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Further Reading
  • Den of Thieves
    Den of Thieves
    by James B. Stewart
  • The Predators' Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders
    The Predators' Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders
    by Connie Bruck
  • License to Steal: The Untold Story of Michael Milken and the Conspiracy to Bilk the Nation
    License to Steal: The Untold Story of Michael Milken and the Conspiracy to Bilk the Nation
    by Benjamin J. Stein
  • Inside Out: An Insider's Account of Wall Street
    Inside Out: An Insider's Account of Wall Street
    by Dennis B. Levine, William Hoffer
  • Martha: On Trial, in Jail, and on a Comeback
    Martha: On Trial, in Jail, and on a Comeback
    by Robert Slater
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NEWS

What Constitutes Insider Trading?


Though "insider trading" is frequently associated with illegal financial undertakings, it is actually a term that includes both legal and illegal conduct. According to the SEC, legal insider trading is simply "when corporate insiders-officers, directors, employees, and major stockholders (more than ten percent of the company)- buy and sell stock in their own companies." Under provisions set out by the Sarbanes-Oxley Act of 2002, you must fill out the first of three separate forms detail the transaction within ten days of the trade. According to the rules described under Regulation FD ("Fair Disclosure"), issuers of material information must make the information public based depending on if the issue was intentional or non-intentional; if intentional, the information must be made public immediately, and if it is not non-intentional, promptly.

Illegal insider trading is defined under Rule 10b5-1, declared by the SEC in 2001, 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 the security." Because massive volumes of information flow through banks and corporations by the hour, prosecuting individual investors of insider trading can be incredibly difficult. Because it carries a base offense level of 8, those guilty of a first-time offense of insider trading are eligible to receive probation rather than incarceration.

The SEC complete statement on insider trading:

"Insider trading" is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC. For more information about this type of insider trading and the reports insiders must file, please read "Forms 3, 4, 5" in our Fast Answers databank.

Illegal insider trading refers generally to 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. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.

Examples of insider trading cases that have been brought by the SEC are cases against:

  • Corporate officers, directors, and employees who traded the corporation's securities after learning of significant, confidential corporate developments;
  • Friends, business associates, family members, and other "tippees" of such officers, directors, and employees, who traded the securities after receiving such information;  
  • Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;  
  • Government employees who learned of such information because of their employment by the government; and

Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.

The SEC adopted new Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is "aware" of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.

Rule 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.