What is Insider Trading and Why is it Illegal?

Now you get why it is hard to hide private information and realize if all these people involved in processes start to trade according to what they know before everyone else does - the whole process of the trading would fall into chaos in days. Is insider trading illegal? How does insider trading work? What are insider trading options? We’ll answer all these questions in this article.

What is Insider Trading?

According to the Oxford Dictionary, insider trading definition is the illegal practice of trading on the stock exchange to one's own advantage through having access to confidential information.

‘What is insider trading and why is it illegal?’ — let’s take a closer look at it. 

Real-life example N1: in 2001 Sam Waksal, founder of an ImClone company told his family and friends to sell the stocks of the company. His close friend Martha Stewart sold stocks at the price of $228,000. She wasn’t the only one who did that - Waksal’s daughter also sold her stocks and all their friends. That led to a significant decline in the stock price of the company. 

During the investigation of the case, it turned out that it was not the first time Waksal overshared some private information but also hid from taxes. He was sentenced to 7 years in prison as well as Martha Stewart who also used this information and was sentenced to 5 months. 

Real-life example N2: R. Foster Winans, one of the most famous journalists of The Wall Street Journal was convicted for passing information from the article he was supposed to publish. He made about $700,000 and after the investigation on the case got the sentence of 18 months in prison. 

Idea to watch: “Wall Street '' movie, 1987 where the main character Gekko makes a fortune on insider information trading. 

It’s very tempting to use non-public information to make some money. In order to protect the free market and companies themselves any sight of using this knowledge in trading is strictly prohibited by the law.  Is there such thing as legal insider trading? Yes, even though there is still a debate on the topic  should insider trading be legal or not, it does exist. Sometimes, it is legally allowed for insiders to sell and buy stocks, however, only after the approval of the special authority on special insider trading terms. In the US this authority is being represented by the Securities and Exchange Commission. They regularly post available information on their website updating everyone on new and already existing cases. For example, they can approve buying and selling of the stocks of the company’s CEO or employees if this deal will not greatly influence the whole stock market and industry. So, if you work in Amazon and you decide to sell some of your private stocks in most cases it will not be an insider trading operation, however, if someone involved in the major decisions is selling his or her stocks in panic after discussing the quarterly revenues - that’s totally illegal. 

Unfortunately, insider trading exists and before the crisis in 2008 a clear tendency of selling stocks of some companies was clearly visible. However, it is hard sometimes to identify what these sales were based on —  intuition of something going wrong, basic sense or some real insider information being shared among people in certain business areas. Special commissions watch closely all the possible cases, but many cases remain unsolved due to the lack of information about tips received. 

How does Insider Trading Work?

Why is insider trading bad, you may ask. Let’s take a closer look at what is insider trading from a long-term perspective for the whole market. 

If some people will trade based on the information that they know and it won’t be punished, insiders will be able to benefit in tremendous amounts and then, at some point, the information on prices on all the stock exchanges would be distorted and the fair market will no longer exist. That’s why maintaining the principles of fair trade is that important. 

However, here you may find some open to public information on insider trading deals and see how it would affect the market and certain areas of the industries. This would also be the part of the research that you make as an investor. The SEC’s Edgar database, the database of the Canadian transactions, is also available for anyone. 

To understand what is considered insider trading let’s look at the most prominent recent case — the accusation of Elon Musk and his brother in insider trading. His brother, who also sits on the Tesla board, has sold $108 mln worth of shares a day before Elon tweeted a poll, asking whether he should sell shares. We all know how powerful is Elon’s Twitter, so the shares dropped the same day. If this is true, you can understand how insider trading works. Elon could’ve told brother what he was about to post, the brother took advantage of it and sold shares ahead of the tweet, voila — brother earned money on insider transaction. Nonetheless, the case is still under investigation. There have been many other accusations to Elon Musk about speculating the market with his tweets, but no legal implications so far.

‍Difference Between Insider Trading and Insider Information

What do we mean by saying “insider information”? Is any information in the company can be considered insider? Basically, any information about operations, financial documents/contracts/proposals, any kind of pipelines and roadmaps, or operational processes that are under a non-disclosure agreement can be considered insider information. Insider trading is a process when non-public information is being shared with third parties with the goal of financially beneficial usage. 

How is Insider Trading Punished?

For those who are wondering ‘Is insider trading legal?’, think about this. The main idea of the free market is fair distribution of information and equal rights to everyone. But If each employee of each company will freely trade based on the information they have it may completely ruin the company’s performance and crush its stock exchange prices. Because they have an unfair advantage of information. Moreover, sometimes they can directly affect financial information or performance. That is why insider trading is illegal. The person caught in insider trading is usually punished by the law. 

 According to the Securities and Exchange Commission in the US maximum fine can reach the amount of 5$ million and more than 10 years of imprisonment. In different countries, this law may vary but usually, the punishment for insider trading is severe enough to stop people from spreading the non-public information. 

Companies involved in insider trading scandals are less popular among traders.  Here is an interesting survey about it. 

Final Thoughts

First tip and rule - do not try to do that. Little oversharing or tipping someone may cause significant results which may lead to very serious consequences for the company and the financial market in general. If you work in a company which is publicly traded, you should check with your compliance department, what insider trading laws there are within the company and when you can sell or buy stocks. Usually, it's a couple of months before or after quarterly reports, so that you don’t speculate with information about company’s quarterly results. However, it is always interesting to learn from real-life insider trading cases and learn how it affects prices and the market in general. 

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