What’s the real dirt on insider trading? Do only the rich and powerful commit these crimes — and can their actions affect the average trader?
Say you overhear the CEO of a big company talk about their next earnings report at a restaurant … Are you in the know? Should you stop eating and cover your ears?
Let’s slow it down. There’s a lot to unpack when it comes to insider trading.
So let’s look at the history of insider trading, what it is, when it became illegal, and why you should care about it as a trader.
Table of Contents
- 1 What Is Insider Trading?
- 2 How Does Insider Trading Work?
- 3 Is Insider Trading Illegal?
- 4 Who Is Usually Involved in Insider Trading?
- 5 What’s the History Behind Insider Trading?
- 6 Insider Trading Laws
- 7 What Are Possible Punishments for Insider Trading?
- 8 Is It Hard to Prove Insider Trading?
- 9 What Are the Two Types of Insider Trading?
- 10 What Are Some Examples Of Insider Trading?
- 11 Should Insider Trading Be a Free Market Freebie?
- 12 Conclusion
What Is Insider Trading?
It’s when you trade a security based on valuable information you have and the public doesn’t. That’s insider trading.
Insider trading information is valuable knowledge about major company events. This could be a change in leadership, a product defect, or a regulatory clearance.
Insider trading news can be about anything with the potential to move a stock in the near term.
If a company changes direction every time a hot sector comes around, be skeptical.
I’m looking at you, Eastman Kodak Company (NYSE: KODK).
How Does Insider Trading Work?
The short answer: it doesn’t. You have to put your nose to the grindstone if you want to get ahead in life. There are no shortcuts.
Learn the mechanics of a good trade instead. You’ll do much better in the long run.
That said, there’s another way nefarious people access insider trading information…
Corporate espionage is the theft of classified corporate information by an organized crime ring. This could be a band of rogue hackers out for themselves or hired by a foreign government.
Any way you cut it, it’s not OK to act on a trade with super-secret information. If you had to steal that information to get it, that’s beyond sketchy.
Is Insider Trading Illegal?
Yes. Here’s the U.S. Securities and Exchange Commission’s insider trading definition…
“buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security … violations may also include ‘tipping’ such information, securities trading by the person ‘tipped,’ and securities trading by those who misappropriate such information.”
If you get insider trading information about a stock, whether through work or a friend, you can’t trade on it. If you do, you’ll be in hot water.
So don’t dream about insider trading your way out of the PDT rule anytime soon.
Why Is It Illegal to Trade on Insider Information?
You do your homework…
But say someone else has the answers to the test. They know their latest vaccine is about to clear a regulatory hurdle before you do. So they buy into their biotech stock and short sell their competitor’s stock.
That’d be unfair, right? They had almost no risk and gained a high reward. Meanwhile, you find out about this catalyst with every other retail trader.
That’s the thing … Insider trading gives a few individuals an unfair advantage over those who put in an honest day’s work.
Who Is Usually Involved in Insider Trading?
It’s more common for corporate executives and directors to commit insider trading, but it’s not only them.
Any person with access to proprietary information about a stock can commit the crime.
High-level execs can share insider trading news outside the company. And a friend or family member might benefit.
If you overhear them at a restaurant, don’t worry. That’s a loophole. You have to have a closer relationship than a stranger at the next table to commit a crime. But don’t quote me on that.
Corporate insiders aren’t the only ones at fault. A Georgia State University study found that U.S. Senators’ portfolios (from 1993–1998) outperformed the market by about 12.3%.
Dr. Alan Ziobrowski later found that members of the U.S. House of Representatives outperformed the stock market by about 6% (from 1985–2001).
For comparison, corporate insiders tend to outperform the average by 7.4%. U.S. households underperform the market by 1.5%.
With odds like those, we little guys gotta do everything we can to improve our odds. To get hot news early, I recommend StocksToTrade’s Breaking News Chat feature. It’s how you can find the news that can move stocks fast. It’s changing the name of the game.
What’s the History Behind Insider Trading?
The first insider trading laws came out in response to the stock market crash of 1929.
Before that, the Massachusetts Supreme Court had ruled, in Goodwin v. Agassiz, that having insider knowledge was a “perk” of being an insider.
In 1933, Congress passed the Securities Act to regulate the securities market. Before then, it was up to the states to govern.
In 1934, the Securities Exchange Act passed as an addendum to the 1933 Securities Act. Most insider trading penalties and laws since then reference the 1934 Act.
Insider Trading Laws
Insider trading laws penalize people who use sensitive information for personal gain. It also prohibits people from passing the information on to others in exchange for a favor.
The misappropriation of information, “tipping” a friend, or set up of a quid pro quo are not acceptable.
Law #1: The Securities Act of 1933
The Securities Act of 1933 passed with two main objectives: “(1) to ensure more transparency in financial statements so investors can make informed decisions about investments, and (2) to establish laws against misrepresentation and fraudulent activities in the securities markets.”
This law focused more on the information investors received, less on third parties.
Law #2: The Securities Exchange Act of 1934
The Securities Exchange Act of 1934 “was created to govern securities transactions on the secondary market, after issue, ensuring greater financial transparency and accuracy and less fraud or manipulation.”
Now brokers and other secondary players in the market were liable for their actions. It also required public companies to disclose financial transactions.
Now, Congress has the Securities and Exchange Commission (SEC) to provide oversight.
What Are Possible Punishments for Insider Trading?
Possible insider trading penalties include hefty fines and jail time.
Individuals can face up to 20 years in prison and/or a fine of $5 million for each “willful violation.” Corporations can face fines of up to $25 million.
What Is the Minimum Sentence for Insider Trading?
