What Is Insider Trading?

In this article, we shall study the topic “what is insider trading?”. Also, we will see how it relates to what makes one an insider, new SEC rules, examples of legal insider trading, when is insider trading legal, etc.

The concept of insider trading simply depicts the illegal possession of the confidential details of a stock you transact on.

Meaning Of Insider Trading

Some people perceive insider trading to be illegal. They don’t think it is something right. This is because one has the secret knowledge of that stock they want to transact on. This can have an impact on the stock’s price.

The championing body that presides on all trades in the U.S is the Securities and Exchange Commission (SEC). Their definition of insider trading still conforms to the general definition. Also, they see it as illegal and offensive.

On a daily basis, people question the legality of insider trading. In the case between two parties, it favors one and suffers the other. For instance, a company that wants to buy another will bring up the initial company’s stock value. This happens when the company notices that a trader has insider knowledge of the plan.

Legality Of Insider Trading

Some believe that insider trading is a legal act. However, the legality of insider trading depends on when the trader makes the trade. Therefore, we shall look at some case scenarios making insider trading legal. They are:

  • When the CEO of a company buys more shares in the company with the knowledge of the SEC.
  • A situation where a worker in a company purchases security in that company.
  • When a part of the governing body of a company buys stocks with the knowledge of the SEC.

Amongst all these, SEC still carries out subsequent scrutiny of insider trading. Consequently, insider trading is illegal if the details of the stock aren’t made public yet. So, that is when it is a punishable offense.

A very popular case scenario is that of R. Foster Winans of Wall Street Journal. A had plans to publish his book. But he leaked this information to about to stockbrokers. They took advantage of the situation and made more profit than the publisher himself. However, the case got to SEC. The SEC passed a judgment on the case and they were guilty of insider trading.  

It is a whole different game in the cryptocurrency world. A tip-off on a coin sale may happen. In the same vein, it will relatively influence the price of this coin. This is obviously a case of insider trading. But this doesn’t warrant the judgment of the defaulters.

Side Note

The U.S SEC sees illegal insider trading as a breach of the confidentiality of a stock detail during the transaction of that stock. So a stock detail has the power to influence an investor’s transaction decision. When this detail is made public, then it isn’t illegal to engage in insider trading. Anything contrary to this is illegal. That is why SEC seeks to maintain market equilibrium by prohibiting dubious means of profit.

There are laid down rules and regulations that the Securities and Exchange Commission operates with. This body of rules isn’t neutral and non-sentimental. Consequently, it prosecutes defaulters when they convict them. So, to be on the safe side, keep any information you obtain to yourself.

Insider Trading Instances

Martha Stewart

The SEC can convict anyone, no matter their status in the company or society. For instance, in the judgment of Martha Stewart in 2003, a couple of allegations were up against her. Illegal cases including insider trading.

An occurrence of insider trading between her and Peter Bacanovic saw her make a huge unfair profit. This was off the sales of shares of biopharmaceutical company ImClone Systems. Peter got the information of the CEO of ImClone Systems selling off his shares. He then tipped off Martha. Then, the company was experiencing downtime from FDA.

Martha made a lot of profit from this downtime. But, as it was made out of illegal information from Peter Bacanovic, SEC got into action. As a result, SEC prosecuted both of them. Although, it wasn’t too harsh.

Amazon

A staff of Amazon.com Inc. was also a victim of this offense. Brett Kennedy by name gave his colleague a tip-off on a prospective Amazon act. The colleague Maziar Rezakhani made a substantial profit from that information. However, SEC caught up with them and they faced prosecution.

What makes insider trading legal, is when the material information is no longer private. So, companies ought to give the transactions and information of stock to SEC. Then, the company can decide on any medium to make this information public. It could be on their site or any other way.

Meanwhile, companies had to adopt the Securities Exchange Act of 1934. It was the pioneer way to legally reveal details of a company’s stock. Also, the company heads must reveal other vital information. So, when the information is legally public, insider trading becomes legal.

  • To show the input of an investor in a company, they adopt Form 3.
  • If a trade of stock happens within 2 days, the company adopts Form 4. This reveals the trade.
  • When there is a revelation or delay in a transaction, the company uses Form 5.

Meaning Of Informed Trading

There are other aspects of a company that can be a target point for insider trading. It could be its economy, commodity, etc. Evidently, the release of the consumer price index can cause a spike in the financial market. Those in charge of the details, keep it private. But, there are a few people who have a knowledge of it before its revelation.

Statistics show that the financial markets gear to the appropriate path. This is before the release of the information. Stocks values were already on the rise before the exposure of the details. Generally, they know this situation as “informed trading”. Similarly, they did observe this in China and U.K. Since the information isn’t yet made public, what could be the explanation?.

Well, we have different people that possess different gifts. So, it may be that some traders made a good study of the financial market as its outcome correlates with the economic declarations. This is to say, in an instance that online prices influence the call of market spikes. In the same vein, forecasts and satellite documentation can guess the inventory availability of crude oil and natural gas.

