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What Is Insider Trading?

UTC by Beatrice Mastropietro · 7 min read
What Is Insider Trading?
Photo: Unsplash

The guide tells you what insider trading is and how to avoid it. Insider trading can be a huge problem for companies, but you will have the knowledge to stay secure from insider traders with the information provided below.

Insider trading is the purchase or sale of a company’s shares by individuals with non-public knowledge about the firm. Non-public information contains news not communicated to the public at large. It is unlawful for an insider (for example, a company officer) to utilize such information while purchasing, or selling, an inventory unless it is first publicly available. The assumption is that if all investors have equal access to public information, the financial market will be more efficient and thus compete on a level field.

Employees of the company with access to confidential information can perpetrate insider trading. Trading on inside knowledge is illegal in most countries and is punishable both civilly and criminally. But in some circumstances, the US allows insider trading. Anybody who traded stocks with information of an incident that took place prior to public disclosure may not be subject to punishment under Insider Trading legislation unless the individual traded.

Insider Trading History

Insider trade was illegal in the early twentieth century. Furthermore, the Supreme Court determined that it was unconstitutional. There were severe punishments for anybody who was doing the act.

Following the Securities Exchange Act by Congress in 1934, the Securities and Exchange Commission became involved in monitoring insider trading for the first time. However, the issue of what constituted criminal insider trading remained unsettled at the time.

The insider trade is lawful but nonethical for the typical investor. It occurs when a person with access to or inside of a company’s expertise utilizes that knowledge in the form of stock dealings to take advantage of it. Insider trade is prohibited. Therefore, you may put yourself in jail if you get involved with the activity. Insider trading does not allow you to use your information for profit. Instead, it uses past earnings reports and other measurements that give away small pieces of information about how the company may perform in its following quarter results. Insider trading can be just as significant an investment risk as protecting yourself from being taken to court. It has been around since 1929 (The Great Depression) when Samuel Insull sold $400 million worth of stocks illegally.

Most Notables Insider Dealing Cases

Let us have a look at the examples of the most famous cases of insider dealing.

  • Jeffrey Skilling

Insider trade was the most damaging of Jeffrey Skilling’s numerous misdeeds while serving as Enron’s chief financial officer. In this conduct, he deceived the investing public by concealing Enron’s severe financial problems. Skilling solicited the assistance of a panel to protect him from legal action when he began dumping his shares. As CFO and one of the individuals who designed the plan, he understood what was going on with Enron was wrong, but investors did not comprehend it. As many as 19 courts found Skilling guilty by a federal jury in 2006.

  • Ivan Boesky / Michael Milken

Michael Milken was regarded as the “junk bond king” for his involvement in establishing the sector for high-yield corporate bonds in the 1980s, which investors used to organize leveraged buyouts or mergers and acquisitions of firms. However, he fell into difficulty when it turned out that he handed along stock-picking information to successful stock picker Ivan Boesky.

Boesky worked as an investment banker, investing in securities and commodities to benefit from short-term transactions. He accomplished this by purchasing and selling equities in businesses undergoing mergers (without giving it away to Milken). After being convicted on one count, Boesky accepted a guilty plea for securities manipulation. The SEC promised him leniency if he cooperated.

  • R. Foster Winans

R. Foster Winans, a newspaper columnist, authored a weekly financial piece titled “Heard on the Street”. Though he was an outsider in the industry, links between the financial media in New York and traders in their city are difficult to avoid.

Winans got caught up in a scheme and eventually confessed to trading on information he learned for his column. Winans got an offer of $30,000 that he accepted because the broker had inside information about stocks that would benefit him financially but hurt others

  • Martha Stewart and Samuel Waskal

After getting early notification of the rejection, Martha Stewart liquidated her interests in ImClone stock, trading for about $50 per share. Following this occurrence, she quit as CEO of her firm following suspicions of insider trading. Shares of ImClone took a sharp dive when it turned out that the FDA rejected its new cancer drug. In 2003, Samuel Waskal was sentenced to more than seven years in jail and fined $4 million for his role in fraud charges linked to ImClone’s unlawful Vioxx activities.

  • Goldman Sachs / Business Week

Eugene Plotkin’s and David Pajcin’s cases appear to mirror the work of others convicted of unlawful insider trading. The most notable example is when they participated in insider trading operations in several different investment vehicles.

Plotkin worked as a stock research analyst at Goldman Sachs Group Inc (NYSE: GS), and Pajcin worked in investment banking. They collaborated to find someone on the Merrill Lynch team who could provide them with information about key deals the company was conducting, such as joining Reebok and Adidas. Plotkin and Pajcin would then buy shares of firms that had almost been acquired in previous deals or that might be purchasing other companies immediately after hearing of new developments. Then they would sell their stocks for a quick profit after all the release of facts, just like Ivan Boesky.

In one of their maneuvers, which was reminiscent of the R. Foster Winansan scenario, they paid someone to get a job at one of Business Week’s printing plants and steal a copy of the magazine before it hit the newsstands.

Penalties for Insider Trading

If discovered, a person faces jail, a fine, or both. According to the SEC, a conviction may result in a $5 million fine and 20 years in jail. According to India’s SEBI, the penalty for an insider trading conviction is INR 250,000,000 (about $3 million), or three times the profit earned from any transaction involving substantial non-public knowledge.

Safeguards against Insider Trading

There are several tips that could prevent insider dealing or show that it takes place and handle it.

  • Monitoring trading activity

Companies are constantly striving for a competitive advantage in the stock market, but insiders have the upper hand. The SEC analyzes trading activity and looks for unusual trades such as significant event announcements, acquisitions, and so on. They may alter a company’s value to its shareholders or those which could lead to insider trading investigations.

  • Complaints from traders

Substantial complaints from traders who have lost large sums of money on large trades may be one approach for authorities to uncover and launch investigations into insider trading. Inside traders frequently use the options market to leverage and magnify their gains as they try to maximize the value of their insider information.

A trader who has insider information can profit from it by purchasing call or put options. If someone does this and regulators make the trade public, it may raise red flags for investigators hunting for someone trading on inside information.

  • Blackout periods

Most companies take a number of steps to prevent insider trading at the company level. It includes blackout periods where officers and board members have no right to buy securities.

  • Seeking clearance from a legal officer

A company’s chief legal officer (CLO) might also have to approve officers’ or directors’ purchases and sales of securities in the company. This is typical to avoid any conflicts of interest or violations of securities law.

  • Educational programs

Companies frequently establish an education program for their personnel in addition to these measures. Generally, these programs aim to educate employees on insider trading. As a result, they can avoid doing it themselves or placing others in a position to do it. These seminars typically instruct employees not to discuss information about earnings, takeovers, security offerings, or litigation with third parties.

Conclusion

Insider trading is subject to punishment by governments and levies criminal sanctions for those who are conducting the activity. It it threatens investor confidence in the capital market. Therefore, it is important to understand what it is not only for individual investors but also for companies.

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FAQ

What is insider trading?

It is the illegal trading practice on the stock exchange to one’s advantage through having access to confidential information.

When is insider trading illegal?

Insider trading is deemed illegal when material information is classified as “non-public.”

When is insider trading legal?

Insiders are lawfully allowed to purchase and sell stocks, but the transactions must be reported to the SEC.

What is the punishment for insider trading?

The penalty is a fine of $5 million, jail term, or both.

How to prevent insider trading?

There are many ways to prevent insider trading; as mentioned in the guide one of the ways is educating employees regularly on insider trading.

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