Insider trading is a complicated topic with many gray areas. In many cases, it is perfectly legal (although it may be unwise) to trade on tips you hear or overhear. Illegal insider trading all depends on the facts and circumstances.
If you’re an active investor who occasionally buys or sells stocks based on tips, you need to know the restrictions – and what can land you in jail. In this article, we’ll help you to avoid bad times.
Even seemingly clear-cut cases of this illegal activity can drag on in court for months or years because of the complexity involved. Let’s examine what insider trading is and how to avoid it when buying and selling securities on the stock market.
You overhear a conversation in public.
Bottom line: You’re off the hook.
You’re standing in line at Starbucks, and a well-dressed couple in front of you is talking about retiring to Mallorca after selling their business. They are the founders of a publicly traded company, and you find out that the deal hasn’t yet been announced. You grab as many shares as you can afford and make a fortune after the announcement of the acquisition.
Is This Insider Trading?
If that couple buys or sells stock – or calls you and tips you off in private – that would be a violation. However, illegal insider trading requires that you not only act on the basis of material, non-public information but that you also have some obligation to keep the information confidential. Former soccer coach Barry Switzer was sued for insider trading in a similar case in 1981 but won the case because he had no duty to ignore a conversation he overheard in a public place.
You learn the rumor on the Dark Web.
The bottom line is that if you’re careful enough, you’re off the hook
You’re an investment banker, visiting your friends on your favorite Dark Web forum, and you learn that a publicly traded company you have nothing to do with is about to become the subject of M&A. As long as you can “prove” that you overheard a private conversation in public, you’re safe.
The SEC’s tools are getting better and better every day. They can cooperate with the FBI so that your Internet activities are easily visible to them. We have devoted a separate article to this complicated topic.
You eavesdrop on a private conversation.
Bottom line: You’re in trouble.
You work in a large company. You overhear the company’s board of directors meeting outside the room you are cleaning and decide to hide in the closet. The board approves the sale of the company at a whopping premium to the current stock price. You stock up on the shares. Illegal insider trading?
Now you’re definitely in trouble. This is not a public place, and “You would be in a position to understand that confidential information is being shared, which changes the calculus.”
You get a hot tip from a talkative cab driver.
Bottom line: You’re fine.
You get into a cab at the airport and are amazed at the Armani suit and gold ring on the driver’s finger. You learn that the driver only took on this shift as a favor to a friend. After retirement, the driver is now living off his investment portfolio. When you complain about yours, he says, “Look; I’ll give you a chance. Buy as much Google stock as you can. You do. Is that insider trading?
It’s probably unwise to take unsolicited financial advice from people you don’t know. The cab driver might be as clueless as you are. But you have no reason to believe he is telling you something that is not public knowledge. There is nothing illegal about that.
You get a hot tip from a talkative cab driver who has a connection
Bottom line: Gray area
Once again, a cab driver offers stock tips, but this time he mentions that his son is an attorney at a large law firm that deals with mergers. Insider trading?
This could qualify as insider trading. It will bring unpleasant scrutiny from the SEC, but perhaps no jail time.
Whether you have cause to believe you are receiving crucial, private information from someone who has a duty to keep it secret will depend on your situation. There would definitely be a ban on cab driver’s trade. This scenario is in a gray area that is difficult to defend.
You realize that corporate insiders are selling, so you sell too
Bottom line: You’re off the hook as long as you’re not the company insider.
You read a while back that executives at your favorite company were dumping their stock. They must know something that you don’t, you concluded, so you also sold your shares. Now you fear the feds will come after you. Are you guilty of insider trading?
You have nothing to fear. However, executives could get in trouble.
Executives can sell their own company’s stock without violating regulations as long as they don’t act on the information they didn’t disclose to the public. In 2009 (after the company’s acquisition by Bank of America), the U.S. Securities and Exchange Commission filed a lawsuit against Countrywide CEO Angelo Mozilo and a number of other insiders, alleging that they engaged in improper trading based on the knowledge that the company’s loan portfolio was rife with danger.
