When hearing news stories about illegal insider trading activity, investors usually take notice because it's an activity that affects them, often negatively. Although there are legal forms of insider trading, the better you understand why illegal insider trading is a crime, the better you'll understand how the market works. Here we discuss what an illegal insider is, how it compromises the essential conditions of a capital market and what defines an insider.
What Is It and Why Is Insider Trading Harmful?
Insider trading occurs when a trade has been influenced by the privileged possession of corporate information that has not yet been made public. Because the information is not available to other investors, a person using such knowledge is trying to gain an unfair advantage over the rest of the market.
Using nonpublic information for making a trade violates transparency, which is the basis of a capital market. Information in a transparent market is disseminated in a manner by which all market participants receive it at more or less the same time. Under these conditions, one investor can gain an advantage over another only through acquiring skill in analyzing and interpreting available information. This skill is based on individual merit and awareness. If one person trades with nonpublic information, they gain an unfair advantage that is impossible for the rest of the public to have. This is not only unfair but disruptive to a properly functioning market: if insider trading were allowed, investors would lose confidence in their disadvantaged position (in comparison to insiders) and would no longer invest.
The Law
In August 2000, the Securities and Exchange Commission (SEC) adopted new rules regarding insider trading (made effective in October of the same year). Under Rule 10b5-1, the SEC defines insider trading as any securities transaction made when the person behind the trade is aware of nonpublic material information, and is hence violating their duty to maintain confidentiality of such knowledge.
Information is defined as being material if its release could affect the company's stock price. The following are examples of material information: the announcement that the company will receive a tender offer, the declaration of a merger, a positive earnings announcement, the release of the company's discovery such as a new drug, an upcoming dividend announcement, an unreleased buy recommendation by an analyst and finally, an imminent exclusive in a financial news column.
In a further effort to limit the possibility of insider trading, the SEC has also stated in Regulation Fair Disclosure (Reg FD), which was released at the same time as Rule 10b5-1, that companies can no longer be selective as to how they release information. This means that analysts or institutional clients cannot be privy to information ahead of retail clients or the general public. Everyone who is not a part of the company is to receive information at the same time.
Who Is an Insider?
For the purposes of defining illegal insider trading, a corporate insider is someone who is privy to information that has yet to be released to the public. Insiders are expected, as well as mandated by law, to maintain a fiduciary duty to the company and to the shareholders and is obligated to retain in confidence the possession of the nonpublic material information. A person is liable of insider trading when they have acted on such privileged knowledge in the attempt to make a profit.
Sometimes it is easy to identify who insiders are: CEOs, executives and directors are of course directly exposed to material information before it's made public. However, according to the misappropriation theory of insider trading cases, certain other relationships automatically give rise to confidentiality. In the second part of Rule 10b5-2, the SEC has outlined three nonexclusive instances that call for a duty of trust or confidentiality:
- When a person expresses agreement to maintain confidentiality
- When history, pattern and/or practice show that a relationship has mutual confidentiality
- When a person hears information from a spouse, parent, child or sibling (unless it can be proven that such a relationship has not and does not give rise to confidentiality).
Partners in Crime
In insider trading that occurs as a result of information leaking outside of company walls, there is what is known as the "tipper" and the "tippee". The tipper is the person who has broken their fiduciary duty when consciously revealing inside information. The tippee is the person who knowingly uses such information to make a trade (in turn also breaking confidentiality). Both parties typically do so for a mutual monetary benefit. A tipper could be the spouse of a CEO who goes ahead and tells the neighbor the inside information as gossip. If the neighbor in turn knowingly uses this inside information in a securities transaction, that person is guilty of insider trading. Even if the tippee does not use the information to trade, the tipper can still be liable for releasing it.
It may be difficult for the SEC to prove whether or not a person is a tippee. The route of insider information and its influence over people's trading is not so easy to track. Take for example a person who initiates a trade because their broker advised them to buy or sell shares. If the broker based the advice on material non-public information, the person who made the trade may or may not have had awareness of the broker's knowledge - evidence to prove what the person knew before the trade may be hard to uncover.
Excuses, Excuses
Oftentimes, people accused of the crime claim that they just overheard someone talking. Take for example a neighbor who overhears a conversation between a CEO and their husband regarding confidential corporate information. If the neighbor then goes ahead and makes a trade based on what was overheard, that would be a violation of the law even though the information was just "innocently" overheard: the neighbor becomes an insider with a fiduciary duty and obligation to confidentiality the moment they comes into possession of the nonpublic material information. Since, however, the CEO and their husband did not try to profit from their insider knowledge, they are not necessarily liable of insider trading. In their carelessness, they may, however, be in breach of their confidentiality.
Bottom Line
Since illegal insider trading takes advantage not of skill but chance, it threatens investor confidence in the capital market. It is important for you to understand what illegal insider trading is because it may affect you as an investor and the company in which you are investing.
