What Is Insider Trading and When Is It Legal?

What Is Insider Trading?

Insider trading involves trading in a public company's stock or other securities by someone with non-public, material information about the company. Insider transactions are legal if the insider makes a trade and reports it to the Securities and Exchange Commission, but insider trading is illegal when the material information is still non-public.

Those who commit insider trading face harsh consequences, so it's important to know what it is and how to avoid it if you own company shares and have information that can affect other investors.

Understanding Insider Trading

The U.S. Securities and Exchange Commission (SEC) defines illegal insider trading as:

The buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, non-public information about the security.

Material information is any information that could substantially impact an investor's decision to buy or sell the security. Non-public information is information that is not legally available to the public.

The question of legality stems from the SEC's attempt to maintain a fair marketplace. An individual with access to insider information would have an unfair edge over other investors, who do not have the same access and could potentially make larger, and thus unfair, profits than their fellow investors.

Legal vs. Illegal Insider Trading

The Securities Exchange Act of 1934 was the first step in requiring the disclosure of company stock transactions. Directors, executives, or anyone else who has information or who holds more than 10% of any class of a company's securities are considered insiders by the SEC.

Anyone who becomes an insider must file SEC Form 3, Initial Statement of Beneficial Ownership of Securities, within 10 days of assuming an insider role.

If an insider makes a transaction, they must file Form 4, Statement of Changes in Beneficial Ownership, within two business days of making the transaction. This form serves to notify the public that an insider acted on a security.

SEC Form 5, Annual Statement of Changes in Beneficial Ownership Of Securities, is required no later than 45 days after a company's fiscal year ends. The SEC requires its filing only if one or more transactions exempted from Form 4 were not reported during the year.

Illegal insider trading includes an insider (by SEC definition) not submitting the required forms after making a transaction. It also includes passing along material non-public information before it is made publicly available. For example, suppose you work for XYZ Company and learn that it is about to post losses in its quarterly report, which can affect investors.

You tell a friend who owns shares in the company, and they sell their shares a few days before the report is published—and share prices drop right after it is. You and your friend may be guilty of insider trading even though neither of you is classified as an "insider" by definition. You acted on information that could affect other investors when they didn't have the information.

Examples of Insider Trading

Insider trading is nothing new—it has been going on for as long as stock markets have existed. However, there are some notable recent examples worth mentioning.

Martha Stewart

Directors of companies are not the only people who have the potential to be convicted of insider trading. For example, in 2003, Martha Stewart was charged by the SEC with obstruction of justice and securities fraud—including insider trading—for her part in the 2001 ImClone case.

Stewart sold close to 4,000 shares of biopharmaceutical company ImClone Systems based on information from Peter Bacanovic, a broker at Merrill Lynch. Bacanovic's tip came after ImClone Systems chief executive officer (CEO), Samuel Waksal, sold all his company shares. This came around the time ImClone was waiting on the Food and Drug Administration (FDA) for a decision on its cancer treatment, Erbitux.

Shortly after these sales, the FDA rejected ImClone's drug, causing shares to fall 16% in one day. The early sale by Stewart saved her a loss of $45,673. However, the sale was made based on a tip she received about Waksal selling his shares, which was not public information. After a 2004 trial, Stewart was charged with lesser crimes of obstruction of a proceeding, conspiracy, and making false statements to federal investigators. Stewart served five months in a federal corrections facility.

Amazon

In September 2017, former Amazon.com Inc. (AMZN) financial analyst Brett Kennedy was charged with insider trading. Authorities said Kennedy gave fellow University of Washington alumni Maziar Rezakhani information on Amazon's 2015 first-quarter earnings before the release. Rezakhani paid Kennedy $10,000 for the information. In a related case, the SEC said Rezakhani made $115,997 trading Amazon shares based on the tip from Kennedy.

The Bottom Line

Insider trading is when non-published information from a company is used to make a trading decision by someone with an invested interest in that company. It is illegal to engage in insider trading, but it is legal to trade your company shares as long as you follow the guidelines set by the SEC.