Legal insider trading? This is what it is and how it affects investors

Arguments for Insider Trading

One argument in favor of insider trading is that it allows nonpublic information to be reflected in a security’s price and not just public information. Critics of insider trading claim that would make the markets more efficient.

As insiders and others with nonpublic information buy or sell the shares of a company, for example, the direction in price conveys information to other investors. Current investors can buy or sell on the price movements, and prospective investors can do the same. Prospective investors could buy at better prices, while current ones could sell at better prices.

Delaying the Inevitable?

Another argument in favor of insider trading is that barring the practice only delays the inevitable and leads to investor errors. A security’s price will rise or fall based on material information.

Suppose an insider has good news about a company but cannot buy its stock. Then those who sell in the time between when the insider knows the information and when it becomes public are prevented from seeing a price increase. Barring investors from readily receiving information or getting that information indirectly through price movements can lead to errors. They might buy or sell a stock that they otherwise would not have traded if the information had been available earlier.

Laws against insider trading, especially when vigorously enforced, can result in innocent people going to prison. As rules become more complex, it becomes harder to know what is or is not legal resulting in participants accidentally breaking the law without knowing so.

For example, someone with access to material nonpublic information might accidentally disclose it to a visiting relative while talking over the phone. If the relative acts on that information and gets caught, the person who accidentally disclosed it might also go to prison. These sorts of risks increase fear to the point where talented people pursue careers elsewhere.

If you happen to get material nonpublic information, do not make any investment decisions based on it until that information becomes public. Also, never share material nonpublic information with outsiders.

Yet another argument for allowing insider trading is that it is not serious enough to be worth prosecuting. The government must spend its limited resources on catching nonviolent traders to enforce laws against insider trading. There is an opportunity cost to going after insider trading because the government must divert those resources from cases of outright theft, violent assaults, and even murder.

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 others who don't have access to these secret tips don't have the same chance.

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. 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; and
  • They planned to personally gain from buying or selling shares based on inside info.

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Understanding Insider Trading

Legal Insider Trading

Insiders are legally permitted to buy and sell shares of the firm and any subsidiaries that employ them. However, these transactions must be properly registered with the Securities and Exchange Commission (SEC) and are done with advance filings. You can find details of this type of insider trading on the SEC’s EDGAR database.

Legal insider trading happens often, such as when a CEO buys back shares of their company, or when other employees purchase stock in the company in which they work. Often, a CEO purchasing shares can influence the price movement of the stock they own.

A good example is whenever Warren Buffett purchases or sells shares in the companies under the Berkshire Hathaway umbrella.

Illegal Insider Trading

The more infamous form of insider trading is the illegal use of non-public material information for profit. It's important to remember this can be done by anyone including company executives, their friends, and relatives, or just a regular person on the street, as long as the information is not publicly known.

For example, suppose the CEO of a publicly traded firm inadvertently discloses their company’s quarterly earnings while getting a haircut. If the hairdresser takes this information and trades on it, that is considered illegal insider trading, and the SEC may take action.

The SEC is able to monitor illegal insider trading by looking at the trading volumes of any particular stock. Volumes commonly increase after material news is issued to the public, but when no such information is provided and volumes rise dramatically, this can act as a warning flag. The SEC then investigates to determine precisely who is responsible for the unusual trading and whether or not it was illegal.

A common misconception is that all insider trading is illegal, but there are actually two methods by which insider trading can occur—one is legal, and the other is not.

The History Behind Insider Trading

Insider trading didn't always have a bad rap. In the early 20th century it was not against the law, or even looked down upon. In fact, a Supreme Court ruling once called it a “perk” of being an executive.

After the stock market crash in 1929 and the Great Depression that followed, trading practices came under more scrutiny. A number of court cases and new laws chipped away at insider trading, even setting severe penalties were set for those who engaged in the practice.

It wasn't until 1934, with the creation 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 in a series of new rules, the SEC was able to criminalize certain actions, one by one. For instance, 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. 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 people financial professionals. These complaints have also been filed against lawyers, corporate insiders, and hedge fund managers.

The Bottom Line

Insider trading has both proponents and critics. Those against insider trading believe that it tips the balance in favor of those with nonpublic information. Advocates of insider trading believe that it avoids risks and makes markets more efficient.

Regardless of the stance individuals take, insider trading is currently illegal and can be severely punished through fines and time in prison.

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