What is Insider Trading and How Do You Avoid It?

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When most people think of insider trading, they picture the wealthy or famous. However, anyone can be guilty of insider trading, including instances where you might not even know you are taking part.

By understanding what the term means and how insider trading happens, you can make sure that your investments are completely legal. That way, you won’t be setting yourself for a jail stint, intentionally or otherwise.

What is Insider Trading?

If you’ve ever wondered “What is insider trading?” you might be surprised to hear that the insider trading definition is fairly simple. It covers the practice of taking information that is not available to the public and using it as the basis for trade decisions.

Essentially, when you have access to non-publicly available details, you have an unfair advantage from an investing perspective. It was made illegal to prevent individuals who are privy to certain information before it is released to the public from buying or selling investments as a means of producing large profits quickly or protecting themselves from a dip in a stock’s value even though others don’t have the same luxury.

Many investors have trouble resisting the temptation that insider information can create. However, it is important to understand that insider trading is illegal. Additionally, the Securities and Exchange Commission (SEC) regularly investigates potentially unlawful activity and is more than willing to prosecute if the evidence suggests that is the proper course of action.

The SEC’s Insider Trading Definition

According to the SEC, insider trading involves the “buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.” The SEC adds, “Insider trading violations may also include ‘tipping’ such information, securities trading by the person ‘tipped,’ and securities trading by those who misappropriate such information.”

This insider trading definition can be a bit confusing at first, as it covers a few potential forms. However, by understanding the various activities that are illegal, you can make sure you don’t act outside of the law.

Types of Insider Trading

Overall, there are five main types of insider trading, primarily defined by who is participating.

1. Organization Members

Members of publicly traded companies, such as employees and people on the board, usually have access to information that isn’t widely available. This can include details like an upcoming unannounced merger, planned product recall, new product announcement, or anything else that is in development but not official.

If an employee or other organization member makes trade decisions based on nonpublic information, that usually qualifies as insider trading. The only exception can be when workers have access to stock options, though those lines are blurry and a securities purchase can fall on either side.

2. Professionals Who Do Business with the Company

Certain other professionals also have access to insider information. For example, lawyers, bankers, brokers, and a range of consultants may have confidential details in their purview, depending on their function.
Using that information to make trade decisions does qualify as insider trading, even though they aren’t an employee.

3. Family, Friends, and Acquaintances

Many people talk about their work with family, friends, and acquaintances. During a conversation, some professionals share details that aren’t available to the general public. While this level of sharing may be innocent, if the person’s intention is to help those they know get ahead as investors, it is insider trading.

Similarly, if an employee trades through their family, friends, or acquaintances, even if the insider information isn’t directly shared, that qualifies, as it is largely done to avoid the watchful eye of the SEC.

4. Government Officials and Employees

Government officials and employees are another group that may learn details about a company during the course of their duties. Getting access to confidential information is common, particularly in regulatory agencies, so using their access to make trade decisions is insider trading.

5. Hackers, Spies, and Thieves

There are unscrupulous ways to gain access to insider information too. For example, hacking into a company’s network or email, using social engineering to gather insight from employees, or similar actions can support insider trading objectives.

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The Investigation and Prosecution of Insider Trading Cases

In many cases, the SEC gets wind of insider trading through their standard monitoring practices. Surveillance systems seek out specific kinds of investing behaviors to identify unusual patterns that may indicate an issue. When the SEC notices anomalous activity, they work to track down those involved. This can include getting warrants for financial records, tapping phones, or anything else that allows them to gather evidence and determine what is happening. If they find enough information to show that insider trading is responsible, they can have the person or people involved arrested.

At times, the SEC may receive a tip or complaint about insider trading, though this is exceptionally rare. However, should that happen, they start gathering reviewing records and examining evidence to see if they need to pursue the matter. If they find enough, then they move forward as they would for activity they spot themselves.

Once an arrest occurs, prosecution proceeds as it would for most any other kind of criminal case. The person faces up to 20 years in prison, along with up to $5 million in fines, for each act of insider trading. However, the typical sentence is far below the maximums.

Martha Stewart Insider Trading Case

Considered by many to be one of the most famous recent examples, the Martha Stewart insider trading case involved ImClone’s stock. In December 2001, the Food and Drug Administration (FDA) let the public know that Erbitux, the company’s new cancer drug, was rejected. This caused ImClone’s stock to tumble.

But, surprisingly, the friends and family of ImClone CEO Samuel Waksal didn’t experience losses. Instead, just days before the FDA officially rendered its decision, they sold some of their shares.

Martha Stewart was one of the people who knew what was coming, and she sold 4,000 shares when the stock was still riding high. While she tried to claim that she had a pre-existing sell order was the reason for the sale, her story didn’t hold up. She was found guilty of insider trading and received a prison sentence of at least five months are a fine of $30,000.

Waksal was also arrested, receiving a sentence of more than seven years incarceration and a $4.3 million fine.

Ivan Boesky, Dennis Levine, Michael Milken, and Martin Siegel

During the mid-1980s, Ivan Boesky was an arbitrageur. However, he seemed to have a strange knack for buying stocks right before takeover offers were made, allowing him to secure massive profits when the announcement went public.

However, the trades didn’t go unnoticed, and Merrill Lynch contacted the SEC regarding someone possibly leaking insider information. It turned out that Dennis Levine and Martin Siegel were sharing details.

After identifying Boesky, the SEC was able to find similar insider trading activity on the part of Michael Milken, who largely operated in the junk bond sector.

The Curious Case of R. Foster Winans

Possibly one of the most unique insider trading cases, R. Foster Winans was a Wall Street Journal columnist who discussed stocks. When he wrote about a security, the price usually went up, as people respected Winans.

However, Winans began sharing information about his columns with brokers before they were printed, allowing them to execute trades ahead of the masses.

What made the case unique is that Winans’ columns were opinion pieces, so they didn’t represent insider information on the surface. But the SEC determined his columns were technically the property of the Wall Street Journal, so disclosing the details in advance was a crime.

How to Avoid Insider Trading

While certain forms of insider trading are intentional, even innocent investors can accidentally commit the crime. However, you can take precautions that can help you stay on the right side of the law, ensuring you follow the SEC’s rules and don’t unintentionally put yourself at risk.

1. Ask with Care

If you are asking questions about a security, make sure you are careful. If your inquiry encourages someone to provide you with confidential information, even if that isn’t your intention, you are on thin ice. Once you know something that isn’t public knowledge, executing a trade is dangerous. Similarly, if someone believes you are trying to dig such details out of them, that also comes with legal ramifications that are similar to actually participating in insider trading.

2. Verify the Information

Whenever you are given a piece of information about a company, make sure it is public before you use it to make a trade decision. If you can’t find that tidbit elsewhere, you might want to assume it is inside information and abandon the trade.

3. Report What You Hear

If you happen to receive information that could impact your portfolio and don’t know if the detail is public, contact the proper authorities. This usually helps prove that your intention isn’t to take advantage of insider information.

4. Consider Confidentiality

Something that is always a warning of potential insider information is hearing details that would likely be covered in a confidentiality agreement. If someone is violating a contract when they discuss the topic with you, be wary of what you hear, as it could be considered illegal if you execute a trade after the conversation.

5. Hold Your Tongue

You can be guilty of insider trading even if you help someone else take advantage of a nonpublic piece of information. If you have access to sensitive details, avoid sharing it. Otherwise, by giving someone else confidential information, you could also be guilty of securities fraud.

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