Insider trading is the act of buying or selling company stocks and securities based on information not known to the public. An insider is considered any officer, manager,
or executive of the firm in question; in some cases, it can also be a person who was given the proprietary information by a company figurehead. Generally, insider trading is illegal, but there are laws and regulations that some are willing to skirt in order to practice trading that they consider “legal” insider trading.
Insider trading is considered by many people to be no different than outright stealing. U.S. laws concerning insider trading have become increasingly more strict throughout the years and include swift punishment for those who garnered the insider information to make the trades as well as those who do the trading, regardless of their involvement or relationship (or lack thereof) to the firm. Several laws now protect companies and employees from insider trading and its negative impact on stocks and the open market in general. Even firms with highly globalized presences with identities on all the world markets now have the legal protection to combat insider trading.
U.S. LAWS AND REGULATIONS AGAINST INSIDER TRADING
Insider trading laws have evolved with the open market since its onset, but many were born after the devastating crash of the stock market in 1929. The 1934 Securities Exchange Act is the backbone for almost any law or regulation against insider trading as well as other types of securities fraud. Considered an appendage of (or sister to) the 1933 Securities Act, the Securities Exchange Act reaches further to protect stocks, while the Securities Act covers issues more germane to securities. Essentially, sections 16(b) and 10(b) of the Securities Exchange Act outline unlawful trading practices and these sections explain—through various rules of the U.S. Securities and Exchange Commission (SEC)—exactly what fraudulent trades are and who can perpetrate them. The 1934 act also denotes when a trade is considered unlawful.
Insider trading can cause major shifts in what the public chooses to do in terms of buying or selling of a firm's stocks or securities. This is the main reason why stocks and companies, as well as their shareholders, must be protected against trades that are based on information that is unknown to the public. In a 1966 federal court case (SEC vs. Texas Gulf Sulphur Company ), it was decided that any person who is party to information not yet publicly known about a firm's stocks or securities has a duty to stockholders and to the firm in question. The privy person can either choose not to trade and sit on the information, or share what he or she knows in a public manner so that everyone can benefit. In this way, the shareholders and the company's holdings are not devalued by trades based on the information at hand.
Many of the parameters that determine the difference between legal and illegal insider trading are determined by the SEC. According to the SEC, the two most recent rules (10b5-1 and 10b5-2) further protect both investors and companies by outlining exactly when information is considered public or nonpublic and by determining when exceptions are to be made (for example, when a trade is made but the person trading can prove that it was made on the basis of something other than nonpublic information). Additionally, 10b5-2 explains when a person would be required to pay a penalty for use of insider information and what, exactly, constitutes misappropriated information in regards to information used by parties with no direct ties to the firm in question.
EFFECTS AND FUTURE OF INSIDERTRADING
The rules and regulations established by the acts of 1933 and 1934—as well as various court cases that further tailored the laws against insider trading—were further built upon, reexamined, and revised following the boom of corporate mergers in the 1980s. It was not until this time that it became illegal to sell insider information. The case United States vs. Newman made it illegal for the first time for a nonrelated party, not just a company insider, to engage in trades based on nonpublic information.
The laws and regulations against insider trading have become progressively more severe because the potential negative effects that insider trading can have are devastating. With mergers on the rise as they were in the 1980s, and with more money invested in the stock market by more people than ever before, insider trading is again a deadly threat. Businesses moving to a global stage will want to protect assets to the best of their abilities, and a strong policy against insider trading is a crucial aspect of that protection.
The United States has the reputation for the least acceptance and lowest tolerance for insider trading. Other major world players—including China, India, and members of the European Union—have started to adopt many of the same perspectives and laws concerning insider trading of stocks and securities as corporations from every locale move in the multinational direction.
Ali, Paul U. and Greg N. Gregoriou. Insider Trading: Global Developments and Analysis. Boca Raton, Florida: CRC Press, 2008.
Macey, Jonathan R. Insider Trading: Economics, Politics, and Policy. Washington, D.C.: AEI Press, 1991.
Newkirk, Thomas, and Melissa A. Robertson. “Speech by SEC Staff: Insider Trading—A U.S. Perspective.” Available from: http://www.sec.gov/news/speech/speecharchive/1998/spch221.htm.
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.
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.
INSIDER TRADING. Gaining an unfair advantage in buying or selling securities based on nonpublic information, or insider trading, has plagued Wall Street from its earliest days. Prior to the formation of the Securities and Exchange Commission (SEC) in 1934 in response to the stock market crash of 1929, insider trading occurred more frequently. Since the mid-1930s, the SEC has regulated trading and attempted to make it a trustworthy system. Spotting and prosecuting illegal insider trades has been a major priority.
Although insider trading is usually associated with illegal activity, it also happens when corporate officers, directors, and employees buy and sell stock within their own companies, for example, exercising stock options. Legal insider trading occurs every day and is permitted within the rules and regulations of the individual company and federal regulations governing this kind of trade, which the SEC requires be reported. Because legal insider trading is reported to the SEC, it is considered part of normal business activity. Illegal insider trading, however, is corrupt, since all parties involved do not have all the information necessary to make informed decisions. Most often, the average investor is duped in insider trading scandals.
Illegal insider trading gained great notoriety in the 1980s, epitomized by the criminal charges brought against junk bond king Michael Milken and financial speculator Ivan Boesky. The hit motion picture Wall Street (1987) centered on insider trading and brought the catchphrase "greed is good" into the popular lexicon. Tom Wolfe's best-selling novel Bonfire of the Vanities (1987) employs a Milken-like figure as its main character.
Given that in the late twentieth century people placed a larger percentage of their money in the stock market and that they tied retirement funds to stock-based 401K programs, any hint of an unfair advantage undermines the spirit of fairness that the general public associates with democracy and capitalism. Breaches in insider trading laws and enforcement efforts routinely become headline news, which helps perpetuate the idea that the stock market is a dependable institution.
Insider trading is punishable by hefty fines and imprisonment, and is prosecuted as a civil offense. Milken pleaded guilty to six counts filed against him and paid fines of $600 million, the most ever levied against an individual. The SEC has broad authority to investigate violations of securities laws, including subpoena power and the ability to freeze profits from illegal activities. In the early years of the twenty-first century, insider trading returned to the forefront of the national conscience as a result of the downfall of Houston-based energy company Enron and many other corporations that used illegal accounting procedures to artificially bolster stock prices.
Chernow, Ron. The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance. New York: Atlantic Monthly Press, 1990.
Gordon, John Steele. The Great Game: The Emergence of Wall Street As a World Power, 1653–2000. New York: Scribner, 1999.
Holbrook, Stewart H. The Age of Moguls: The Story of the Robber Barons and the Great Tycoons. New York: Doubleday, 1954.
Stewart, James B. Den of Thieves. New York: Simon and Schuster, 1991.
See alsoStock Market .
in·sid·er trad·ing (Brit. also insider dealing) • n. the illegal practice of trading on the stock exchange to one's own advantage through having access to confidential information.