Insider trading is buying or selling a stock or other security while using material, nonpublic information in violation of a duty of trust or confidence. It can also involve giving confidential information to someone else who trades, known as tipping, or trading on information taken from an employer or another source.
Insider Trading at a Glance
| Term | Meaning |
|---|---|
| Material information | Information a reasonable investor would consider important when deciding whether to buy, hold or sell a security |
| Nonpublic information | Information that has not been broadly disclosed to the investing public |
| Insider | An officer, director, employee, adviser or other person with confidential access to company or market information |
| Illegal insider trading | Trading, tipping or recommending trades while improperly using material, nonpublic information |
| Legal insider transaction | A permitted trade made without using material, nonpublic information and reported when disclosure rules require it |
Why Is Insider Trading Illegal?
Insider trading gives one investor an information advantage that other investors do not have. U.S. securities laws prohibit trading on material, nonpublic information when the person has a duty to keep it confidential or a duty to refrain from trading. The practice can also weaken confidence in the fairness of financial markets.
The word insider does not decide the issue by itself. The key questions are:
- Was the information material?
- Was it nonpublic?
- Did the person trade, tip someone else or recommend a trade?
- Did the person breach a duty of trust, confidence or confidentiality?
What Is Material Nonpublic Information?
Material nonpublic information, often called MNPI, is confidential information that could reasonably influence an investor's decision or affect a security's market price. It can be positive or negative.
Examples include:
- Earnings results that have not been released
- A pending merger or acquisition
- An expected bankruptcy or serious financial problem
- A major contract or the loss of an important customer
- A significant product failure or recall
- A major regulatory decision
- A cybersecurity breach
- An undisclosed change involving senior management
There is no universal dollar threshold for materiality. Whether information is material depends on the facts, the circumstances and how the information would change what investors know about the company.
Information is generally nonpublic until it has been distributed broadly through an SEC filing, press release or another channel intended to reach investors generally. A rumor shared with a small group does not necessarily make confidential information public.
Who Can Commit Insider Trading?
Illegal insider trading can involve anyone who receives or misuses confidential information. Potentially liable people may include:
- Corporate officers, directors and employees
- Lawyers, accountants, bankers and consultants working for a company
- Friends or family members who receive confidential information
- Government employees who obtain confidential market information through their jobs
- Investment professionals and analysts
- Anyone who takes confidential information from an employer or another source
A person who receives an illegal tip may face liability even if that person has no job or other connection to the company whose stock is traded.
What Are Common Examples of Insider Trading?
Trading Before an Earnings Announcement
A company employee learns that quarterly earnings will be substantially below expectations. Before the company releases the results, the employee sells company stock.
The employee may have committed illegal insider trading because the sale used material, nonpublic information.
Tipping a Friend
An employee tells a friend that the company is about to be acquired. The friend buys shares before the acquisition becomes public.
The employee may face liability for tipping. The friend may also face liability for trading on the tip.
Misappropriating Information
A lawyer working on a confidential acquisition learns the identity of the target company and buys its shares. The lawyer may violate insider trading rules even though the lawyer does not work for the target company. The information came through a confidential professional relationship.
Is All Insider Stock Trading Illegal?
No. Corporate insiders can legally buy or sell company stock. A trade becomes illegal when it uses material, nonpublic information or otherwise violates applicable securities laws.
Certain officers, directors and shareholders who own more than 10% of a class of a company's securities generally must report their holdings and transactions to the SEC using Forms 3, 4 and 5. In most cases, Form 4 reports a transaction within two business days.
Filing a transaction does not make an illegal trade legal. The filing addresses a reporting requirement. Insider trading law focuses on the information used, the person's duties and the circumstances of the trade.
What Is a Rule 10b5-1 Trading Plan?
A Rule 10b5-1 trading plan is a written arrangement that can allow an insider to schedule future purchases or sales before becoming aware of material, nonpublic information.
For the regulatory defense to apply, the plan generally must be established in good faith before the person learns the information. It must specify the amount, price and timing of trades, use a written formula or algorithm, or remove the person's later control over the transactions.
A Rule 10b5-1 plan is not an automatic exemption from insider trading law. Its validity depends on whether the applicable conditions have been met.
What Are the Penalties for Insider Trading?
The SEC can bring a civil enforcement action seeking remedies such as:
- Monetary penalties
- Repayment, or disgorgement, of unlawful gains
- Injunctions
- Restrictions on working in the securities industry
- Restrictions on serving as a corporate officer or director
A case may also be referred to law enforcement. A criminal conviction can result in imprisonment.
The SEC investigates suspected insider trading through market surveillance, investor tips, whistleblower submissions, brokerage records, emails and trading data.
How Can Investors Avoid Illegal Insider Trading?
If you receive information that may be material and nonpublic:
- Do not buy or sell the security.
- Do not share the information with anyone else.
- Do not recommend or encourage a trade.
- Do not trade related options or other securities.
- Ask a securities lawyer or compliance officer before acting.
The practical rule is simple: if confidential information could reasonably influence an investor's decision, do not trade until the information has been publicly disclosed and the market has had a reasonable opportunity to absorb it.