Insider Trading

What It Means

Insider trading refers to the buying or selling of a company’s securities (financial holdings, such as stocks, bonds, and mutual funds) by a company insider, which can be a company director, official, or any individual with a stake of 10 percent or more in the company. Insiders frequently buy and sell stock in their companies, but there are legal and illegal forms of insider trading. When someone buys or sells securities based on knowledge about the company unavailable to the general public, the trade is illegal. For example, the president of a technology company would be guilty of illegal insider trading if he sold thousands of shares of stock in his own company after learning that the company was going to lose one of its most important clients. The sale in this example is illegal because the president knew that the company was going to lose money before most other stockholders. He therefore had an unfair advantage over the other investors.

For insiders to trade legally in company stocks, they must base trades only on public information, and they must report their transactions to the Securities and Exchange Commission (SEC; a government agency that protects investors and maintains fair, orderly, and efficient markets) within two days of the purchase or sale. The SEC then posts this information on its website where any investor can find it.

When Did It Begin

The United States has been a world leader in establishing insider trading laws and in prosecuting cases against corrupt investors. The first U.S. laws against insider trading were not established by Congress and then tried in the nation’s courts, in the normal way federal laws against an illegal activity are enacted; these laws were developed in the Supreme Court. The first known prosecution for insider trading occurred in 1909, 25 years before Congress passed a law dealing with the violation. In 1909 the Supreme Court ruled that a corporate executive was guilty of fraud for buying a large number of shares of company stock when he knew that the stock was going to jump in price. Congress did not formally ban insider trading until 1934, when the first law on the topic was included in the Securities Exchange Act. Section 16(b) of that act forbids insiders from both buying and selling corporate stock within the same six-month period. This provision helps ensure that insiders make long-term investments in their companies rather than using insider knowledge to gain short-term profits.

More Detailed Information

The SEC’s official term for inside information is material nonpublic information. Though the majority of insider trading cases involve corporate insiders, anyone who buys or sells a stock based on material nonpublic information is guilty of insider trading. This means that family or friends of insiders can also be found guilty if investigators determine that they have traded stocks based on inside information. For instance, a finance journalist could be prosecuted for insider trading if he bought or sold stock in a company based on information he discovered in the process of reporting on the company. The journalist in this instance would be recognized as a temporary insider.

Gathering enough evidence to prove that someone is guilty of insider trading is one of the SEC’s most difficult challenges. The SEC monitors all stock trades closely, looking for suspicious behavior. In addition, stock markets such as the New York Stock Exchange and NASDAQ (the National Association of Securities Dealers Automated Quotation System) also follow trading activity closely. Evidence used against those accused of insider trading often consists of phone and e-mail records and the testimony of informants. Penalties for insider trading vary, with the maximum sentence being 10 years in prison and a fine of $1 million for an individual. A corporation found guilty of insider trading may be fined up to $2.5 million.

Not everyone thinks that insider trading should be illegal. In fact, debate is vigorous on this matter. One of the arguments opponents of insider trading laws put forward is that while insider trading is illegal in the stock market, the same activities are legal in the real estate sector. For example, if a person happened to know that there were large deposits of precious metals, such as gold and silver, under someone’s property, that person could make an offer to buy the property without telling the current homeowners about the gold underneath their home.

Many investors follow the patterns of legal insider trading when they buy and sell on the stock market. For instance, if an investor is thinking about buying stock in Google, that investor can consult the SEC website to see if insiders at Google are buying or selling their stock in the company. If insiders are selling their Google stock, the investor might decide to sell his or her stock as well. Though this is not a foolproof investment strategy, market reports indicate that when executives buy large amounts of stock in their own companies, those companies tend to outperform other companies on the market, which means that prices for those shares tend to rise, and investors make money.

Recent Trends

Between 2001 and 2006, the SEC brought 300 charges of insider trading against more than 600 individuals. During that time insider trading cases made up 7 to 12 percent of the SEC’s caseload. Several of these cases received attention in the national news. In 2001 Oracle Corporation CEO (chief executive officer) Larry Ellison was accused of insider trading when he sold $900 million worth of stock before the value of the company’s stock fell significantly. In 2005 Ellison paid $100 million to charity to settle the charges brought against him. Jeffrey Skilling, the former CEO of the Texas-based energy company Enron, was convicted of insider trading in 2006. Many economists argue that the numerous charges of fraud against Enron in 2001 brought about the SEC’s increased vigilance. In 2002 the SEC initiated 598 enforcement actions, a 24 percent increase over the number of cases in 2001, and in 2005 there were more securities lawsuits than in the previous 10 years combined.