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What Is Insider Trading and How to Avoid It – Definition, Laws & Cases

By Kalen Smith

insider trading informationWhen you hear the term “insider trading,” you probably immediately think of someone like Martha Stewart.

But you don’t have to be famous or wealthy to be guilty of it. In fact, it’s possible to engage in insider trading without even knowing it.

In this article, we’ll look at the ins and outs of insider trading and how to make sure that the investing you’re doing is above board – and won’t come with a stint in jail.

What Is Insider Trading?

Insider trading is the practice of using information that has not been made public to execute trading decisions. It gives traders an unfair advantage over others and most forms of insider trading are illegal. Many investors are tempted to make quick returns from insider trading, but doing so can be dangerous. Insider trading is routinely investigated by the Securities and Exchange Commission (SEC) and prosecuted.

What Constitutes Insider Trading?

Investment markets need investors to have access to the same information in order to be effective (i.e. the efficient market hypothesis). The point of these markets is to reward investors who can make the best analyses of the securities they hope to invest in. However, some choose to manipulate the system by using information that others don’t have available to them.

The most recent definition by the SEC outlines insider trading as “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. Insider trading violations may also include ‘tipping’ such information, securities trading by the person ‘tipped,’ and securities trading by those who misappropriate such information.”

The stereotypical example of insider trading involves a cloak and dagger campaign where someone inside a company is intentionally passing information to an outsider who then places trades. The 1987 movie Wall Street demonstrated this example in a way that helped educate Americans on the nature and consequences of securities fraud. The SEC has broadened its definition of insider trading so that it can narrow the possibilities of an investor or organization finding a loophole and escaping punishment. Insider trading can now involve many different offenses, so investors should be wary if they feel they are doing anything that may look shady if they are ever looked at by the SEC.

Forms of Insider Trading

There are a variety of ways that insider trading can be conducted:

  1. Members of an organization purchasing a security. Employees or members of publicly traded companies are in key positions to access information that would not otherwise be available to the general public. Some of them buy and sell securities based on this information and hope to profit from it when the news is eventually released. Employees are given stock options so there are legal instances where they can purchase shares. However, the rules are complicated and the line is often blurred between what is a legal form of insider trading and what is not.
  2. Professionals who do business with the corporation. Bankers, lawyers, paralegals, and brokers are but a few of the consultants who have access to confidential documents of their corporate clients. They may choose to abuse this privilege as an opportunity to make a quick buck through insider trading.
  3. Friends, family, and acquaintances of corporate employees. Corporate employees often share information within their own circles that is not shared with Wall Street and the general public. Sometimes these disclosures are made innocently, but other times they are made with the intention of allowing their friends to trade securities with an advantage that other investors would not have. Employees may give these tips to help out a friend in a tough time or they may be asking their friends to pay them a small incentive. Employees may trade through their friends and acquaintances since they are less likely to be scrutinized by the SEC than the employees themselves.
  4. Government officials. Officials of different government agencies can gain access to confidential information through the execution of their duties. They may conduct insider trading with this information.
  5. Hackers, corporate spies, and other thieves. Clever criminals find a number of ways to gain access to corporate information which they can use to conduct securities fraud.

How Is Insider Trading Investigated and Prosecuted?

Insider trading is usually identified through market surveillance systems. The SEC monitors securities markets and tracks them for abnormal trading patterns. They rarely are made through tips or complaints.

Once an abnormal pattern has been identified, the SEC vigorously pursues anyone they believe may be involved. They obtain warrants for financial records and wiretaps, and find any other means to pursue the evidence that comes their way. If enough evidence is found to indict someone for insider trading, those individuals will be arrested and the case is handed over to a U.S. attorney.

Insider trading is prosecuted just like any other criminal case. Anyone convicted of insider trading can be sentenced up to $5 million in fines and up to 20 years in prison for each act they commit. However, actual sentences for these crimes are often much less. In New York, almost half of those sentenced didn’t have to spend any time in prison.

