Last Updated on: 19th October 2023, 01:51 pm

What Is Insider Trading?

Insider trading is when someone buys or sells stock in a company based on non-public information that gives them an unfair advantage. It’s illegal because it violates the idea of a fair and open market. Let’s break it down…

What Makes It “Insider” Trading?

The “insider” part refers to someone who has special access to confidential info about a company. This could be an executive, director, large shareholder, or anyone who learns secret details about a company’s plans or performance.¹

For example, say a CEO knows their company is about to release a new product that will boost profits. If they buy more stock based on that inside info before it’s public, that’s insider trading.

Why Is It Illegal?

Insider trading violates the idea of a fair stock market. Investors are supposed to make decisions based on public information available to everyone.² When insiders use secret info to get an advantage, it cheats other investors.

It also erodes public trust in the stock market. People won’t want to invest if they think insiders control everything and the game is rigged.

What Counts As “Material” Information?

For info to be considered insider material, it has to be important enough that a reasonable investor would consider it useful when deciding whether to buy or sell a stock.³ Examples include:

• Financial results before they’re announced
• A pending merger, acquisition, or divestiture
• Major new products or services
• Regulatory approvals or investigations

If the info could move the stock price when made public, it’s probably material.

Who Can Be Charged with Insider Trading?

Not just corporate insiders get charged. Outsiders like lawyers or bankers who learn confidential details through their work can be charged too. Even your friend who works at a company could be charged for tipping you off.⁴

But it has to be proven that they breached a duty by misusing inside information. Like that they knew it was wrong but did it anyway.

How Do They Catch Insider Traders?

The SEC looks for suspicious patterns like someone buying right before a big announcement.⁵ Or a sudden spike in trading volume before news breaks. They can subpoena phone records, emails, and other evidence to build a case.

Big trades by corporate execs are always scrutinized. Like if the CEO suddenly dumps all their shares before bad news drops.

What Are the Penalties for Insider Trading?

The penalties can be severe. Like facing years in prison and millions in fines. In some cases profits made can be taken away too.⁶

People convicted often get banned from working in the finance industry again. And they open themselves up to major civil lawsuits.

Are There Any Legal Defenses?

There are a few legal arguments defendants try to make, with mixed success:

• Lack of “Duty” – Claiming they didn’t have a duty to keep the information confidential.⁷
• No Actual Knowledge – Denying they knew the info was material or nonpublic when they traded.
• Pre-Planned Trades – Arguing the trades were planned before learning the inside info under a Rule 10b5-1 plan.⁸

But these defenses don’t always work. The duty argument failed for a hairdresser who traded on tips from a client.⁹ And “forgetting” the info was inside doesn’t fly either.

How Can Insider Trading Be Prevented?

Companies try to stop insider trading by:

• Restricting who can access confidential data
• Using encrypted communications and code names for deals
• Requiring pre-clearance for trades by execs
• Blackout periods where execs can’t trade
• Monitoring networks for large data transfers

But leaks still happen. Greed finds a way. The SEC tries to crack down with bigger penalties. But insider trading cases can be hard to prove.

Is All Insider Trading Bad?

Some argue it helps make stock prices more accurate. And that bans mostly benefit professional investors.¹⁰

But others say it erodes public trust too much. The SEC tries to balance policing abuses while not over-regulating.

The bottom line is insider trading cheats the system. It may take some sleuthing, but the SEC tries to catch the crooks.

The Million Dollar Question

Would you engage in insider trading if you thought you could get away with it? Get rich quick based on secret info before everyone else? Ethical or not, it’s a tempting proposition for some. But it often ends badly when you get caught. Is the risk worth the reward?

At the end of the day, insider trading undermines fairness and trust in the market. The SEC has a big job trying to enforce the rules. But how much can laws really stop human greed? It’s a constant battle to protect the integrity of the stock market.

The Takeaway on Insider Trading

Insider trading boils down to misusing privileged access to confidential information for unfair personal gain. It violates principles of an open market and erodes public trust. Penalties can be severe for those caught engaging in the shady practice. While it may be tempting on the surface, insider trading often ends in scandal and ruin when secrets come to light.