What is Insider Trading?
Insider trading occurs when a person uses information that is not known to the public to buy or sell stocks or other securities and involves a breach of trust or fiduciary duty. An insider is typically considered a person who has access to material information (i.e. a friend of a company executive who sees company documents, a company employee or executive, etc.) or a person who has stock ownership greater than or equal to 10% of a company’s equity.
Material information is considered information in all likelihood would influence an investor’s investment decisions or information that can affect the price of an issuer’s security. Material information can include (but is not limited to) information concerning:
- Changes in previously released earnings estimates
- Dividend changes
- Earnings estimates
- Extraordinary management developments
- Liquidity issues
- Litigation
- Significant merger or acquisition proposals or agreements
Legal vs. Illegal Insider Trading
It is important to note that insiders can legally buy and sell shares of their firm or subsidiaries. However, their transactions must adhere to federal laws, be properly registered with the Securities and Exchange Commission (SEC), and be done with advance filings. Legal insider trading can occur when an employee purchases stock in the company that employs them or an executive buys back shares of their company. Insider trading only becomes illegal when non-public information is used for profit or to avoid a loss.
Insider Trading Examples
Insider trading can happen in a variety of ways. It is also important to note that anyone can commit insider trading—not just company executives, employees, or stockbrokers. Example scenarios of insider trading are:
- A family friend uses information from a company employee to dump certain stocks.
- A company executive trades corporate stocks after they learn undisclosed information about the company’s financial health.
- An employee at a brokerage, law, banking, or printing firm made a trade based on files or financial statements they have access to as they render services to clients.
- A political consultant offers tips to other people on what to buy or sell based on private government data.
Some real-life examples of insider trading cases include the following four infamous cases.
- Albert H. Wiggin & Chase. He was discovered to have shorted over 40,000 shares of his company after the Wall Street Crash of 1929; he had a vested interest in running his company into the ground as he was head of the bank (Chase National Bank) and knew of the impending market crash. When many investors left Chase National Bank stock because of the 1929 crash, Wiggin profited $4 million. Since insider trading wasn’t illegal at the time, he was able to keep this money despite the public outcry and anger at his “ill-gotten” gains.
- Jeffrey Skilling & Enron Corporation. After learning of his company’s financial situation, Skilling dumped $60 million of Enron stock and then quit his job. Soon after the company struggled and got involved in a complicated bankruptcy.
- Martha Stewart & ImClone. After a new cancer drug from ImClone was not approved by the Food and Drug Administration (FDA), the company’s stock experienced a drastic and quick drop. The SEC discovered that many people, including company executives and family and friends of the CEO of Erbitux (the new drug), had not experienced losses and had sold their stocks. Martha Stewart was amongst those who sold their shares before the stock plummeted, and an investigation revealed that her broker told her the stock would drop in advance.
- R. Foster Winans & The Wall Street Journal. Winans was a Wall Street Journal columnist who wrote a column that highlighted a certain stock; each stock highlighted in the column either went up or down based on the opinions in the column. Winans made a deal with a group of stockbrokers to share the details about the stock he was featuring in the column so that the brokers could make purchases before the column was published. The SEC initially had problems prosecuting Winans, since a newspaper column is not typically considered material insider information. However, eventually, Winans was charged and convicted, because the column was The Wall Street Journal’s property and not his own.
Is Insider Trading a Felony?
Insider trading can have both criminal and civil consequences. The SEC can pursue civil action against any person who violates insider trading rules, and the violator may be required to pay fines that are vastly greater than the amount of profit gained (or losses avoided).
Criminal insider trading is punishable by up to 20 years of imprisonment and/or a fine of up to $5 million for individual violators or $25 million for business entities.
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