What Constitutes Insider Trading?

Insider trading is a term most of have heard but know little about. Lately anytime you turn on CNBC or Bloomberg there seems to be a new insider trading case brewing. In this article, we are going to take a look at what exactly constitutes insider trading as well as when it is actually legal. We will take a look at the different authorities that enforce these rules as well as the punishment for insider trading. We will take a look at cases like Enron and Martha Stewart along with some arguments for insider trading.

The obvious place to start is to cover what exactly insider trading is and how it differs from other types of trading. Insider trading is defined by the SEC as buying or selling a security in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, non-public information about that security. Although somewhat vague, directors, CEOs, employees, third-party business partners (in control of confidential information of a publicly traded company), friends and family of employees or just anyone who trades off non-public information can be considered an insider. Insider trading laws have been on the books since the mid-1930’s. The SEC has insider trading laws on the books because trading off inside information undermines the public’s confidence in the fairness and integrity of the securities markets. The insider trading rules in the United States are considered to be the most stringent in the world as well as the most regulated. Since the early twenty-first century, most industrialized nations with an organized securities market have some sort of insider trading laws on the books as the barriers to enter foreign markets have all but been done away with with the advent of electronic markets.

There are some types of legal insider trading and it is done all the time in the markets. Within the past twenty years, compensating employees with stock or stock options has gained widespread popularity. In order for these employees to actually cash in on their stock, they would have to engage in a sale of said stock, but with limitations. First off, since they are employees of the issuing company, any transaction they engaged in would be considered an insider transaction. For this transaction to be in compliance of the SEC, the employee must file a Form 4. The Form 4 (Statements of Changes in Beneficial Ownership) is a public document that details how much of their stock they wish to unload and when they want to do it. A typical example of this would be someone retiring from a company who wants to cash in their stock. For them to do this, they would file with the SEC their intent to sell stock, how much and when they were going to do it. So just because you see an insider selling their stock, it doesn’t necessarily constitute that they believe their stock will soon dive. They could be selling their stock to pay for their kid’s college or to pay for a new house. As far as buying their own stock, insiders are allowed to buy their stock at any time, given they have filed with the SEC beforehand. They are plenty of news services available that only track insider buying, believing that any insider buying is a positive for the stock.

Regulation of insider trading falls to the SEC (and to some extent the NASD) here in the United States. Back in the 1930s (right after the crash), it was an insider transaction involving Albert Wiggin that actually brought the SEC into existence. Wiggin, who was the head of the Chase National Bank in 1934, had shorted 40,000 shares of the bank and now had a financial interest in seeing his company fail. This ultimately led to the Securities Act of 1933 which was much tougher on insider trading. Wiggin ended up netting a profit of $4 million through the short (and was never prosecuted) while his bank was buying large shares of stock to help halt the fall of the US stock market. Today, the SEC can seek a court order requiring violators to give back their trading profits as well as impose a penalty of up to three times the amount gained. The SEC can also ask that a violator give up to three times the amount they would lost if their insider transaction kept them from losing money. In addition to the financial penalties, the SEC can ask for a prison sentence to accompany the fine. These prison sentences are getting longer and longer in the wake of the all the dirty financial dealings of the past ten years.

Many notable economists have stated that insider trading is a good thing and should be legal. Milton Friedman, who won the Nobel Memorial Prize in Economics in 1976, stated that insider trading brings material information of the deficiencies of a company to the forefront faster. One could also argue that mass distribution of material information (via CNBC, Bloomberg or any other financial news service) therefore gives the subscriber information before the general public and they are therefore trading on inside information. There are also people out there who argue this is a violation of free speech since it censors people from being able to talk about certain issues for fear of punishment. Probably the argument that carries the most weight is that people use inside information to make transactions in other markets, most notably real estate and commodities.

Famous Insider Trading Cases

Ivan Boesky was a stock trader during the 1980s and was involved in one of the more well-known insider trading case ever. Boesky made a fortune in the 70’s and 80’s by playing corporate takeovers and arbitraging the differences in the stock prices. At the time, although insider trading rules were on the books, they were rarely enforced. Boesky was well known for basing investments on tips he received from corporate insiders. Sometimes he would even buy massive amounts of stocks just days before a takeover was announced. Boesky was one of the first prosecuted by the SEC for this type of insider trading in the 80’s. Boesky ended up getting 3.5 years in jail and was fined $100 million. Boesky did cooperate with the feds which helped led to the arrest of Michael Milken.

Michael Milken in best known for his role in developing high yield bonds (aka junk bonds) back in the 70’s and 80’s. Milken was ultimately charged with over 90 counts of racketeering and securities fraud after the SEC opened an insider trading case against him. He ended up pleading guilty to six counts of securities and reporting fraud, but never insider trading specifically. Milken was sentenced to ten years in prison and was permanently barred from the securities industry.

One of the more famous recent cases of insider trading would be that of Martha Stewart. Back in December of 2001, Stewart sold nearly 4,000 shares of ImClone stock right before it took a 16% hit after a bad FDA ruling. Stewart’s Merrill Lynch broker, Peter Bacanovic, told Stewart to sell after hearing that the CEO of ImClone, Sam Waskall, was selling all his shares in front of the FDA ruling. Although Stewart was never convicted of insider trading (she was convicted of obstruction of justice and making false statements to federal investigators), she did serve time in jail. Waskall and Bacanovic were convicted of insider trading and were sentenced to prison terms along with fines. All in all, Stewart saved herself $45,000 in the trade and paid a fine of $30,000.

These are just some of the cases that the SEC has brought against investors. In wake of the financial turmoil of the past five years and Madoff, the SEC has ratcheted up its pursuit of those who stain the integrity and confidence of the markets.

See also: Raj Rajaratnam Profile