Insider Trading

The term “insider trading” is used to describe the buying and selling activities of an individual who has information about a stock that has not been made public. While the term is typically associated with illegal activity, insider trading can actually be done legally, depending on when the investor makes the trade. Insider trading is generally illegal due to the fact that it is unfair to the other investors who are not privy to such information. To explore this concept, consider the following insider trading definition.

Definition of Insider Trading

Noun

1. The act of buying and selling securities, by someone acting on privileged information, or information that has not been made available to the public.
2. The illegal use of information, which is available only to someone inside the industry, to profit in financial trading.

Origin

1965-1970

What is Insider Trading

Insider trading is the act of buying and selling stock, or other financial commodities, by individuals who have access to information that has not been made publicly available. The practice is generally illegal because it is unfair for one investor to be able to make decisions based on privileged information not available to others. However, some economists have actually advocated for insider trading, saying that it should be allowed because the practice could potentially benefit markets.

The rules associated with insider trading are complicated, and they vary widely in countries throughout the world. Similarly, some countries are harder on enforcing penalties for insider trading than are others. For instance, the very definition of the term “insider” can refer, depending on the country, not only to the investor but also to those related to him. This includes brokers, associates, and perhaps even members of the investor’s family. Any individual who is made aware of information that is not available to the public, and then trades on that information, may be guilty of insider trading.

An example of insider trading would be an employee’s gaining of confidential information about his company after attending a meeting with his superiors, then using that information to buy or sell on the company’s stock. This would give the employee an unfair advantage over that company’s investors who were not privy to such information, such as public investors or even his own coworkers. Another example of insider trading would be a company’s officers, directors, and employees trading on their company’s stock after learning about significant corporate developments that were not made available to the public.

Insider Information

Insider information is information that is not made available to the public and that concerns the future intentions or present or future condition of a publicly traded company. Insider information can potentially provide investors with a financial advantage when they engage in buying or selling that company’s stock. For instance, a company may be thinking about releasing a new product. This information may be both confidential and beneficial to those in the know. If an investor then comes across this information and makes a trade based on what he knows, he may have an unfair advantage if the information has not been made public.

Insider information is usually gained by someone who is either working for or close enough to the company to be made aware of such material. If a person then makes a trade based on this information, then he may be guilty of partaking in insider trading. In the U.S., the Securities and Exchange Commission (SEC) regulates legal insider trades, such as those made by a company’s officers, directors, and employees, and investigates potentially illegal insider trading. The caveat, however, is that it is very difficult to prove that someone may have received an inside “tip” and then made a trade based on that information.

Those who are found guilty of insider trading may be ordered to pay a fine and/or receive a jail sentence for his crime. In addition to potentially receiving civil sanctions, an individual who is convicted of insider trading may be required to serve a maximum prison sentence of 20 years. He may also be ordered to pay a maximum fine of five million dollars. If a company is caught collectively engaging in insider trading, then the company itself may be ordered to pay a maximum fine of twenty-five million dollars. In addition, its individual members may be subjected to individual punishments as well.

Legal Insider Trading

Legal insider trading may sound like an oxymoron, but certain forms of insider trading are actually legal. In fact, legal insider trading happens every week in the stock market. The SEC requires all transactions to be submitted timely and electronically – usually within a few business days after the trade has been made. The transactions must also be made publicly available on the company’s website. Directors and major shareholders must disclose their stakes, transactions, and any changes in ownership. Legal insider trading by specific insiders, like employees, is only legal if the trades do not rely on information that is not available in the public domain.

Insiders are perfectly within their right to buy and sell stock in their own company. As long as insiders are trading on information that has been made generally available to the public, then they are not breaking any laws by engaging in trades because everyone has been given the same fair shot at participating in a trade.

Insider Trading Example Involving a Celebrity

Perhaps the most famous example of insider trading that ever saw the inside of a courtroom was the case involving home decorator and television personality Martha Stewart. In 2003, Stewart was indicted by a federal grand jury on charges of securities fraud, making false statements, and partaking in the obstruction of justice after selling off all her shares of a public stock based on an insider’s “tip.” Merrill Lynch’s Peter Bacanovic, Stewart’s stockbroker, was also indicted on charges of obstruction of justice and perjury for his part in the case.

It all started on December 27, 2001, when Bacanovic’s assistant, Douglas Faneuil, learned that Samuel Waksal, then the chief executive of biopharmaceutical company ImClone Systems, was looking to sell all his ImClone shares. Merrill Lynch was, at the time, ImClone’s broker, and the company’s shares were valued at nearly $7.5 million. Faneuil then brought this information to Bacanovic.

During Stewart’s trial, federal prosecutors stated that Waksal had tried to sell off his shares after learning that the FDA was going to publish a negative report on Erbitux, a promising new cancer drug that played a major role in ImClone’s business. Faneuil ultimately pled guilty to lying to investigators about his part in the case. Stewart had been elected to serve as a director of the New York Stock Exchange right before this situation was made public, however she resigned the day after Faneuil entered his plea.

The indictment went on to explain that Bacanovic had instructed Faneuil to inform Stewart that Waksal intended to sell off all his stock. Stewart then instructed Faneuil to sell off all her stock in the company, which added up to about 4,000 shares. Minutes later, all of Stewart’s shares were sold, to the tune of almost $230,000. The stock sales took place days before ImClone publicly announced that is application to the FDA for approval of Erbitux had been rejected due to insufficient data. Ironically, a study published after the fact concluded that Erbitux was, in fact, effective in fighting cancer.

The indictment went on to say that:

“As a client of Merrill Lynch and as a former securities broker, Martha Stewart knew that information regarding the sale and attempted sale of the Waksal shares had been communicated to her in violation of the duties of trust and confidence owed to Merrill Lynch and its clients.”

Waksal pled guilty to securities fraud and was sentenced to more than the maximum of seven years’ imprisonment that was initially expected. He was given a jail sentence of 87 months, or seven years and three months, along with a fine of $4.3 million in restitution. Stewart was not as heavily penalized. She was found guilty on all four counts of obstruction of justice and lying to investigators, and her sentence was affirmed on appeal. However, she only ended up serving five months in prison at the Alderson Federal Prison Camp in West Virginia, five months of house arrest, and two years of probation upon her release.

Related Legal Terms and Issues

• Restitution – The restoration of rights or property previously taken away or surrendered; reparation made by giving compensation for loss or injury caused by wrongdoing.
• Shareholder – Someone who owns shares in a company. A shareholder, also referred to as a “stockholder,” profits when the company makes money, but also loses money when the company is unsuccessful.
• Stock – A type of security that signifies an investor’s partial ownership of a corporation.
• Stockbroker – Someone who buys and sells stock on behalf of his clients.
• Stock Market – The collection of markets wherein the stocks of publicly held companies are traded, or bought and sold, by the companies’ investors.
• Trial – A formal presentation of evidence before a judge and jury for the purpose of determining guilt or innocence in a criminal case, or to make a determination in a civil matter.