What is Insider Trading?
Its safe to say that when people hear the words ‘insider trading’, Martha Stewart, Enron, Galleon Group, SAC Capital and many others come to mind. But, what exactly are the elements of insider trading and is all insider trading activity considered illegal?
The U.S. Securities and Exchange Commission (SEC) defines illegal insider trading as the buying and selling of a public company security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information (MNPI) about the security.
What is Legal Insider Trading
An insider is defined as an individual who has either access to material, non-public information about a public company corporation or ownership of stock that equals more than 10% of a firm’s equity. The vase majority of corporate C-level management, directors, high-level executives fall under the insider definition. These insiders are legally permitted to buy and sell shares of the company so long as all transactions are properly registered with the SEC and filed accordingly. Legal insider trading happens pretty frequently – most common examples include a CEO or C-level management buying back shares of their company or when employees purchase stock of their employer. In the case of C-level management, often the buying/selling of the stock by these individuals may move the needle in terms of price just because these individuals hold large blocks of shares (C-level management typically earns stock options as part or all of their compensation).
What is Illegal Insider Trading?
Illegal insider trading is the type that makes headlines and means big trouble ahead with the SEC. This type of insider trading is not limited to company insiders – in fact, it can be done by anyone. Company executives, employees, friends of the employee, relatives, even a random person on the street can engage in insider trading so long as the information that they are trading on is not publicly known. The key here is that the person buys or sells a public company stock in breach of a fiduciary duty (relationship of trust and confidence) while in possession of material, non-public information and gains an unfair advantage.
What does Material even mean?
The definition of material information has not been precisely defined but has been explained in case law as any information specific to a company that would be considered important enough for an investor who is considering buying or selling the stock. This could be business developments, mergers/acquisitions, dividend share increases/decreases, winning or losing major contracts, positive or negative earning statements, strategic plans, impending or potential litigation, etc.
Tipper liability arises when an individual who possesses material non-public information and does not trade on the information himself, but passes on the confidential details to another individual who trades on the non-public information. Insider tipping is also illegal because the tipped off individual gains an unfair advantage over other investors from the price movement when the confidential information is finally announced. Both the tipper (individual sharing the information) and the tippee (individual receiving the tip and trading on it) are guilty of violating the securities laws.
How does the SEC catch Insider Trading?
The SEC monitors all insider trading by tracking the trading volumes (basically total number of shares transacted between a buyer and seller during a specified time period) of any particular stock. When there is material news announced to the public – like a merger, closing down of business, CEO stepping down, criminal charges filed – trading volumes commonly increase in response to the news. If no news is announced but the trading volume is irregular or at increased volume, this pattern is a red flag for the SEC because trading volumes should not be irregular if there is nothing that would induce this type of public reaction.
Once the red flag is noted, the SEC investigates to better understand which firm and/or individual is responsible for the trading and whether it was illegal or not. Read more about how the SEC tracks insider trading, the prosecution and the consequences here.