Understanding Insider Trading
Insider trading undermines the fairness and efficiency of financial markets. It occurs when an individual trades a company's securities while in possession of material, non-public information about that company. This information is not available to the general public and could significantly impact the stock price. By exploiting this privileged knowledge, insiders gain an unfair advantage over other investors.
Federal law prohibits such activity under Rule 10b-5 of the Securities Exchange Commission (SEC) Act of 1934. This rule broadly prohibits "employing any manipulative or deceptive device or contrivance in connection with the purchase or sale of any security." Insider trading is considered manipulative as it creates an uneven playing field where some investors have access to crucial information that others do not.
Securities include a range of financial assets that denote ownership, including but not limited to:
- Stocks
- Limited partnership interests
- Bonds
- Notes
- Oil and gas interests
- Investment contracts
Legal vs. Illegal Insider Trading
The line between legal and illegal insider trading can be blurry. Rule 10b-5 of the Securities Exchange Act prohibits trading on material, non-public information (MNPI). However, Rule 10b5-1 attempts to provide a safe harbor for insiders by allowing them to establish pre-planned trading arrangements.
Rule 10b5-1 allows company insiders to trade their company's stock legally under specific conditions. An insider can set up a pre-determined trading plan that outlines the amount, price, and timing of trades. This plan must be established before the insider becomes aware of any MNPI.
By following these steps, the insider demonstrates they are not basing their trades on undisclosed information. Any deviation from the strictures of Rule 10b5-1 can veer into illegal activity.
What is Insider Trading? | Examples
Examples of illegal insider trading include:
- Tipping off friends, family, or associates to company information
- Trading corporate stock after learning about non-publicly disclosed information as a company executive, director, or employee
- Trading based on non-public information as a government employee
Some real-life examples of insider trading include:
- Brett Kennedy (2017). A former Amazon financial analyst, Brett Kennedy, admitted that he received payment for sharing non-public quarterly financial results to a friend. This friend used the information to buy Amazon stock and later sold it at a profit after the results became public. He faced civil and criminal consequences.
- Steven A. Cohen/SAC Group (2013). Prosecutors alleged that SAC Capital, under Cohen's leadership, profited by using non-public information to make trades. Multiple employees, including portfolio manager Matthew Martoma, were accused of getting insider tips on pharmaceutical companies like Elan and Pfizer. While Cohen himself never faced criminal charges, SAC Capital pleaded guilty in 2013. It was a record-breaking penalty – a hefty $1.8 billion in fines. The case against Cohen focused on his role in supervising his employees. The SEC believed Cohen failed to prevent a culture of insider trading at SAC. Though he wasn't found criminally liable, Cohen settled with the SEC in 2016, facing a two-year ban on managing outside funds.
- Jeffrey Skilling (2006). While not a classic insider trading case, the Enron scandal involved executives like Jeffrey Skilling manipulating financial statements and misleading investors. Prosecutors alleged Skilling used his knowledge of Enron's true financial state to sell millions of dollars worth of his company stock just before its collapse. Skilling was ultimately convicted on one count of insider trading in 2006, alongside several other charges, including securities fraud and conspiracy US Securities and Exchange Commission. This case highlights the broader concept of market manipulation, which can sometimes overlap with insider trading activities.
- Martha Stewart (2004). Martha Stewart was under suspicion for insider trading after selling her shares in ImClone Systems just before the company's stock price plummeted due to a negative FDA decision on a crucial drug. She allegedly received information from her stockbroker, who allegedly learned that ImClone System’s CEO was selling his own shares. While both parties were accused of insider trading, they were not convicted of insider trading, as her defense counsel argued she had a pre-existing sell order with her broker. The prosecution could not establish a link between the trade and known insider information. Thus, Stewart only faced obstruction of justice and conspiracy charges.
- Albert H. Wiggin (1938). One of the earliest high-profile insider trading cases involved Albert H. Wiggin. He profited from insider trading in a way that was legal at the time but unethical and led to a change in laws. In 1929, as the market began to show signs of trouble, Wiggin started selling short massive amounts of Chase National Bank stock (over 40,000 shares). As the head of the bank, Wiggin had a unique vantage point. He likely possessed a much clearer picture of the bank's true financial health than the public.
Consequences of Insider Trading
Insider trading convictions carry hefty penalties to deter such activity. The SEC can impose civil penalties of up to three times the profit gained or loss avoided through the illegal trades. You can also face criminal prosecution and face 20 years of imprisonment, and fines of up to $5 million for individuals and $25 million for corporations.
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