What is Insider Trading?
When an individual or a group of individuals indulges in trading activity directly or indirectly as a result of having access to certain confidential information about an organization which can change the perception if that information is made public, hence affecting the stock prices of a listed entity is known as the insider trading.
To understand this, let’s look at the phrase.
- The first word is “insider”, meaning when an individual is inside a company or an individual works for a business (i.e. an employee).
- The last word is “trading”, meaning when an individuate security.
Clubbing these two words, we get this meaning– an employee who trades the securities of the company.
Now, trading can both be legal and illegal insider trading
- Illegal insider trading is when the insiders want to benefit from the company information at the cost of the company.
- Legal insider trading is when the insiders of the company trade shares but at the same time report the trade to the Securities and Exchanges Commission (SEC).
Let’s take various examples to illustrate how legal and illegal insider trading works.
- Let’s say that a company would go for a merger in a few months. An executive of the company gets to know about this. And to benefit from this, he purchases the shares of the company before the announcement of the merger is actually made public. This is called illegal IT.
- Let’s say that a government employee learns that due to a regulation a transportation company would greatly benefit. Secretly he decides to buy shares of the transportation company and pushes to pass the regulation as early as he can. This is illegal trading by an insider since the employee is only benefiting from the information that is not being made public yet.
- Mr. H is an employee of an organization. He has been attending a meeting where the CFO of the company has been talking about how the company would go toward bankruptcy within a few short months. Knowing this Mr. H secretly calls his friend who owns a large number of shares of the company and warns that the company would go toward bankruptcy and his friend should sell the shares of the company immediately.
For illegal trading, the guilty party may need to pay a huge fine or even get imprisonment.
SEC charged Jun Ying, a former CIO of the US Business unit of Equifax for this trading. Ying sold his stock ahead of the public disclosure of the company’s massive data breach.
As a business owner or as a member of the board of directors, if you see any trading inside your company, you must report to the Securities and Exchange Commission (SEC) by using the form 4. (also have a look at Types of SEC Filings)
Now, let’s look at a few examples.
- The CEO of a company has bought 10,000 shares of his own company. Since it’s trading by an insider, the owner of the company reports the same to the Securities and Exchange Commission (SEC). This is legal because the trading by an insider is reported.
- Employees are often provided with stock options as part of their compensation. In that case, if an employee exercises his stock options and gets 500 company shares, we can call it legal trading by an insider.
- Mr. T is on the board of the company. He decides to buy 3000 shares of his own company. And the transaction is immediately reported to the SEC. We can call it legal insider trading as well.
Difference between legal vs illegal insider trading?
As we have cited examples of both legal and illegal insider trading of the companies, we still need to highlight the points where legal trading can get wrong.
- First, we can call a trading legal when the trading is done during a window of time where non-public information won’t affect the investment decisions of the outside investors.
- Second, we will call a trading legal, when the trading by an insider is immediately reported to the Securities and Exchange Commission (SEC) because doing so discloses the information to the public.
- Third, any trading that is legal (e.g. employee stock options) would also come under legal insider trading.
- Fourth, if any employee shares non-public information with his friends to benefit them, it’s not legal trading by an insider. And this trading should immediately be reported if found out. If the SEC finds the employee guilty, he needs to pay a fine or it may lead to harsher punishment as well.
- Fifth, the board of directors and the owners of the company should be vigilant that any insider information shouldn’t be shared without the prior consent of them.
This has been a guide to what is Insider trading, its meaning along with practical examples. Here we also discuss differences between Legal Insider Trading vs Illegal Insider Trading. You may also have a look at the following articles to learn more about trading –