Trying to beat the stock market is hard enough, but when some people have an unfair advantage, it can seem impossible. That's what insider trading is all about.
Insider trading refers to using non-public information to make investment decisions. This means that people with access to important information that the general public doesn't have are using it to make a profit. This tilts the playing field in their favor, and they're more likely to make money while everyone else loses.
This article will explain what insider trading is, how it works, and why insider trading is illegal. Let’s dive in.
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What is insider trading?
Insider trading is the practice of using information that is not publicly available to make investment decisions. This information can be material, non-public information about a company.
Material information is information that could reasonably impact a company's stock price. For example, if a company is planning to merge with or acquire another company, this would be material information because it could impact the stock price of both companies.
Non-public information is information that has not been made available to the general public. This information is not available through a company's filings with the SEC or other public sources.
Someone who has access to such information is often referred to as an insider. For example, a company's CEO, CFO, or other executive officers are insiders. Insiders can also include board members, lawyers, and accountants who work with a company and have access to material, non-public information.
Insider trading, as opposed to other forms of informed trading, can harm the integrity of the markets and lead to serious legal implications for the individuals involved. It also victimizes everyday investors who don't have access to the same information as the insiders.
How insider trading works
For someone to be guilty of insider trading, the U.S. Securities and Exchange Commission (SEC) must prove that they knew the information was confidential and that they used it to make a profit. The information doesn't necessarily have to be about a company's financials. It could be anything from inside information about a merger to details about a new product.
If you work for a company and learn something confidential that could affect the stock price, you're legally obligated to keep that information to yourself. You could be charged with insider trading if you buy or sell stock based on that information.
You don't have to work for a company to be guilty of insider trading. If you learn confidential information from anyone – a friend, family member, or even a stranger – and use it to buy or sell stock, you could be charged with insider trading.
That said, the SEC uses a few different theories to prove insider trading. These include:
Breach of Fiduciary Duty
This theory applies when an insider uses material, non-public information to make a profit while violating their duty to the company. For example, a company's CEO or CFO would be in a position of trust and would owe the company a fiduciary duty.
This theory applies when an insider uses confidential information for their own personal gain, without the company's permission. For example, if a company's CFO uses information about an upcoming acquisition to buy shares of the target company before the news is made public, he would be guilty of insider trading.
This is when an individual receives material, non-public information from someone else and then trades on it. For example, if a friend told you about a company's upcoming earnings report, you would be liable for trading on that information.
The SEC is able to bring charges for insider trading even if the individual did not actually make any money from the trade.
Examples of insider trading
Here are a few hypothetical examples of insider trading:
A board member of a pharmaceutical company learns about a new drug that is going to be approved by the FDA. He buys shares of the company before the news is made public and sells them after the stock price goes up.
A government employee overhears a conversation about an impending regulation that will negatively impact a certain industry. The employee then buys shares of companies in that industry, knowing that their stock prices will soon drop.
A CFO learns that his company is about to announce lower-than-expected earnings. The CFO then sells his shares of the company's stock before the news is made public.
A large shareholder in a company is approached by the CEO with a view to sell his shares. The shareholder, knowing that the company is about to go bankrupt, sells his shares before the information sees the light of day.
Why is insider trading bad?
To most people, insider trading is a victimless crime. The reality, though, is that it can cause harm in many ways. Some of them include:
Damages market liquidity and efficiency
When insiders are sharing confidential information, it can prevent prices from responding normally to new information. This damage to market liquidity and efficiency can have a ripple effect, making it more difficult and costly for other investors to trade.
Creates a culture of corruption
Allowing insider trading can create a culture of corruption and self-dealing in which people in positions of power abuse their position for personal gain. This can have far-reaching consequences, damaging institutions and harming innocent people who become caught up in corruption.
Violates the trust placed in corporate insiders
Insiders are given access to confidential information because people in positions of power and responsibility are trusted to act in the best interests of the company and its shareholders.
When insiders abuse that trust by trading on material, nonpublic information for their own benefit, it violates the faith placed in them.
