Insider Trading Explained

Definition

Purchasing or disposing of stock in a publicly traded firm based on substantial, non-public information about the company is known as “insider trading.” If this information has the potential to materially affect an investor’s decision to purchase or sell the stock, it is deemed “material.” The nature of the information is crucial in this case: it needs to be non-public (not accessible to the broader public) and material (important).

The Legality

Legal Insider Trading:

Not all insider trading is illegal. In fact, company insiders, such as directors, executives, or employees, can legally trade stocks of their own company. However, they must report these trades to the U.S. Securities and Exchange Commission (SEC) within specific time frames. This is to ensure transparency and fairness in the market. For instance, if an insider makes a transaction, they are required to file Form 4, which is a “Statement of Changes in Beneficial Ownership,” within two business days of the transaction.

Illegal Insider Trading:

Insider trading becomes illegal when it involves trading based on material, non-public information. This could be information about upcoming financial results, mergers, or any other significant events that could affect the stock price. If someone trades based on this kind of information before it’s released to the public, they are breaking the law. Penalties for illegal insider trading can be severe, including hefty fines and even imprisonment.

Why It Matters

The primary concern with insider trading is fairness. The stock market operates on the principle that all investors should have equal access to information. If certain individuals have an unfair advantage because of access to insider information, it disrupts the level playing field. This can erode trust in the financial markets and deter regular investors from participating.

Real-World Examples

Martha Stewart:

Martha Stewart was charged with insider trading in 2003. A secret piece of information she got led her to sell shares in the biotech company ImClone Systems. Even though she didn’t lose a lot of money because she sold her shares before the price dropped, she was charged with insider trading because she acted and sold her shares on inside information that was not available to the general public.

Amazon:

In 2017, Brett Kennedy, a former financial analyst at Amazon, was charged with insider trading. He provided non-public information about Amazon’s earnings to an acquaintance, who then traded on this information, leading to legal repercussions for both.

In Conclusion

Insider trading, while a common term, is often misunderstood. While company insiders can legally trade their company’s stock, they must do so transparently and without acting on non-public, material information. The rules and regulations surrounding insider trading aim to maintain trust in the financial markets and ensure that all investors, big or small, operate on a level playing field.