What is insider trading?

Insider trading refers to the trading of a company’s stocks or other securities by individuals with access to confidential or non-public information. Taking advantage of this privileged access is considered a breach of the individual’s fiduciary duty.

The law requires that a company report trading by corporate officers, directors, or other company members with significant access to privileged information to the Securities and Exchange Commission or be publicly disclosed. United States federal law defines an “insider” as a company’s officers, directors, or someone in control of at least 10% of a company’s equity securities. Congress has criminalized these insiders’ use of non-public information under the theory that the use fraudulently violates a fiduciary duty with which the company has charged the insider. From an economic public policy perspective, scholars consider insider trading socially undesirable because it increases the cost of capital for securities traders and therefore depresses economic growth. The Insider Trading Sanction Act of 1984 and the Insider Trading and Securities Exchange Act of 1988 provide for insider trading penalties to surpass three times the profits gained from the trade.

Problems also exist with regard to insiders “tipping” friends about non-public information that may influence the company’s publicly-traded stock price. Because the friends do meet the definition of an insider, a problem arose regarding how to prosecute these individuals. Today, a friend who receives such a tip becomes imputed with the same duty as the insider – that is not to make a trade based upon that privileged information. Failure to abide by the duty constitutes insider trading and creates grounds for a prosecution. The person receiving the tip, however, must have known or should have known that the information was company property to be convicted.

There is criminal liability for an individual who trades on any stock based upon misappropriated information. Previously, the prosecutor could only charge the insider if the stock of the insider’s company had been traded. While proof of insider trading can be difficult, the Securities and Exchange Commission actively monitors trading, looking for suspicious activity. Under §10(b)-5, however, a defendant can assert an affirmative pre-planned trade defense.

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