What Is Insider Trading and Why Is It Illegal?

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

Insider Trading
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Insider trading made major headlines back in 2003, as a result of the infamous 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.

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.  

With as many news stories, front page articles, and documentaries as there are surrounding the subject, you would think that people would understand that insider trading is illegal. Yet, from time to time, scandals erupt that cause it to re-enter the public consciousness in a big way.

Some investors' desire to make money is so strong, it causes them to ignore the rules and regulations designed to protect them and keep the market fair for all investors. However, when they're caught (which always happens eventually), they are going to have to live with the consequences. 

The Definition of Insider Trading

In short, insider trading happens when someone makes a trade of stock based on information that is not available to the general public.

To be accused of insider trading, you must usually be someone who has a fiduciary duty to another person, institution, corporation, partnership, firm, or entity. You can get in trouble of you make an investment decision based upon information related to that fiduciary duty that is not available to everyone else. This insider information allows a person to profit in some cases, and avoid loss in others (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.

Believe it or not, insider trading was not considered illegal at the beginning of the 20th century; in fact, a Supreme Court ruling once called it a “perk” of being an executive. After the excesses of the 1920s, 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.

Punishable Insider Trading and Non-Punishable Insider Trading

Defining all the activities that constitute criminal insider trading is much trickier than it might seem on the surface. There are many factors that must be considered in order for the Securities and Exchange Commission (SEC) to prosecute someone for insider trading, but the main things they must prove is 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.

This test of fiduciary 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 $4 million gain. After being found guilty on 57 charges, the conviction was overturned on appeal. The case eventually found its way to the Supreme Court where the conviction was reinstated.

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 at $59, making around $98,000 in the process. The charges against him were later dismissed by a federal judge due to 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.

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 SEC has moved to ban insider trading violators from serving as an executive at any publicly traded company.

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.