Make Sure You Don’t Accidentally Conduct Insider Trading

Innocent investors may accidentally conduct insider trading. There are a few precautions you can take to make sure that you are acting within SEC regulations and not putting yourself at risk of prosecution or losing any trading licenses you may hold. Here are some suggestions:

  1. Watch the questions you ask when you are receiving information about a security. You need to be careful that you don’t phrase questions in a way that provokes someone to divulge confidential information before you conduct a trade. It is equally important that you don’t give the impression that you are looking for that kind of information. Doing so can get you in just as much trouble as actually conducting an inside trade.
  2. Check your sources. If anyone you are connected to gives you information before you conduct a trade, make sure that you can find the same information through publicly available information. If you can’t find that information anywhere else, you may not want to pursue the trade.
  3. Report to the proper authorities when you receive information relevant to your portfolio that you are unsure is public or not. This can help prove that you have no intention of discreetly using insider information and that you have honest intentions.
  4. Identify when someone providing information to you is violating a breach of duty. This is a red flag that you are hearing information you shouldn’t be. Also, if they signed a confidentiality agreement and provide information, the consequences for insider trading are even worse. Make sure that you are aware of what information they pass along to you and whether or not that information is passed in a way that is likely to violate insider trading statutes.
  5. Make sure everyone you trade with is clear on insider trading policies. You may be held liable for the actions of anyone else on your team. Have policies and agreements in place to ensure that no one trades outside the bounds of securities laws.
  6. Be careful how you repay favors. You may be in a situation where you have access to insider information on your employer or a company you have worked with. If somebody has done a favor for you before, make sure that you are careful how you repay that favor. Don’t offer sensitive information. If you do, you are just as guilty of securities fraud as they are.

Insider Trading Examples

Many people have been prosecuted for insider trading, although some cases have received much more publicity than others. A few of the more famous insider trading cases include:

  1. Ivan Boesky. Ivan Boesky was an arbitrageur in the 1980s who made millions from takeovers. The value of stocks of companies he intended to buyout would increase significantly before he made a takeover bid. Sometimes, he would buy stocks just before he made a proposal and wait for the value of those stocks to increase. Eventually, Merrill Lynch informed the SEC that someone appeared to be leaking information. This person was Dennis Levine, one of the men that Boesky paid to help him orchestrate the scam. After the SEC audited Levine’s bank account overseas, Levine gave up Boesky, who then took a plea bargain in exchange for a lesser sentence. He paid $100 million in fines and was sentenced to three and a half years in prison, of which he served two. Some have claimed that the main antagonist of the film Wall Street, Gordon Gekko, is based off of Ivan Boesky, but that link can only partially be made. In actuality, Gekko was inspired by many traders in the 1980s who committed securities fraud.
  2. Albert Wiggin. Albert Wiggin was the head of Chase National Bank during the Great Depression. He was short-selling shares of stock in his own company, which would be a very serious act of securities fraud today. He proceeded to drive his company near bankruptcy. Since there were no laws against insider trading back in the 20s, he was never charged with a crime. He was even offered a pension from the very bank he ruined, but the public’s anger at what he did made him decide to decline. Wiggin and men like him during this time were the reason the Securities and Exchange Act was introduced.
  3. Martha Stewart. Martha Stewart is possibly one of the most classic cases of insider trading over the past decade. She had a tendency to know when the FDA would make a particular decision regarding a drug. Later, it was discovered that she received some information from Peter Baconovic, who was her broker at the time. She could see that a new drug offered by ImClone would be rejected by the FDA and sold her shares before the stock dropped. When it was discovered she had a preexisting sell order, she was indicted and convicted of securities fraud. She spent five months in a federal prison and two years of supervised release.
  4. R. Foster Winans. R. Foster Winans was a columnist for the Wall Street Journal. His advice was very well-respected and had a tendency to drive up the price of the stocks he covered. He was caught leaking information on the stories he was going to cover to brokers, who could trade before his column was actually published. It was difficult to find that Winans was selling insider information, because he was really only selling his own opinions. However, the SEC was able to find that his contents were actually the property of the Wall Street Journal and that he was disclosing material information. This precedent meant that he could be convicted of a crime but the Wall Street Journal was  legally allowed to trade on the information contained in its stories.

Final Word

The act of insider trading is a serious crime. Before you are tempted to trade securities based on information that is not publicly available, you should be aware of the consequences for doing so. You could possibly spend up to 25 years in prison and the chances of getting caught are a lot higher than you’d think. If professional investors and financial managers have been convicted of securities fraud, you should do everything you can to avoid these charges.

What are your thoughts on insider trading?

(photo credit: Shutterstock)

Kalen Smith
Kalen Smith has written for a variety of financial and business sites. He is a weekly contributor for Young Entrepreneur and has worked as a guest blogger on behalf of Consumer Media Network. He holds an MBA in finance from Clark University in Worcester, MA.

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