Insider trading is when a company’s securities are traded by individuals or entities with non-public, confidential information. Said individuals then use this information to purchase or sell the company’s securities for their own personal gain. Insider trading is a way to use classified information that may influence a security to profit or avoid major losses.
When an individual makes a trading decision based on information that could impact the value of an organization’s securities or influence an investor’s decision making, it’s an illegal insider trade.
How Does Insider Trading Work?
An employee at a company may get information about the organization that will likely affect its stock price. For instance, they may know about an upcoming acquisition that could cause their stock to rise exponentially. If said individual acted on this insider info and bought a significant amount of their company stock right before the news went public, that would be classified as insider trading.
Other examples of insider information that could influence the value of a security include loan defaults, the launch of new products, upcoming joint ventures, or new litigations.
It’s important to note that insider trading isn’t only a case of individuals trading based on exclusive information. They may also tip someone else off based on the exclusive information they have and the person being tipped might also trade based on information they’ve received.
Other examples of illegal insider trading may include:
- An employee telling their family member about non-public information and said family member trading as a result
- Company executives trading after learning of new information about their organization
- Service providers trading based on information they got from a client about their company e.g. a broker trading based on information obtained from a client
Since there may always be some degree of insider trading in a company, investors may want to assess risk before jumping in. They can do that by looking at a company’s reports of insiders’ (legal) purchases and sales of company’s securities. The SEC’s Edgar database is a resource that enables people to see all filings related to insider buying and selling of stock shares.
Consequences of Insider Trading
The SEC takes insider trading seriously and issues harsh penalties for individuals who engage in it. Consequences include being sent to prison, having to pay a fine, or in some cases, both.
According to the SEC, an individual convicted of insider trading could end up with a maximum fine of $5 million and up to 20 years in prison.
A real-life example of insider trading is when entrepreneur Martha Stewart sold her shares in ImClone after receiving insider information from the CEO of the company, Samuel Waskal. The information was that the FDA rejected a new cancer drug the company was set to launch. When the news became public, shares fell to $10, but Stewart had already sold 4,000 shares the day before when shares were trading at around $50. After the SEC got wind of what happened, Stewart was sentenced to five months of prison, five months of house arrest, and two years of probation. While she wasn’t convicted of securities fraud, the entrepreneur was convicted of four counts of obstruction of justice and lying to investigators.
Stewart also had to resign as the CEO of her company. Waskal’s fate was more than seven years in prison and a $4.3 million fine in 2003.
