Introduction to Insider Trading
Insider trading seems simple enough to understand, and yet it’s one of the more misunderstood terms in the financial world. It’s not as abstract as “you know when you see it” but whether something constitutes insider trading really comes down to access and intent.
The everyday retail trader or investor has access to more information than ever before. And there are professional traders and analysts who publish content to keep fueling this news cycle. In a certain way, that makes defining insider trading a little easier. Simply put, there’s a lot of information, including speculative rumors, that is found in the public domain.
This is because for something to constitute insider trading individuals must have access to information that the general public does not have the ability to access. And, the individuals then act on that information to inform trading usually of specific equities.
With that in mind, it may surprise you to know that there are times when insider trading is legal.
Continue reading this article to help you understand the topic of insider trading. We’ll define insider trading and look at important specifics such as what makes someone an insider, why insider trading is harmful to markets and to the point we just made under what conditions insider trading can be legal.
Insider Trading Defined
According to the Securities & Exchange Commission (SEC) insider trading “refers generally to 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.”
That definition would seem to imply that insider trading violations only occur when someone acts on the information. However, the SEC also says that insider trading violations also include the act of “tipping” inside information.
To keep it simple, here are three conditions that have to be met for an act of insider trading to be illegal:
- Information must be passed along by an insider.
- The individual(s) receiving the information must act upon that information (make a trade).
- The trading activity must take place before the tipped information is available to the general public.
That last point is a key one to understand. In many cases, the information used for a trade becomes public knowledge. The point is that if an individual were to find out something days or weeks before the general public, they could prepare a trade to maximize their own gain.
What Makes Someone an Insider?
Once again, let’s look at what the SEC has to say about this. The commission says the definition of who is an insider “can include officers, directors, major stockholders and employees of an entity whose securities are publicly traded.” This is a broad definition that is intended to presume that insiders should put the company’s interest ahead of their own.
The SEC policy states that, in general, “an insider must not trade for personal gain in the securities of that entity if that person possesses material, nonpublic information about the entity.” They go on to say that individuals “must not disclose that information to family, friends, business or social acquaintances, employees or independent contractors of the entity.” However, an insider may make trades or discuss the information after it has been made public.
As it relates to insider trading, the definition of “insider” expands even more. In fact, any individual who buys or sells shares of a security based on inside information can be guilty of insider trading.
What’s the Harm of Insider Trading?
The first reason that insider trading is harmful relates to the insider’s fiduciary duty. A common question that gets asked is why shouldn’t individuals benefit from having insider information? The answer is they are supposed to put the company’s interests ahead of their own. This includes brokers and analysts who have access to this information. When that information is traded on, they are allowing that information to be used to benefit others ahead of the company.
This idea of benefiting some to the exclusion of others leads to the second fundamental harm of insider trading. It violates the principle of transparency. When the market is functioning properly both retail and institutional investors have access to the same information. At times, you already hear retail traders claiming the market is a rigged game. If insider trading was allowed to proceed without any consequences, retail investors would lose even more confidence in the market.
Examples of Insider Trading
Two recent high-profile cases illustrate the relationship between insiders and insider trading. The first involved American retail businesswoman, writer, and television personality Martha Stewart. In this case, Stewart received a tip from her broker who worked at Merrill Lynch. Stewart did not work for the company in question nor did she work for Merrill Lynch. However, she was an existing shareholder of the stock in question.
Stewart was convicted of insider trading based on evidence that she had made trades before the information that was tipped to her became public. She served five months in prison and two years of probation including five months under house arrest.
The other case involves Mychal Kendricks a professional football player. Kendricks entered and exited trades based on information he received from an acquaintance who was a broker with Goldman Sachs. This case was a bit greyer because Kendricks was not a client of the broker. Nevertheless, he was given access to confidential information that could materially affect the price of the securities he traded prior to that information being released to the public. Kendricks served one day in prison, was sentenced to three years of probation and 300 hours of community service.
How is Insider Trading Different from an Idle Conversation?
In reality, it’s not but it has to do with intent of the person giving the information. In the case Dirks v. SEC, the Supreme Court determined, “the mere disclosure of material, nonpublic information, by itself, does not necessarily constitute a breach of an insider’s fiduciary duties.”
What does that mean in plain terms? If someone overhears a conversation in which insider information is disclosed, they can act on the information if they were not aware that it was confidential. This was the premise behind the ruling in the Dirks v. SEC case.
At that time, Barry Switzer at the time the head football coach at the University of Oklahoma overheard a conversation between the former CEO of Texas International and his spouse while at a track meet in Texas. The former CEO had no idea that Switzer heard the information and Switzer had no idea the information was confidential. The case went to trial and the Supreme Court ruled that the CEO did not breach his fiduciary duties. However, this was only because the CEO was engaged in what he had reason to believe was a private conversation. If he was relaying that information to Switzer himself, even if he believed the information wouldn’t be acted on, it would have met the standard for insider trading.
When Does Inside Information Become Insider Trading
The key definition of insider trading stems from the word trading, which constitutes an action. Here’s a hypothetical example. Jane is an executive at XYZ Company. She knows that the company is going to acquire another company and shares that information with family and friends before it becomes public information.
In and of itself, that does not constitute insider trading. It does, however, become insider trading if anyone who is privy to that information uses it to make enter and/or exit trades prior to the information going public.
The same logic goes for those that receive the information. If they don’t act on it, then it’s just information. If they make trades based on it, then it constitutes insider trading.
However, this serves to clarify the importance of the insider not disclosing the information. They may trust their family members and close friends to not trade the news. However, once the information is out, they have less control of who else may hear about it and act on it.
How Can Insider Trading Ever be Legal?
With every example we’ve discussed, how can insider trading ever be legal? The answer is only under very restrictive conditions. First, the trade must be reported to the SEC via a Form 4 within two business days of when the trade occurred. This will make the trade part of the public record. Additionally, the trader must list all the company’s directors and officers along with any share interest they have in a Form 14a filing.
Although insider selling frequently draws the attention of retail investors, the reality of life is that company insiders sell company stock. And they can do so for a lot of reasons, many being personal.
Information about insider trades is available on many financial websites. However, the best place to look is the SEC’s EDGAR (Electronic Data Gathering, Analysis and Retrieval) database. Furthermore, SEC rules prevent insiders from trading company stock within any six-month period.
With that in mind, it’s more telling when insiders buy their company’s stock. To do so under those conditions, an investor could not be blamed for presuming the company’s outlook was good.
The Bottom Line on Insider Trading Comes Down to Intent
The practice of allowing a select few group of investors to profit trading securities based on non-public material will always meet the standard for insider trading in the eyes of the Securities & Exchange Commission. This is why many companies make even low-level employees sign non-disclosure agreements and ensuring they know the penalties associated with passing along confidential information to outside sources.
In the end, there are three basic questions that have to be asked. One is the information idle speculation or is it credible information from someone with access? Second, is the information in the public domain?
In the case of illegal insider trading, the intent is to act on inside information before the public has knowledge of it. In this way, a select few “insiders” can profit from the information.
However, legal insider trading has always existed. And if properly disclosed, it can be a benefit to retail and institutional investors as a supplement to fundamental or technical analysis.