Distinguishing Qualities Of Insider Trading

Both legal and illegal insider trading are all rampant. Also, it is beneficial to those who engage in it. But, the prevalence of insider trading has become eminent in the U.S. Approximately, SEC handles 15% of insider trading cases. Some notable cases are:

The Steven Cohen and his now-defunct SAC Capital Advisors hedge fund case. Popular Martha Stewart’s case. Then, the case of Chris Collins, who got 26 months in prison.

At the time the U.S economy was dwindling as a result of the pandemic in 2020, two fed workers were engaging in a detrimental trade to the U.S economy. The SEC gave them an appropriate prosecution.

Significance Of Insider Trading.

High liquidity and low cost of buying and selling are the notable features of an effective financial market. Therefore, insider trading jeopardizes most of these prospective attributes. Most Americans wish that it can fade away. Because it adversely affects them.

On the other hand, the effect of insider trading can lead to increasing the cost of giving out stocks to investors. This is because the company will want to cover for any irregularity of an insider. However, it has an impact on the company’s finance.

Moreso, an incident of insider trading discourages people from participating in the financial market. The fact that there is an unfair way, by which some investors obtain profit, propels this. Consequently, they perceive the system as corrupt and lose trust in it.

How To Stop Insider Trading

There could be effective ways to stop insider trading. They should regulate the eligibility of people who can buy a stock. Especially, lawmakers, the supreme court, bank policymakers, and senior staff. The quest to make this regulation got the support of some reputable individuals. The likes of Nancy Pelosi, Kevin McCarthy, and Sen. Ben Sasse.

Also, there should be regulations that govern the accessibility of private information or materials. If the U.S and the U.K policymakers reform the way of releasing economic data, it will reduce the incidence of insider trading. For instance, in previous years, the information of economic data was accessible to public officials before its release. When a stop was put to this, the incidence of insider trading went down.

Generally, a poll to regulate lawmakers was done. A greater percentage was in support of it. However, it doesn’t mean that lawmakers are no longer eligible to purchase stocks.

New SEC Rules On Insider Trading

Around the end of the year 2000, new rules were set by the Securities and Exchange Commission (SEC). These rules were put in place to curb insider trading.

Evidently, the release of material information influences the prices of stock. Some of the examples are: when a company declares reception of an offer, merger, positive earnings, etc.

Therefore, companies must release material information at a time that everyone can access it. Instead of the previous way of choosing who gets it first. This statement was made under the Regulation Fair Disclosure (Reg FD).

What makes one an Insider?

In relation to the topic, an insider is one, who has first-hand details of any information before it is made public. You can term an insider as illegal only when he or she releases the information without due process. The goal of an illegal insider is to make an illegal profit. So, the maintain the integrity of the company, an insider must not reveal any information regarding the company’s stock.

Certainly, an insider must come from the embodiment of company heads. This is because they have direct contact with material information. There are some cases, that bring about confidentiality. This is based on the misappropriation theory. However, let us look are the three examples:

  • A situation of a firm stand to uphold confidentiality.
  • Proof of a relationship having mutual confidentiality
  • Obtaining direct information from a spouse, parent, child, or sibling. However, there is an exception. This is invalid if there is no authenticity in the relationship supporting confidentiality.

Tipper And Tippee In Insider Trading

Basically, a tipper is one who breaks the trust of a company by letting the confidential information. While a tippee is one who receives the information and utilizes it for illegal profit. Consequently, a tipper must have direct contact with someone with knowledge of the information. Upon releasing that information to a third party, it becomes insider trading.

Meanwhile, many circumstances surround the identification of a tippee. Some traders make trades out of their own market analysis. So, the trader may deny the knowledge of the material information. Similarly, a broker can transact on shares with the knowledge of the stock information. But can still deny not having the knowledge. In conclusion, the lack of evidence can hinder the SEC from apprehending a tippee.

One can actually be a tipper out of clumsiness or unknowingly. When making a discussion with a company head about material information, one may overhear you. This way, the person becomes a tippee without your knowledge. If the person utilizes that information and makes a trade, the person is guilty of insider trading. However, the discussing parties are to be held accountable for their clumsiness. Because they indirectly broke the fiduciary of the company.

Conclusion

The act of insider trading has an adverse effect on the financial market. It makes traders and investors lose trust in it. So, to avoid this, there should be regulations on the accessibility of private material information. Also, those in possession of the information should never disclose it unless it is legal. Lastly, always ensure you DYOR on insider trading, as it will be beneficial to you as a trader or investor.

See the List of things to learn.

  1. Blockchain Technology
  2. Defi
  3. NFTs
  4. DAOs
  5. Crypto
  6. Web 3.0
  7. Altcoin Tokenomics
  8. Metaverse
  9. Smart Contracts

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