What is Insider Trading?
Insider trading is the trading of a corporation’s securities, such as stock, bonds, or stock options, by people who have access to non-public information about the company. Although generally thought of as criminal, certain types of insider trading are completely legal and in fact common. The Securities and Exchange Commission (“SEC”) is the government entity in charge of policing and prosecuting illegal acts of insider trading as well as creating rules to clarify what conduct is prohibited.
An “insider” is a person with access to “material” inside information – information that might affect the company’s stock price and/or the investment decisions of the public and is not available to the public. Certain parties, such as officers, directors, and holders of more than ten percent of a corporation’s common stock are always considered insiders. Additionally, the company’s accountants, attorneys, and bankers are always considered “constructive insiders” if, by virtue of their employment, they have access to inside information.
Legal Insider Trading
By necessity, insiders are allowed to trade in the stock of their company; however, these trades are subject to significant regulation. First, directors, officers, and principal stockholders (the beneficial owner of more than ten percent of any class of stock or any equity security) are required to report any purchase or sale of a corporation’s securities to the SEC within two business days of the transaction. Purchases and sales are reported to the SEC by filling out SEC Form 4.
Additionally, directors, officers, and large shareholders must forfeit any “short swing” profits to the corporation. A short swing profit is any profit made by buying and selling the same security at different prices within a six month period. For example, if a director sells 10 shares of stock for $100 on June 1, 2010, and has bought shares of stock between December 1, 2009 and December 1, 2010 for less than $100, he can be sued and will be forced to pay the company the difference between what he paid and the $100 he sold the stock for.
Finally, directors, officers, and large shareholders are allowed to buy or sell stock in accordance with a preexisting written binding plan for future trading, regardless of whether or not they contained inside information during that time period. For example, if an officer enters a binding agreement to buy 100 shares at the market price on May 1, 2012, he is permitted to buy 100 shares at market price on May 1, even if he is in possession of inside information indicating the market price is too low.
Illegal Insider Trading
Illegal insider trading occurs in two primary ways. The first is trading that would otherwise be legal, but does not comply with the requirements articulated above, for example an otherwise permissible trade by an insider that is not reported using SEC Form 4. The second type is engaging in prohibited acts of trading, generally by trading in violation of SEC Rule 10(b)-5. Although Rule 10(b)-5 prohibits a wide range of deceptive practices (and not just insider trading) its primary application is to prohibit insider trading.
As applied to insider trading, Rule 10(b)-5 requires parties in possession of material non-public information, who do not necessarily have to be insiders themselves, to either disclose any nonpublic information (which, under SEC Regulation FD they must disclose to the public at large, not only the counter-party to a trade) or abstain from trading. Under 10(b)-5, both insiders and their tippees (people they communicate the inside information to) can be held liable if either the insider or their tippee trades on the information. Parties that acquire inside information by misappropriating the information (for example stealing financial documents) are liable for insider trading if they trade on the information, in addition to any civil or criminal liability for misappropriating the information.
Consequences of Insider Trading
Federal law provides three primary forms of liability for insider trading. First, under the Insider Trading Sanctions Act, the SEC is authorized to sue people insider in insider trading for damages equal to three times the profit gained and/or the loss avoided as a result of the defendant buying or selling securities based on insider information. Additionally, individuals who traded at the same time the insider traded. Damages for suits of this kind are limited to amount of profit gained or loss avoided by the insider. Finally, insider trading is a criminal act punishable by up to 10 years in prison and a fine of up to 2.5 million dollars.
