In this case, “trading” refers to the buying and selling of financial securities. “Insider trading” involves the trading of securities by a person who is an “insider,” based on information that is not available to the public. The insider may be a corporate officer, director, employee or someone else who has received non-public information.
A “security” is a financial instrument which represents some amount of financial value. In general, securities take the form of a certificate which grants the holder rights related to the distributions of profit from a business. Securities include stocks, bonds, debentures and mutual funds.
Securities are typically exchanged on securities markets. Securities markets may be subject to manipulative or unfair business practices, which may include insider trading and securities fraud. Because of the prevalence of securities violations, securities markets are regulated heavily by both federal and state laws. These securities laws are designed to protect investors.
Securities laws derive from one principal, straightforward concept: that all investors, whether they are private individuals or large institutions, should have access to certain basic facts regarding an investment before they purchase it, and they should have access to the same information as all other potential and current investors.
Insider trading can only be committed by “insiders.” “Insiders” include shareholders who hold more than five percent of a company’s voting stock, and corporate employees who have access to confidential corporate information (including the company’s officers, directors, employees and shareholders). Securities trades by insiders must be reported to the Securities and Exchange Commission (SEC).
Insider trading includes both illegal and legal conduct. Examples of insider trades that are legal include:
- A CEO of a corporation buys 100 shares of stock in the corporation. The trade is properly reported to the Securities and Exchange Commission.
- An employee of a corporation exercises his stock options and buys 100 shares of stock in the company that he works for. The trade is properly reported to the Securities and Exchange Commission.
Illegal insider trading occurs when a person who has special access to, or is aware of, unpublished corporate information takes advantage of that body of information to make a profit. The SEC has brought insider trading cases against:
- Corporate officers, directors, and employees who traded the corporation’s securities after discovering major, nonpublic corporate developments. As an example, a company’s president knew that a merger between the company and its largest competitor was going to be announced within the next day or so. The president was confident that once the merger was announced, the value of the company’s stock was going to skyrocket.
- To make a profit on this special knowledge of the upcoming merger, the president bought shares of the company’s stock. To make things worse, the president bought the stock in their mother’s name so they could avoid reporting the trade to the Securities and Exchange Commission.
- Friends, business associates, family members, and other outsiders who traded securities on tips received from corporate officers, directors, or employees. Example: a high-level employee of a company overheard a conversation where the CFO was talking about how the company was going to be driven into bankruptcy as a result of severe financial problems.
- The employee knew that a friend owned shares of the company. The employee warned the friend to sell the shares right away before the price of the stock could go down. Note that it is easier to fall into the commission of insider trading than you would think: most people would not think twice about acting on a friend’s helpful tip.
- Employees of other professional practices (e.g. law, banking, brokerage and printing firms) who traded corporate securities on confidential information given to them in exchange for services. For instance, a lawyer representing the CEO of a publicly-traded company learned in a meeting at the law firm that the CEO was going to be indicted for accounting fraud the next day. The lawyer quickly sold their shares of the company because they were sure that the stock price was going to plunge once news of the indictment was released.
- In another case, a printing company was hired by a corporation to make copies of its annual report. The report indicated that the company had had a banner year. The employee who did the photocopying quickly bought shares of the stock, assuming (reasonably) that their new stock would escalate rapidly once the annual report was made public.
- Government employees who traded securities on nonpublic corporate information they had access to by virtue of their government employment. As an example, a state senator was aware that a new regulation was going to be passed that would significantly benefit an electricity company. To make a profit on the passing of the new legislation, the state senator secretly bought shares of the electricity company and then pushed for the regulation to go through as quickly as possible.
- Other persons who misappropriated, and took advantage of, confidential information gained from their employers.