Insider Trading: What It is and When It’s Illegal
“Insider trading tells everybody at precisely the wrong time that everything is rigged, and only people who have a billion dollars and have access to and are best friends with people who are on boards of directors of major companies—they’re the only ones who can make a true buck.” – Preet Bharara, former US Attorney for the Southern District of New York.
The free markets envisioned by Adam Smith in The Wealth of Nations stipulated that consumers make decisions based on the most recent and relevant information so that the “invisible hand of the market” can have its full effect.
The founder of classical capitalism viewed externalities such as tax incentives from the government, lobbying groups, and unfair monopolies as sources of market fatigue. He would likely find the prohibition of insider trading just as intrusive.
So why does the Securities and Exchange Commission (SEC) prohibit trades based on non-public information?
We’ll get to that after we take a look at some important points of insider trading.
There are two types of insider trading: one is legal and one is illegal.
The first kind, the legal kind, is just insiders buying their own company’s stock. It’s called ‘insider trading’ because, well, they are insiders either in the form of directors and managers or other employees.
Where insider trading becomes illegal is a fine line … and a blurry one.
By definition, this illicit form of insider trading is the illegal practice of trading on the stock exchange to one’s own advantage through having access to confidential information.
According to the SEC (which is all that matters here), illegal insider trading “refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include ‘tipping’ such information, securities by the person ‘tipped’, and securities trading by those who misappropriate such information.”
So, the legal version is simply insiders buying and selling their own company’s stock. The illegal version is WHEN they choose to do this, and WHY. Insiders may have access to information not known to the public, whether it is information about a new product, a merger with another company, a change in leadership or great earnings reports upcoming. If they act on this before it’s public knowledge, that’s insider trading. And they must report their trades to the SEC 10 days from the end of the month when the transaction took place.
In other words, insiders can’t trade when they have the advantage over the public.
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Here’s a recent example:
A Florida man was charged by the SEC for insider trading when Apple bought his employer, AuthenTec, a mobile security company. After learning nonpublic information about a merger in July 2012, and after hearing non-public information from a special AuthenTec board meeting, Stimpson—a senior network administrator for AuthenTec–bought call options knowing that the stock would rise. He then sold his options within three months after Apple announced the $356-million takeover. AuthenTec’s share price jumped by two-thirds. But Stimpson didn’t make a killing on this because he had to settle in July 2017 with the SEC, agreeing to pay $278,773.
One of the most famous examples, though, is the case against HGTV star and home goods vendor, Martha Stewart.
This household name got caught in the insider trading trap back in 2003 when she sold shares in the pharmaceutical company ImClone after receiving a tip from a Merrill Lynch advisor. The Food and Drug Administration (FDA) had been on track to approve Erbitux – an essential cancer treatment drug. CEO Samuel Waksal gave Merrill Lynch broker Peter Bacanovic a thumbs down, signaling that a denial from the U.S. government was imminent. Stewart’s transaction became illegal the second she acted on the illicit information. She went to prison for three months, and her broker was behind bars, too.
Was it worth it? Hardly. While she temporarily saved $46,000 that she would have lost when the stock dropped over the failure to gain FDA approval. She would have earned $60,000 if she had just waited. She would also have avoided prison and a $30,000 fine.
Cases are usually high profile because, at the end of the day, it’s hard to prove (but much easier if you’re a celebrity).
Should Insider Trading Be a Free Market Freebie?
Libertarian economists argue that the current system is based on a legal agenda that is hostile to natural market activities, inflating or deflating the value of key sectors due to restrictions.
“The objective of insider trading laws is counter-intuitive: prevent people from using and markets from adjusting to the most accurate and timely information,” says Doug Bandow of the Cato Institute. “The rules target ‘non-public’ information, a legal, not economic, concept. As a result, we are supposed to make today’s trades based on yesterday’s information.”
Businesses of all sizes have benefited monetarily from the unprecedented level of connectivity brought on by the internet age.
The current system ensures that a broker will get the most recent information in the timeline they desire, but it still does not guarantee the delivery of the most RELEVANT data. Privileged information is protected by the U.S. government as an illegal weapon in the stock market game.
There is a good reason for this rule. The richest and most well-connected members of American corporate life would benefit from this rule most immediately. Middle-class families would be too intimidated to funnel their savings into a system that overtly benefits private information that could legally and easily be bought or sold by the upper class.
The inherent inequity in allowing transactions like Stewart’s to be legal is clear. But this story does reveal something deeper about the functionality of the U.S. legal system in the handling of insider trading cases: It’s all about the big fish.
Making an example of a high-profile public figure to emphasize the weight of a new or important law has been a tactic of nation-states forever. Public prosecution and punishment establish the legitimacy of laws considered obscure or unnecessary.
Stewart paid a high price for a total savings of $45,673. The Securities Exchange Act of 1934 hit her reputation with full effect. Mothers and middle-aged women across the world saw Stewart face American courts on the same television sets that used to bear her cooking and home improvement shows.
The morality of insider trading is tough to navigate. The current system affords the upper class the privilege of their network with consequences as long as they make a major public sacrifice every few years.
The long and short of it is that if this darker form of insider trading were legal, it would eventually render the stock marketirrelevant because everyone but the insiders themselves would lose trust and pull their money out. The free market can only be defended so long as it actually exists.
Or, from the perspective of The New Yorker’s James Surowiecki, “If companies tell us more, insider trading will be worthless.”