What Is Insider Trading? Is It Illegal?

Investing
Updated: 9th Sep 2021
Written by Zikry Koh
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Investing
September 9, 2021
Written by Zikry Koh

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The U.S. stock market is one of the most reputable platforms to trade securities. Thanks to strict regulations and the federal regulatory body that constantly looks out for potential fraud, the U.S. economy has gained and benefited from investors’ trust from all around the world.

Of the many ways to commit fraud, insider trading is probably the most commonly committed. But what is insider trading, and what is so bad about it? Read on to learn more about it!

What Is Insider Trading?

Insider trading involves trading a public stock with non-public information. Depending on when the transaction was made, insider trading can be legal or illegal.

How Insider Trading Works

Large shareholders and executives are naturally the first few to hear about the company’s news, especially when it’s important to the business.

However, because they may not be publicized yet, it can provide insiders an advantageous insight to make a trade. 

An investor is considered an insider if they own more than 10% of the company or have ways to access non-disclosed information about a corporation.

In addition, trades conducted by insiders have to be registered with the Securities Exchange Commission (SEC), the federal regulatory body responsible for regulating the securities markets and protecting investors.

This way, trades conducted by insiders are made public through the SEC, which provides transparency for other investors to ensure a fair game in the stock market.

Without registering with the SEC, it is illegal to trade with insider information that might impact the stock price, whether the impact is positive or negative. 

>> More: How to Start Investing

Examples of Insider Trading

Arguably the most infamous and well-publicized case of insider trading involved Martha Steward. She was a former CEO and founder of Martha Stewart Living Omnimedia.

In 2001, Martha Steward allegedly obtained insider information regarding a stock she had invested in, ImClone, through her stockbroker. With that information, she avoided a loss of $45,673 when the stock price dropped 16%. 

The SEC was tipped about this event and filed securities fraud charges against Martha Stewart and her stockbroker.

Eventually, her former stockbroker was found to be wholly responsible for insider trading because he was the one who tipped the insider information.

While Martha Steward was found not guilty of insider trading, she was sentenced to 5 months in jail for lying to authorities. 

Why Is Insider Trading Illegal?

The SEC’s mission is to make the stock market a fair, transparent, and equitable platform to purchase securities.

According to Investor.gov, a website run by the SEC, insider trading “undermines investor confidence in the fairness and integrity of the securities markets.” 

It is illegal because an investor with insider information has an advantage over other investors. Insiders usually own large portions of the company, so naturally, whatever they do with their trades can swing the stock price drastically.

This leaves investors who are non-insiders to deal with the price movements resulting from their transactions. 

>> More: How to Research Stocks

What Are the Penalties for Insider Trading?

According to the SEC website, the maximum prison sentence for insider trading is 20 years. In addition, the maximum criminal fine for individuals is now $5 million, and the maximum fine for institutions and companies involved in insider trading is $25 million.

A Brief History of Insider Trading

The first known prosecution for insider trading occurred in 1909 when an executive was guilty of fraud for buying a large number of shares of company stock when he knew that the stock was going to soar price. This was before Congress passed the Securities Exchange Act in 1934, after the Great Depression. 

The first prominent case of insider trading after the Securities Exchange Act involved the Texas Gulf Sulphur Company.

It was found the insiders were heavily trading the company’s stock after obtaining news of a new mining site. 

In 1973, Raymond Dirks, a financial analyst, uncovered massive fraud in Equity Funding. He provided the information to his clients to sell the stock, bringing up the case for insider trading.

However, he received backing from the SEC for his actions, who said that insiders have the responsibility to pass on tips that may harm the interest of other investors in the event corporate shareholders breach legal duties.

This is the first of the many examples of the SEC’s role being a just regulatory body that does not simply prosecute every act involving insider trading.

Can You Go to Jail for Insider Trading?

According to the SEC, you can be jailed if involved with insider trading, as we have also seen in the examples.

However, the SEC claims to seek corrective measures usually and prefers barring investors instead of jail time.

Does the SEC Prosecute Insider Trading Cases?

The SEC only has powers to investigate an alleged inside trader and pursue civil cases against them. It does not have the power to prosecute anyone for violating securities law. 

The SEC will bring the case they are investigating to the U.S. Department of Justice, the only entity that executes prosecutions towards alleged violators of U.S. securities laws.

Bottom Line: What Is Insider Trading?

Insider trading involves trading securities with material non-public information. It is a crime to execute a trade based on insider knowledge without first registering it with the SEC. 

Insider trading provides an unfair advantage over the public, discouraging other investors from participating in the markets.

This would make it harder for companies to raise capital and possibly lead to detrimental consequences to the country’s economy.

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Zkoh
Zikry Koh
Zikry is a Respiratory Therapy Student and an Associate Financial Planner. His passion for serving others has extended beyond the healthcare industry and into finance. He aims to equip his readers with the knowledge to build a sense of empowerment towards their health and finances. "Prevention is better than cure", he believes, is true in finance as with health.