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 insider knowledge to profit.

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.

Insider trading breaks key rules that are meant to keep the market fair for all investors. Learn more.

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.

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. If you have a fiduciary duty to someone else, you can get into trouble if you buy or sell shared based on info that not everyone 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 other investors don't have the same chance.

Those who have been prosecuted for insider trading include corporate officers, employees, and government officials. Anyone who tips off someone else with insider information can also be charged and found guilty.

Insider trading can happen where no fiduciary duty is present. In these cases, often another crime has been committed.

One kind 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
  • 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, or 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. The SEC has moved to ban trading violators from serving as executives at publicly traded companies.

The History Behind Insider Trading

Insider trading wasn't thought of as illegal at the beginning of the 20th century. In fact, a Supreme Court ruling once called it a “perk” of being an executive.

It was banned, and severe penalties were set for those who engaged in the practice, after the 1920s.

The 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. 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 financial professionals. These complaints have also been filed against attorneys, corporate insiders, and hedge fund managers.

Notable Happenings

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 overheard executives from Phoenix talking about the liquidation of 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. 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 Metropolican planned to launch a tender offer for Pillsbury.

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

O'Hagan eventually sold his options. He made $4.3 million.

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

The case found its way to the Supreme Court. There, the conviction 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. Stewart was 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

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 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 another kind of trust.
  • The SEC can charge both those who get information and those who gave it with insider trading.
  • If found guilty, penalties can include heavy fines and jail time.