What is Insider Trading?

Compliance Knowledge Base | Ethics

Posted by: India Wentworth Published: Wed, 17 Jul 2019 Last Reviewed: Wed, 17 Jul 2019
What is Insider Trading?

Insider trading is the process of trading company stocks and shares through individuals with access to non-public information about the company, otherwise known as 'insider' information. The huge development in internet usage has led to an acceleration in the speed that insider trading can occur and makes it more difficult to control.

This may sound familiar, and this is because it was the focus on the ITV drama, Cleaning Up, starring Sheridan Smith in January 2019. The programme featured two cleaners that used their place within a business to exploit the stocks and shares trading information – making a healthy profit as a result.

Although the rules and laws around insider trading vary, in the majority of countries it is illegal due to the fact that it gives some people an unfair advantage. A person who trades using insider information may be guilty of a crime.

Understanding insider trading

Insiders can be in the position of having access to information not known to the public. This could be information about a new product, a merger with another company, a change in leadership or annual earnings reports. Insider trading is apparent when they act on this information before it becomes public knowledge.

Insider trading can be legal and illegal, depending on the ways it is carried out. There is a very fine line between the two, so it is important to understand the difference.

Insider trading is legal when insiders such as employees buy their own company's stock. It is all about the circumstances in which the shares are bought/sold that determines whether it is legal or not.

Trading on the stock exchange using confidential information for one's own advantage is when insider trading becomes illegal. Insider trading crimes can also mean 'tipping' people with confidential information to help them make a profit.

The money made from insider trading becomes criminal, and therefore becomes proceeds of crime (money made through illegal activities).

To clarify, the legal version is simply insiders buying and selling their own company's stock. The illegal version is all about when they choose to trade, why they're doing it, and what information they're using to make that decision.

In other words, insiders can't trade when they have the advantage over the public.

Examples

As explained above, insider trading isn't always illegal. Here are some examples of legal insider trading:

  • A CEO of a corporation buys 1,000 shares of stock in the corporation. The trade is reported to the Securities and Exchange Commission.
  • An employee of a corporation exercises his stock options and buys 500 shares of stock in the company that he works for.
  • A board member of a corporation buys 5,000 shares of stock in the corporation. The trade is reported to the Securities and Exchange Commission.
What is Insider Trading?

Comparably, here are some examples of illegal insider trading:

  • A lawyer representing the CEO of a company learns from a confidential meeting that the CEO is going to be accused of fraud the next day. The lawyer sells 1,000 shares of the company because he knows that the stock price is going to plummet because of news of the fraud.
  • A board member of a company knows that a merger is going to be announced within the next day or so – a move that means the company stock prices are likely to increase. He buys 1,000 shares of the company stock in his mother's name, failing to report the Securities and Exchange Commission so that he can make a profit.
  • A high-level employee of a company overhears a meeting where it is revealed that the company is heading towards bankruptcy because of severe financial problems. The employee has a friend that owns shares of the company, so he tells him to sell his shares in order to avoid losing money.
  • A government employee is aware that a new regulation is going to be passed that will significantly benefit a certain electricity company. The employee secretly buys shares of the electricity company and then pushes for the new regulation to go through as quickly as possible so they can make a profit without being found out.
  • A corporate officer learns of a confidential merger between his company and another lucrative business. Knowing that the merger will require the purchase of shares at a high price, the corporate officer buys the stock the day before the merger is going to go through.

Martha Stewart

One of the most famous examples of insider trading is the case against American TV star and home goods vendor, Martha Stewart.

In December 2001, the Food and Drug Administration (FDA) announced that it was rejecting ImClone's new cancer drug, Erbitux. As the drug represented a major portion of ImClone's pipeline, the company's stock took a sharp dive. As a result, many pharmaceutical investors were hurt by the drop, but not Martha Stewart. She sold 4,000 shares when the stock was still trading in the high $50s and collected nearly $250,000 on the sale. The stock would plummet to just over $10 in the following months.

Stewart claimed to have a pre-existing sale order with her broker, but her lies unravelled and soon enough the public shame eventually forced her to resign as the CEO of her own company. Her friendship with CEO Samuel Waksal suggests that she was warned for the drop in price the shares were about to go through. Waksal was arrested and sentenced to more than seven years in prison and fined $4.3 million in 2003. In 2004, Stewart and her broker were also found guilty of insider trading. Stewart was sentenced to the minimum of five months in prison and fined $30,000.

Legislation

The term 'insider trading' has labelled a 'criminal offence' since 1980 – insider trading is a criminal offence in the UK. All over the world it is seen as the biggest offence against the ethics of a business and is also seen as a way to destroy the confidence in the public around the stock exchange.

The laws around insider trading come from the Criminal Justice Act 1993 and the Financial Services and Markets Act 2000 – although there are small differences between them, both need to be considered when looking into whether insider training has occurred. Additionally, it is sanctioned by civil law under the control of the Financial Services Authority, the FSA.

How can insider trading be avoided?

Follow these top tips to protect yourself from insider trading:

  1. Carry out due diligence checks on everyone you deal with – Whether it is new or existing employees or any other contacts you have, you need to know who you are dealing with to avoid insider trading.
  2. Be careful in trade or social events – If you are in close contact with other financial firms, and sensitive topics are being discussed, stay out of them.
  3. Know your information – Make sure you actually know what information is non-public, and what you are and aren't legitimately allowed to share – this knowledge means you can avoid unlawful disclosure.
  4. Keep things to yourself – Never disclose non-public information to outsiders, you never know what they might do with that information, and if they profit off information you have given them, you are just as guilty as them.
  5. Be aware – If you have any concerns, don't stay quiet. Report any worries you have to your manager.
  6. Blackout periods – This is when traders are barred from buying or selling stocks and shares at certain times, such as just before any company changes.

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