What is insider trading and when is it illegal?

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• Insider trading is the trading of stocks and securities based on non-public insider information.
• While insider trading can be done legally, illegal violators can face serious penalties.
• The SEC has put laws and safeguards in place to protect investors and ensure a more fair market.

Fair trading opportunities are necessary for people to feel like they can trust the price of securities and participate in the stock market with confidence. This is why there are laws and regulations in place to eliminate market trades that aren't conducted on a level playing field. One example of this is insider trading.

Insider trading violates trust and fiduciary duty while also leading to serious legal implications. The victims are often everyday investors — and the economy as a whole. Here's how it works and what to watch out for.

What is insider trading? 

Insider trading is the practice of buying and selling stocks, bonds, or other securities based on material or information that the general public doesn't have access to. Material information is defined as non-public (financial) information about a publicly traded company or security that would influence an investor to buy or sell securities.  

Insider trading has been a hot-button issue for many years. In 1934, Congress created the Securities Exchange Commission (SEC) as a government oversight agency designed to regulate securities and protect investors. 

That same year, Congress also passed the Securities Exchange Act of 1934, which allows the SEC to require publicly traded companies to periodically report financial statement schedules, profit and loss statements, and material contracts information regarding directors and officers in the organization who hold more than 10% of an equity security. 

The SEC is key in that it protects investors by enforcing federal security laws like the Securities Exchange Act and holds violators accountable for breaking the law. 

Understanding insider trading 

It's common for people to discuss the stock market and make predictions, which can lead to certain trading decisions. But it's always important to know when the information being exchanged is okay to have and use to inform your investing decisions. 

The SEC defines insider trading as when someone trades a security while they possess knowledge of material non-public information about that security or company. While the Securities Exchange Act is clear about when insider trading is considered a securities fraud violation, there are some cases where it can be legal. 

So what exactly constitutes illegal insider trading? 

Let's say an insider works at a company and owns some shares of its stock. This person receives private information about the company being faced with a major lawsuit. As a result, they opt to sell their shares before the news is made public. 

The person who buys the shares from this insider has no idea about the lawsuit and that the company's value will soon decrease. The following week, the news breaks and the stock value goes down. This is a prime example of illegal insider trading and how it can negatively impact everyday investors.

"The worry is that if this happens often, people won't be as willing to buy stocks and they'd be less trusting of the market in general,'' says Robert C. Hockett, a lawyer and law professor at Cornell University. "Less investment money flowing into companies can mean fewer productive activities, wealth generation, and even employment opportunities."

But then there are situations where insider trading may be legal. Legal insider trading is common since insiders can buy and sell shares of their own company — so long as they follow specific timing guidelines and accurately report the trades to the SEC. Finally, insiders are also required to fill out Form 4 detailing what they bought, when, and for how much. 

The information on this form is made public through the Electronic Data Gathering, Analysis, and Retrieval system also known as EDGAR, which is the primary system for companies and others submitting documents to the SEC under the Securities Act of 1933. In some cases, the insider may have to refrain from trading (often until the non-public information becomes public) and can trade during a specific trading window in the future.

Insider trading vs. insider information 

Insider information is non-public knowledge that insiders obtain about a company and/or its assets. If this person uses this information to improve their investments in the market, then it becomes insider trading.

A real-life example of someone misusing insider information occurred in 2014, when a California attorney heard from his pharmaceutical client, Spectrum, that the company was about to experience a significant decline in revenue. One of the company's best-selling drugs was underperforming, but this was confidential information that was not yet public. 

The attorney decided to sell all his shares of Spectrum within 48 hours. The lawyer tipped off his wife who also sold her shares of stock and together they avoided $45,000 of losses before the bad news was made public. In this situation, insider information quickly turned into illegal insider trading.

Hockett explains that while situations like this one clearly violate the Securities Exchange Act, there could be a gray area in regards to what counts as inside information. 

"Legitimate expertise is okay to trade on because insider trading rules weren't established to punish people who do their research and make smart trades," says Hockett. "If you're an expert on solar power and do your due diligence, which allows you to make some profitable trades, there is nothing wrong with this."

Hockett adds that it's always wise to do your own research when making investment decisions. However, the key point is that insiders have unfair access to some information and shouldn't be able to trade freely this way without disclosing it.

What are the penalties for insider trading? 

The penalty for insider trading could range from a fine to jail time of up to 20 years. 

"There are two main ways to enforce insider trading laws," says Hockett. "Someone can decide to sue the insider and say they defrauded them and took advantage of them by selling them securities that they knew would lose value shortly after."

Hockett says that victims of insider trading can report insiders to the SEC and from there, the SEC could decide to pick up the case.

"The SEC has more resources than the average person so it could be easier for them to pursue violators and gather evidence," Hockett adds.

In civil suits, violators of insider trading laws could be ordered to give back the money they received from the sale and repossess ownership of the stock. The SEC could then add fines on top of this punishment totaling up to $50,000 per individual violator. The California attorney and his wife who were both implicated in doing illegal insider trading back in 2014 agreed to pay a fine at the steep price of $90,000.

Keep in mind that the SEC also tracks market activity regularly to identify situations that might involve insider trading. So a report may not even need to be filed for them to notice illegal insider trades.

The bottom line

Insider trading can lead to a loss of trust in the stock market which can negatively affect the entire nation's economy. If you ever find yourself in the position of an insider, it's important to know the clear difference between legal and illegal insider trading to avoid any financial and legal implications. 

Investing and risk go hand-in-hand. However, you also have the ability to determine your risk tolerance and do your due diligence by researching public information about your securities and noting market trends. Thanks to the Securities Exchange Act that's closely regulated by the SEC, there are few annual cases of insider trading to be wary of.