Mozilo, who had made about $140 million selling Countrywide stock before the company’s collapse, eventually settled the suit without admitting guilt, paying $67.5 million in fines and forgoing the profits.
As for you, Mozilo’s trades were disclosed in SEC filings and in numerous newspaper reports. Trading based on publicly available information is perfectly legal.
You put two and two together and make a trade
Bottom line: You’re off the hook
A woman in your group says she wants to quit her job because she can’t take the strain of working in a doctor’s office where all the patients are dying. From previous conversations, you know that the patients in this practice are involved in early trials of a new drug. You know what drug it is and who makes it. You sell short shares of the drug’s developer, betting that the shares will fall in value. Have you violated insider trading rules?
This could pique the SEC’s interest but probably won’t be insider trading.
Your gambling partner is sharing information that is so general to gauge whether the clinical trial will fail. Therefore, the tip fails the materiality test. It is not significant enough for the company’s stock price. And since the woman is only sharing information about the status of the office’s patients, not the trial (including whether the sick patients are taking the new drug or a placebo), no one seems to have a duty of confidentiality.
Read More: Discover some of the most notable incidents in which people traded information that the general public lacked.
You trade on the information you have received in the course of your work.
Bottom line: a clear no, no.
You are entrusted with confidential information that the company you work for has been affected by a massive data breach. You buy options on your company’s stock before the public announcement of the security breach to profit if the stock falls on the news.
Now you’ve stepped into it. Remember the Equifax case. Bonthu used confidential information to determine that his company had suffered a massive data breach and then violated company policy to illegally profit from it.
Your stock broker advises you to sell based on non-public knowledge.
Bottom line: It’s better to avoid.
Your broker calls and says you need to get out of your favourite stock immediately because the CEO, who is also his client, is selling all his shares. Insider trading?
That’ll get the SEC on your tail, but maybe not jail time.
If this scenario sounds familiar, that’s because it happened to Martha Stewart. The SEC filed a lawsuit against the stay-at-home mom in 2003 with just that. In the end, Stewart went to jail – but not for insider trading. She was convicted of obstruction of justice and lying to prosecutors.
Stewart settled with the SEC, paid a fine, and agreed not to violate securities laws in the future. The settlement eliminated the need for a trial and a definitive answer to the question of whether she was “required” to ignore the tip. However, Stewart’s previous work as a stockbroker made the situation more challenging. The SEC contended that she should have known better.
Learn how the SEC employs data analysis to discover suspect patterns over time, such as successful insider trading in numerous securities.
You pay professionals for research, analysis, and advice
Bottom line: You’re safe
You are a hedge fund manager and you pay dozens of analysts and consultants to advise you on buying and selling stocks. Some of these advisors may have access to classified information, but you trade based on a wide range of factors, including a review of public documents and detailed analysis of industries and the companies operating in them. Insider trading?
That might get the SEC’s attention, but it’s probably not insider trading.
The key to the famous 2009 case against Galleon Group CEO Raj Rajaratnam. Hinged on whether his lawyers could prove that his trading was based on assembling a “mosaic” of information or whether he paid “consultants” to give him insider tips. The former is perfectly legal.
Who Can Be Charged With Insider Trading?
Purchasing or selling securities while using materially non-public information is known as “insider trading.” It also includes tipping others with this type of information. The Securities and Exchange Commission (SEC) defines insider trading as someone who has access to material, nonpublic information in breach of a fiduciary duty or other relationship of trust and confidence. The SEC states four types of insiders:
- Corporate insiders (a director, officer, or 10% company owner)
- outside directors
- officers
- employees who have access to material nonpublic information
When insiders buy or sell securities based on material nonpublic information while violating their fiduciary duty, they may be charged with insider trading. Corporate insiders include a director, officer, or 10% company owner. A person who sits on a company’s board that another company controls either controls or is known as an outside director. Another corporation. A person who sits on a company’s board that another company controls either controls or is known as an outside director.
Officers include those managing day-to-day operations at a firm, like CEOs, presidents, and vice presidents. Employees with access to material nonpublic information are considered inside traders if they trade shares at any time before the public release of such data.
