. Switzer

Barry Switzer was the University of Oklahoma 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. He later sold it at $59 per share. He made about $98,000 in the process.

The charges against him were later dismissed by a federal judge due to a lack of evidence. But Switzer might have been fined and served prison time if one of his players had been the son or daughter of the executives and they mentioned the tip to him. The U.S. Supreme Court found that the tipper had not breached their fiduciary duty for personal gain in this case.

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. O'Hagan bought a large number of options in the company with this knowledge. He knew that the options would soar in value after the tender offer was made public. He later sold his options at a prime moment. O'Hagan made $4.3 million.

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

The O'Hagan case found its way to the Supreme Court, where 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."

Other Major Headlines

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

Insider trading was front page news again in 2011 when 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 the issue of insider trading. Some even allow it, at least to a degree. Section 16 of the Securities and Exchange Act of 1934 requires that all the profits must go to the company when an "insider" buys a corporation's stock and sells it within six months. all officers, directors, and 10% owners count as insiders in this case. 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 must also disclose any changes in the ownership of their positions, including 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 give it with insider trading.
  • Penalties can include heavy fines and prison time.

Article Sources

  1. U.S. Securities and Exchange Commission. "SEC Enforcement Actions: Insider Trading Cases."

  2. U.S. Securities and Exchange Commission. "Insider Trading."

  3. HG.org. "What Is Insider Trading and Why Is It Illegal?"

  4. Britannica. "Historical Timeline: History of Insider Trading, 1611-2012, With an Emphasis on Congressional Insider Trading."

  5. Securities and Exchange Commission Historical Society. "Fair To All People: The SEC and the Regulation of Insider Trading."

  6. 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.” Select "Download," Page 276-277.

  7. Oyez.org. "United States v. O'Hagan."

  8. Cornell Law School, Legal Information Institute. "UNITED STATES, Petitioner, v. James Herman O'HAGAN."

  9. U.S. Securities and Exchange Commission. "SEC Charges Martha Steward, Broker Peter Bacanovic With Illegal Insider Trading."

  10. U.S. Securities and Exchange Commission. "SEC Obtains Record $92.8 Million Penalty Against Raj Rajaratnam."

  11. U.S. Securities and Exchange Commission. "Officers, Directors and 10% Shareholders."