Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Insider trading — the practice of using confidential, nonpublic (or “insider”) information to the investor’s own advantage — can be a criminal offense.
Trading specialists have defined the term “confidential information” as material information about an investment that is not available to other investors. That insider knowledge can tilt the playing field in favor of the recipient, leading to an imbalanced trading landscape that investment industry regulators rigorously attempt to keep fair and balanced.
That said, there are some types of insider transactions that fall within the boundaries of the law.
Key Points
• Insider trading refers to the illegal practice of buying and/or selling shares of a public company, using nonpublic information about the company that’s material to its performance.
• The most egregious examples of insider trading involve stealing or illegally obtaining sensitive company information.
• If discovered, insider trading may provoke severe penalties, including fines or time in prison.
• That said, some investors may be privy to “inside” information that is legal to use when making trades, as long as they follow SEC rules.
• When investors file the requisite reports with the SEC about potential insider trades, these may be considered legal.
History of U.S. Insider Trading Laws
Insider trading rules and regulations in the U.S. date back to the early 1900s, when the U.S. Supreme Court ruled against a corporate executive who bought company stock based on insider information. The ruling, based on common law statutes long used by the United Kingdom, laid the path for Congress to pass a law prohibiting sales security fraud (the 1933 Securities Act of 1933) that was further solidified by the Securities Exchange Act of 1934.
Those laws not only prohibited profiting from the sale of securities tied to insider information, they also largely blocked quick turnaround trading profits by an investor who owned more than 10% of a company stock.
Fast forward to 1984, when Congress passed the Trading Sanctions Act, and subsequently the passage of the Securities Fraud Enforcement Act of 1988. These set financial penalties of three times the amount of income accumulated from insider trading, further clarifying the definition and rules surrounding insider trading.
Examples of Insider Trading
The practice of insider trading can manifest in myriad ways. Broadly, anyone who steals, misappropriates, or otherwise gathers confidential data or nonpublic information, and uses it to profit on changes in a company’s stock price, might be investigated for insider trading.
Here are some common examples:
• A company executive, employee, or board member who trades a corporation’s stock after being made aware of a particular business development — like the sale of the firm, positive or negative earnings numbers, a company scandal or significant data breach — could be construed by regulators as insider trading.
• Any associates — like friends, family, or co-workers — of company executives, employees, or board members, who also trade on private information not available to the investing public, may be targeted for insider trading.
• Executives and staffers of any company that provides products or services to another company, and who obtain information about a significant corporate move that would likely sway the firm’s stock price, could be trading on “inside” news.
• Local, city, state, or federal government managers and employees who may come across sensitive, private information about a company that’s not available publicly, and use that knowledge to profit from a change in the company’s stock price, could be involved with insider trading.
The above examples are among the most egregious insider trading scenarios, and are also more likely to become an enforcement priority for government regulators.
Is Insider Trading Ever Legal?
Most investors who buy stocks online or through a brokerage don’t need to worry about insider trading rules. In addition, there are scenarios where what is technically considered “insider trading” is in fact legal under federal regulatory statutes.
For instance, anyone employed by a company could fall under the definition of an insider trader. But as long as all stock transactions involving the company are registered with the U.S. Securities and Exchange Commission in advance, an employee stock transaction may be considered legal.
That’s the case whether a rank-and-file employee buys 100 shares of company stock or if the chief executive officer buys back shares of the firm’s stock — even if that more high-profile trading activity significantly swings the company’s share price.
Who Enforces Insider Trading Rules?
Insider trading enforcement measures operate under the larger umbrella of the U.S. government.
How Insider Trading Is Investigated
Insider trading investigations usually start on the firm level before the SEC gets involved. Self-regulating industry organizations like the Financial Industry Regulatory Authority (FINRA) or the National Association of Financial Planners (NAPF), for example, may also come across illegal trading practices and pass the lead on to federal authorities.
It’s also not uncommon for insider trading practices to be revealed by government agencies other than the SEC. For example, the FBI may run into insider trading activity while pursuing a completely separate investigation, and pass on the tip to the SEC.
When the U.S. Securities and Exchange Commission (SEC) investigates potential insider trading cases, they do so using multiple investigatory methods:
Surveillance. The SEC has multiple surveillance tools to root out insider trading violations. Tracking big variations in a company’s trading history (especially around key dates like earnings calls, changes in executive leadership, and when a company buys another firm or is bought out itself) is a common way for federal regulators to uncover insider trading.
Tipsters. Investors aware of insider information, especially those who lose money on insider trades, often provide valuable leads and tips on insider trading occurrences. This often occurs in the equity options market, where trade values increase significantly with each transaction, and where stock prices can especially be vulnerable to big price swings after suspicious trading activity in the options trading marketplace.
If, for example, a trader with inside information uses it to buy company stock or to buy an option call for profit, the party on the other side of the trade, who may stand to lose significant cash on the trade, may alert the SEC that profiteering via inside information may be taking place. In that scenario, the SEC will likely appoint an investigator to follow up on the tip and see if insider trading did occur.
Company whistleblowers. Another common alert that insider trading is occurring comes from company whistleblowers who speak up when company employees or managers with unique access to company trading patterns seem to be benefitting from those price swings.
What Happens in an Insider Trading Investigation
When federal regulators are made aware of securities fraud from insider trading, they may launch an investigation run by the SEC’s Division of Enforcement. In that investigation:
• Witnesses are contacted and interviewed.
• Trading records are reviewed, with a close eye on trading patterns around the time of potential insider trading activity.
• Phone and computer records are subpoenaed, and if needed, wiretaps are used to gain information from potential insider trading targets.
• Once the investigation is complete, the investigation team presents its findings to an SEC review board, which can decide on a fine and other penalties (like suspension of trading privileges and cease-and-desist orders) or opt to take its case to federal court.
• After the court hears the case and decides on the merits, any party accused of insider trading is expected to abide by the court ruling and the case is ended.
Penalties for Insider Trading
An individual convicted of insider trading can face both a prison sentence and civil and criminal fines — up to 20 years and as much as $5 million. Additionally, civil penalties may include fines of up to three times the profit gained, or loss avoided, as a result of the insider trading violation.
Companies that commit insider trading can face civil and criminal fines. The maximum fine for an entity whose securities are publicly traded that has been found guilty of insider trading is $25 million.
The Takeaway
Insider trading — executing a trade based on knowledge that has not been made public — is a serious offense and can lead to severe punishment, including jail time and heavy fines.
That’s all for good reason, as restrictions on insider trading help ensure a balanced financial trading market environment — one that accommodates fair trading opportunities for all market participants.
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FAQ
What is an example of insider trading?
If a company executive or employee at a pharmaceutical company learns of an upcoming drug approval and buys shares based on that information, that could be insider trading.
Is it illegal to buy stock in a company you work for?
No. Buying stock in a company you work for is not necessarily an incidence of insider trading — unless you used confidential, nonpublic information to time the purchase of the shares and gain accordingly.
How do people get caught for insider trading?
The SEC and companies themselves may use a combination of surveillance and data analysis, especially watching trades around news headlines, to catch insider traders.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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