What Are the Consequences of Insider Trading?
Insider trading involves transactions in which a person with access to confidential information about a corporation’s plans trades the stock, making profits for themselves. In recent years, there have been many high-profile cases of insider trading involving heads of companies such as Martha Stewart and Rajat Gupta. Insider trading is also sometimes referred to as insider dealing or insider knowledge.
According to both state and federal securities laws, insider trading is prohibited. It can lead to penalties, including fines, criminal charges, and imprisonment. Individuals convicted of violating these laws are often sentenced to jail time and ordered to pay significant fines.
A recent example of this is Rajat Gupta, the former director at McKinsey & Co. He was found guilty in 2012 for passing inside tips about Goldman Sachs that he learned from his friend Rajaratnam to his friend Galleon Group founder Rajaratnam.
What Are the Implications of Insider Trading?
Some people think insider trading is an unfair advantage, but others argue that it’s simply a case of someone with more information making better decisions. One way to avoid insider trading would be to ensure there are no inside sources or traders in your company who are privy to confidential information not available to the public. Insider trading does come with some serious risks and implications for those involved.
For example, if you trade on non-public information and you’re caught, you could face civil penalties or even criminal charges. Some people believe this to be an unfair advantage since only those with the power to get this kind of information can benefit from it. However, others contend that insider trading is just a case of someone with more information making better decisions than anyone else because they can factor so much detail into their analysis.
Regardless of your side, both sides agree on one thing: at the end of the day, insider trading comes down to personal ethics and how you want to live your life, either as a cheater or as an honest citizen.
What Are the Risks of Insider Trading?
When a person purchases or sells a security while possessing knowledge that has not been made public, they engage in insider trading. This can be risky because it is illegal and can cause problems if you are caught. Here are some risks to consider before engaging in insider trading:
- You may make money on trade but then get in trouble with the law.
- The company could go bankrupt, and you could lose all your money.
- It’s hard to know how much insider information is about a company, so it’s possible you will still take an unnecessary risk even after hearing information from someone inside the company.
- There are other ways to get valuable information about companies, such as reading their financial statements carefully.
- Be aware of any special relationships you have with people at the company. These relationships might be considered conflicts of interest by securities regulators.
- Insider trading is against the law. You could face prison time and fines and be sued by anyone who loses money because they bought or sold stock based on false information.
How Can Insider Trading Be Prevented?
A common way insiders trade on a company’s confidential information is by sharing it with friends and family. When this happens, the group of people can share the privileged information amongst themselves and profit from any future trades. One way to prevent insider trading from happening, in this case, would be to have a policy that prohibits employees from disclosing any confidential or inside information they have learned while working at their company. If an employee suspects that someone else has been using such inside information, they should report it as soon as possible.
Another way insider trading can happen is when high-level executives are given access to confidential or inside information about their company that was not previously available to other investors. In these cases, the executives may use the knowledge gained to make trades based on what they believe will increase the company’s value. For example, if one executive knows that a new product is coming out next year, but he does not reveal this to anyone else, he could use his knowledge of this information to buy shares in his own company before it becomes public knowledge so that he makes more money once its stock goes up.
How Can You Avoid Being Charged With Insider Trading?
If you’re not privy to information that would allow you to make a trade on inside knowledge, you don’t have to worry about insider trading. Insider trading can only occur when someone with access to sensitive information takes an investment position before that information becomes public. Don’t buy or sell stocks based on nonpublic material information to avoid being charged with insider trading.
Insiders who believe they own material nonpublic information are required by law to keep it confidential and refrain from making trades until after the time at which this information is made public. Violating these laws could lead to serious penalties, including jail time. Violators may also be fined up to three times the profit gained or loss avoided plus the greater of $5 million or three times the value of profit gained or loss avoided. In extreme cases, violators may also face civil lawsuits for damages suffered by those who traded securities due to their illegal activity.
Disclaimer: This article and the information it contains are not intended to be a source of legal advice. We don’t promote any illegal activities such as insider trading or any other crime.