The least harsh of insider trading penalties is a fine without any jail time. This punishment is likely when a defendant claims to have “no knowledge” of the rule they violated.
Is It Hard to Prove Insider Trading?
It can be. Bigwigs with valuable information tend to keep that information close to the vest. They move in small circles of power.
With small potatoes like you and me, tracking what we do is easy. Our brokerage accounts are in our own names.
Not so with the big guys. Their stuff is often hiding in offshore accounts and other proxy entities.
Also, CEOs have full discretion over when to release company information and how much. This means that insider trading news can appear less direct.
For example, a CEO could release confusing or conflicting press releases close together. Instead of dropping negative news and tanking the company’s stock.
The market hates uncertainty. This could be a way to profit from short-term market volatility that’s less easy to prove.
What Are the Two Types of Insider Trading?
The first type happens when executives or directors trade their company’s stock. They must report these trades to the SEC within two business days. This is legal.
Where insider trading becomes illegal is a fine line … and a blurry one.
According to the SEC, illegal insider trading “refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security. Insider trading violations may also include ‘tipping’ such information and securities trading by those who misappropriate such information.”
Legal Insider Trading
So the legal version is insiders buying and selling their own company’s stock…
Illegal Insider Trading
The illegal version is when they choose to do this — and why.
If they act on this before it’s public knowledge, that’s insider trading.
In other words, insiders can’t trade when they have an advantage over the public.
What Are Some Examples Of Insider Trading?
One of the most famous examples is the case against HGTV star and home goods vendor, Martha Stewart.
She was busted for insider trading in 2003. After receiving a tip from a Merrill Lynch advisor, she sold shares in the pharmaceutical company ImClone.
The Food and Drug Administration (FDA) was on track to approve Erbitux — a cancer treatment drug. CEO Samuel Waksal gave Merrill Lynch broker Peter Bacanovic a thumbs down. A denial from the U.S. government was imminent.
Stewart’s transaction became illegal the second she acted on that information. She went to prison for three months.
This guy is the inspiration for Gordon Gekko in the movie “Wall Street.” Ivan Boesky committed some egregious crimes, including insider trading. He flew under the radar for a long time…
By the mid-80s, he’d made a fortune by knowing about mergers and acquisitions ahead of time. He traded days before the company announced a takeover, and — boom — his wealth grew.
He gave a commencement speech to UC Berkeley’s School of Business Administration. His advice? “You can be greedy and still feel good about yourself.”
It’s hard to say how long that good feeling lasted. Authorities caught him in 1986. They fined him $100 million in insider trading penalties and he spent three years in prison. The SEC also banned him from trading.
I don’t know about you, but I’d consider that a huge bummer!
Bernard Ebbers Insider Trading
This guy is a cautionary tale for anyone who doesn’t respect the risks of a margin call.
Bernard Ebbers was the CEO of a large telecommunications company called WorldCom. He had hundreds of millions of dollars in company stock. And decided to borrow against it to fund other ventures.
Unfortunately, WorldCom’s stock tanked in 2000. Ebbers was stuck with a margin call of over $400 million dollars. He then produced fraudulent accounting records to prop up WorldCom’s valuation.
In 2005, an internal auditing department tipped off the SEC, and it was game over. They convicted him of conspiracy, securities fraud, and false regulatory filings.
After serving 13 years of a 25-year prison sentence, a judge let him out for health reasons. He died early the following year.
R. Foster Winans Insider Trading
It isn’t always high-profile execs getting caught up in the game. Winans was a journalist for The Wall Street Journal in the 1980s. He wrote a financial column called “Heard on the Street.”
He had a significant following and got to a point where the public would make trades based on what he said.
Unfortunately, the power got to his head. He shared information from his column with a stockbroker the day before he published it … And accepted kickbacks in return. Classic quid pro quo.
After his conviction for insider trading in 1985, he served nine months in federal prison.
Sometimes you’re better off learning how to pick your own stocks.
Yoshiaki Murakami Insider Trading
Yoshiaki Murakami was an activist fund manager from Japan. He gained notoriety as a self-described corporate raider.
Then he turned away from his life as a bureaucrat. And his culture’s reverence for established companies and loyal salary earners.
He took large stakes in a company and put pressure on it to tilt the balance of power in favor of shareholders.
But he paid the price for insider trading over a potential Livedoor merger. He traded knowing Livedoor would bid to take over Nippon Broadcasting System (NBS). Even though the takeover never happened, he made a sizable profit off the rumor.
He pled not guilty, and the Livedoor founder testified on his behalf, but he was still convicted. His punishment was a $10 million dollar fine and two years in jail.
Should Insider Trading Be a Free Market Freebie?
Some economists argue that the current system is hostile to natural market activities.
Thanks to the internet, businesses and individuals now enjoy quick information access. That’s helped balance the power to some degree.
Without insider trading regulations, retail traders might not trust the markets. If industry elites can rig the market in their favor, why risk your hard-earned money? And if people lose faith in the stock market, then it’s bye-bye volume.
Finding your edge in a world with algorithmic trading is enough of a challenge.
Insider trading has been around for almost as long as the stock market itself. It took Congress time to realize the dangerous impact it could have on the integrity of the markets.
Since the Great Depression, laws and insider trading penalties have increased over time. The last bill signed into law was the Stop Trading on Congressional Knowledge Act (STOCK Act) in 2012.
Let’s hope the market continues to flourish and provide opportunities for us all for many years to come. I don’t really see it going anywhere. And thank goodness — I’m obsessed with the market.
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What do you think? Should insider trading be illegal? Let us know in the comments below!