You may have heard the term “insider trading” in financial dramas on television or in movies, but what exactly does it mean? Insider trading involves trading a public security, such as a stock or bond, by someone with material, non-public information that affects the security’s value.
Here’s what else you need to know about insider trading, including when it can happen legally.
What is insider trading?
The Securities and Exchange Commission, or SEC, defines illegal insider trading as “buying or selling a security, in breach of a fiduciary duty or other fiduciary relationship, based on material, non-public information about the security.”
The rule also applies to people who pass on the information or tip others so that they can benefit from the information. People who trade on the tipped information may also be violating insider trading laws.
Insider trading laws exist to maintain confidence in the securities markets. Allowing some people to trade with privileged information undermines public confidence in the financial system.
Information is considered material if it could affect the value of a security, and is considered non-public if it has not been publicly announced or widely shared. Companies typically announce material information, such as earnings announcements or corporate merger news, in press releases or SEC filings.
When is insider trading illegal?
Insider trading is illegal when a person or entity buys or sells a security while in possession of material, non-public information. Once the information has been made public, it is no longer illegal to trade with it as you would not have an unfair advantage.
Suppose you work in the accounting department of a publicly traded company and help prepare the company’s financial statements every quarter. If you notice that the company’s results are particularly strong for the current quarter and buy shares before earnings are announced, you will be violating insider trading laws and risking fines and possible jail time.
At the same time, if you pass that information on to someone else, you could both be prosecuted for illegal insider trading.
When is insider trading legal?
Insider trading is not always illegal. It also refers to the buying and selling of shares by executives or directors of a company. These transactions must be disclosed to the SEC shortly after they are made and are sometimes planned months in advance.
These SEC forms involve insider trading:
- Form 3: This form must be filed within 10 days of someone becoming an “insider,” which is defined as an officer or director of the company. It shows the insider’s initial interest in the company.
- Form 4: When an insider trades in the company’s securities, he/she must disclose the transactions within two business days of the date of the transaction.
- Form 5: This form is similar to Form 4, but covers transactions from the previous year that were not previously disclosed due to an exemption or failure to report. Some transactions do not need to be reported directly on Form 4, but must be reported on Form 5.
Examples of well-known insider trading scandals
Martha Stewart
In 2003, Martha Stewart and her Merrill Lynch broker were charged with securities fraud in connection with insider trading of ImClone stock in 2001. The CEO of ImClone, a biopharmaceutical company, was also a client of Stewart’s broker and had all the shares he owned sold. and his daughter at Merrill Lynch awaiting the FDA’s rejection of an ImClone cancer treatment.
Stewart’s broker tipped her off, and she avoided a $45,673 loss when the FDA’s ruling was made public. She later lied to the SEC and investigators about the transactions and ultimately served five months in federal prison.
Former Amazon (AMZN) employee
The SEC charged former Amazon financial analyst Brett Kennedy and his college roommate with insider trading in 2017. The indictment alleged that Kennedy obtained early access to Amazon’s first-quarter 2015 earnings report and sold the information to Maziar Rezakhani, his roommate, for $10,000. Rezakhani made more than $116,000 in illegal profits by trading on the information and shared some of those profits with his advisor Sam Sadeghi, the SEC alleged. Kennedy was sentenced to six months in prison and a $2,500 fine.
Dean Food
In 2016, the SEC charged famed Las Vegas sports gambler Billy Walters with insider trading, alleging he made $40 million in illegal profits after former Dean Foods board member Thomas Davis, who owed Walters money, told him had tipped off about information about the company over a five-year period.
Walters shared the material non-public information with professional golfer Phil Mickelson, who used the information to make nearly $1 million in illegal profits, which he used to pay a debt to Walters. Mickelson was not charged, but was named as an assistant defendant for the purpose of recovering the profits made from Walters’ illegal scheme.
Walters was sentenced to five years in prison, while Davis was sentenced to two years.
In short
If you are involved in the financial markets, it is important that you have a good understanding of insider trading laws. If you are unsure whether information is material or non-public, it is a good idea to consult a financial expert or attorney before acting on it. Anything close to insider trading should probably be avoided.
