Insider Trading is the illegal practice of trading on the stock or other financial instruments of a public company based on nonpublic, valuable information. An insider can access a company’s sensitive, nonpublic information or own 10%+ of its stock. Thus, the executives and directors of a certain company are considered insiders.
Any information that could cause a significant impact on the decision of investors to buy or sell a security is considered material information. Information not legally available to the public is referred to as nonpublic information. Investors with access to insider information enjoy an advantage over others who do not, and in some cases, make unfair, higher gains than their peers who don't have access to the same information.
The U.S. Securities and Exchange Commission (SEC) has a specific definition of illegal insider trading, which is “The buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security.”
Legal Issues of Insider Trading
Illegally using nonpublic information is usually done for financial gains only. Some types of insider trading are prohibited in several countries as it is perceived as unfair to an investor who cannot access the information that the insider has, which helps insider investors make higher gains than others. Insider trading regulations are complicated and differ greatly from government to government, and the degree to which laws are enforced differs from one varies by country.
An insider is allowed to practice trading, but they must record their trades with the Securities and Exchange Commission (SEC). This happens when CEOs buy back the firm's shares or when employees acquire stocks in the firm they are working in. The SEC keeps track of any illegal practice through trading volumes that rise when the company does not release any news and has no news released about it.
Legal insider trading is not rare in the industry. It is generally lawful for a firm insider to trade its shares as long as they record them to the SEC. Directors and prominent stockholders, for example, are required to report their transactions, holdings, and ownership changes.
An insider can be defined in a variety of ways in different jurisdictions, and they may also include associates and brokers. In some countries, someone who gains access to nonpublic information and practices trading on it could be charged with a felony.
- Pro Tip: Even if you overheard it accidently, the easiest way to prevent legal issues is to avoid spreading or exploiting material nonpublic information.
Is Insider Trading a Good Thing?
While insider trading may seem like a bad thing, there are surprisingly some people that support it. In defense of insider trading, some argue that this type of trading paves the way for nonpublic information (rather than merely public information) to be reflected in the prices of securities, hence increasing the efficiency of the market.
Other proponents of insider trading claim that prohibiting it just slows down the market’s natural process and causes investment errors. The prices of securities fall and rise in response to material information.
Imagine if a certain insider has positive news about a firm but is unable to purchase its stocks. The people that sell in the period between when he learns the information and when it is made public are thereby protected against price increases. An investor who is denied access to information or who obtains knowledge indirectly through market movements is more likely to make mistakes. If the information was learned earlier, they may have bought or sold a stock that they otherwise wouldn’t have traded.