Learn About Insider Trading and the Implications

Insider Trading

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Insider trading is a topic that historically generates a great deal of news. The first name you may think of (among all the executives and business professionals accused and/or convicted) is home design guru Martha Stewart who spent time behind bars for insider trading.

If you're not familiar with this world, insider trading is the trading in a security (buying or selling a stock) based on material information that is not available to the general public. It is prohibited by the US Securities and Exchange Commission (SEC) because it is unfair and would destroy the securities markets by destroying investor confidence.

What Constitutes An Insider

A company insider is someone who has access to important information about a company that might influence investor decisions that would impact the firm's stock price or valuation. This important information is often described as material information. 

Company executives and general managers have material information. For example, the Vice President of Sales knows how much product the company has sold and whether it will meet the revenue estimates it provided to investors. Others in the company have material information, such as the accountant who prepares the sales forecast spreadsheet. The firm's administrative assistant also has material information because he or she prepares the press release and has advance insight into income results.

Other insiders include financial analysts; top salespeople; individuals in Investor Relations and/or Public Relations who prepare the public announcements;  key people in Research & Development (if the company is developing a new product that could be a big seller); brokers; bankers and lawyers. As you can see the potential for inside trading is broad, which is why publicly traded organizations have clear procedures for notifying those individuals deemed insiders and explaining to them the rules, limitations, and potential penalties.

A Temporary Insider

So does that mean you are not an insider unless you are on the company's management team, financial or development teams, or someone hired to handle the material information? In a word, "No."

The SEC includes in its definition of insiders those who have "temporary" or "constructive" access to the material information. If the president of a company tells you that the company's best hope for a breakthrough product isn't going to get regulatory approval, you are now every bit as much an insider as he is. It is illegal for him to trade based on that knowledge before it becomes public knowledge.

It is equally illegal for you to do so because you are now a "temporary insider." This remains true regardless of how many times the information is passed. If the president tells his barber, who tells his babysitter, who tells his doctor, who tells you, that means that the barber, babysitter, doctor and you are all "temporary insiders".

Anyone who has material information is prohibited from trading, based on that knowledge, until the information is available to the general public. The US Supreme Court ruled that this even applies to someone with no ties to the company. Possession of material information makes you an insider, even if you didn't steal the information.

Penalties for Violating Insider Trading Rules

Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 gives the SEC the authority to seek a court order requiring violators to give back their trading profits. The SEC can also ask the court to impose a penalty of up to three times the profit the violators realized from their insider trading. In addition to the financial penalties, there are criminal penalties, as was the case with Martha Stewart. 

Protecting Your Company

Police your insiders yourself, don't allow insider trading and don't engage in it yourself. Be diligent about not sharing material information with anyone who is not an insider and make sure all insiders understand the responsibility this places on them and the circumstances under which they might become "temporary insiders." It is in your company's best interest to prevent insider trading. Even if the company and all its employees are eventually cleared by the SEC of any wrongdoing, the investigation itself can have lasting detrimental effects on the company in the eyes of the public and stakeholders.