Leads to civil and criminal penalties
Insider trading is a serious violation of the law, and it can lead to both civil and criminal penalties. This includes fines, jail time, a ban from the securities industry,and being barred from serving as a corporate officer or director
Civil penalties can include a fine of up to $5 million and up to 20 years in prison. Criminal penalties can include a fine of up to $5 million and up to 20 years in prison.
In some insider trading prosecutions, the SEC may also require those involved in insider trading to give up their ill-gotten gains. This is known as disgorgement.
Causes reputational damage
When a company is caught up in an insider trading scandal, it can damage its reputation and make it harder to do business. This can lead to a loss of customers, contracts, and investments.
Creates a perception of unfairness
When some investors are able to profit from inside information while others are not, it creates a perception of unfairness. This can damage confidence in the markets and discourage participation.
Market professionals such as securities analysts, investment bankers, and money managers may be less likely to share their own valuable insights if they believe that others may be using insider information to trade against them.
Reduces the overall quality of financial markets
When insider trading is allowed to flourish, it can reduce the overall quality of the market. This includes making it harder for good companies to raise capital and making it easier for bad companies to stay in business.
Preventing Insider Trading
There are a number of steps companies can take to prevent insider trading, including:
Appointing an in-house watchdog
Some companies choose to appoint an in-house watchdog to monitor employee trading activity and compliance with insider trading regulations. This role can be rotated among employees to maintain objectivity and prevent any one individual from becoming too powerful.
Educate employees on insider trading rules
Employees should be regularly educated on insider trading laws and the potential consequences of violating them. This can be done through online insider trading training modules, in-person seminars, or other methods. Also, companies should have a clear policy in place that prohibits insider trading and outlines the disciplinary actions that will be taken if it occurs.
Require employees to disclose any potential conflicts of interest
Employees should be required to disclose any potential conflicts of interest, such as owning shares in a competitor company. This information can then be used to make informed decisions about who should have access to sensitive information.
Implement a pre-trade approval process
Some companies choose to implement a pre-trade approval process for employees who want to buy or sell company stock. This involves submitting a trade request to a designated individual or committee, who will then review the request and determine whether or not it is permissible.
Consider implementing a trading blackout period around key events, such as earnings releases
Whenever a company is about to release earnings, release a new product, or experience any other type of key event, it may be wise to implement a temporary trading blackout period. This means that employees will not be allowed to trade company stock during this time. Blackout periods typically last for a few days before and after the event in question. This helps to ensure that employees can not take advantage of any insider information they may have and make money on insider trades.
Use data analytics to monitor employee trading activity
Many companies are now using data analytics to monitor employee trading activity and identify potential insider trading. This approach can be used to flag unusual patterns of trading, such as sudden and suspicious stock trades before a key event.
Analytics can also be used to track the time between when an employee is granted access to inside information and when they make a trade. If there is a short time period between the two, it may be worth investigating further.
Conduct periodic compliance audits
Companies should periodically conduct compliance audits to ensure that their insider trading policies and procedures are effective. These audits can be conducted by an external firm or by the company’s internal audit team. They should assess the adequacy of the company’s controls and identify any areas of improvement.
Take prompt action to address any potential violations.
If a potential case of securities fraud is discovered, it’s important to take prompt and decisive action. This may involve launching an investigation, terminating the employee in question, and/or reporting the violation to the authorities. By taking prompt action, companies can send a strong message that they take compliance seriously and will not tolerate any violations of the law.
Let EasyLlama Handle Your Company's Compliance Training
To prevent insider trading, companies need to foster a culture of compliance, where employees feel comfortable reporting potential violations without fear of retribution. One way to do this is by regularly conducting compliance training.
EasyLlama offers comprehensive compliance training solutions that can be customized to your company's specific needs. Our online platform makes it easy to deliver training to employees across the globe, allowing you to ensure that everyone is up-to-date on the latest regulations.
Contact us today to learn more about how we can help you promote a culture of compliance within your organization.