The term “insider trading” tends to carry a negative connotation. After all, the common perception is that insider trading is always illegal, partially because illegal insider trading cases can gain high-profile notoriety in the press. Whether insider trading is deemed legal or illegal, however, depends on when and how the trade is made.
A trade is illegal when the material information is not public. If the public has equal access to the information, however, then the trade is legal, as long as certain regulations surrounding proper reporting of the trade are followed.
Anyone can be suspected of insider trading. Because of the nature of their positions, however, highly placed executives within public companies are more at risk than other people. These executives always know nonpublic information about the company, so any purchase or sale of stocks, bonds, and securities—no matter how innocent—may possibly come under scrutiny if it seems to benefit them in any way.
Because of this potential for misunderstanding, public executives must understand and follow Securities and Exchange Commission (SEC) insider trading rules to the letter in all financial dealings. They must also be familiar with insider trading examples to gain insight into these issues in action.
This knowledge is best gained through specialized coursework in programs such as an Executive Master of Business Administration Online. An Executive MBA Online degree can help anyone interested in becoming a business executive learn the ins and outs of U.S. financial regulations and avoid any impropriety.
What Is Insider Trading?
Insider trading occurs when a publicly-traded company’s stock is either bought or sold by an insider, or someone possessing material information on the stock that has not been disclosed to the public. To be considered an insider, a person must have either access to such information or stock ownership equaling more than 10% of the company’s equity.
This latter qualification categorizes a company’s C-suite executives and directors as insiders. However, this does not mean that these individuals are prohibited from buying and selling shares. They are permitted to do so, but their transactions must be above board and conducted via processes overseen by the SEC.
Following SEC-overseen processes is crucial. Failure to execute them can result in hefty consequences. Illegal insider trading carries a maximum fine of $5 million and a maximum prison sentence of 20 years, per SEC regulations.
Examples of Insider Trading
Insider trading takes multiple forms. The SEC lists several potential violation scenarios on its website. These scenarios include the following:
- Company executives, directors, and employees who traded corporate stock after learning about nonpublicly disclosed information
- Friends, family, or business associates tipped off to such information from company employees of any level
- Employees of brokerage, banking, law, or printing firms who traded based on information they obtained through providing services to the company using their firm to trade securities
- Government employees who traded because of nonpublic information they learned due to the nature of their employment
- Political intelligence consultants who trade or offer tips due to nonpublic data ascertained from government employees
- People who misappropriated and used nonpublic information from numerous sources, including family, friends, and employers
These examples demonstrate that insider trading is not exclusive to individuals who fall under the “insider” definition. Because information and how it is used is central to the concept, a person outside of a company can be just as guilty of insider trading as a corporate executive.
Such a scenario can play out like this: Imagine an employee is walking down a company corridor when he overhears a conversation between the CEO and the chief financial officer (CFO). The CFO is telling the CEO that the company has not met its sales expectations and will register a loss for the quarter when the numbers are made public in two weeks’ time.
The employee is alarmed. He knows that this is bad news and that the company’s stock value will drop when the figures are released. He also knows that acting on his advice, his cousin has invested heavily in the company. When the stock prices tumble, his cousin will take a big financial hit.
The employee goes home that night and phones his cousin. He tries not to give away any company secrets. However, without getting into specifics, he strongly suggests that his cousin sell her stock in the company. The employee understandably has some inside information that is spurring his suggestion.
The next day, the cousin follows the advice she has been given and sells her stock. She makes a nice profit on it. Two weeks later, when the company’s sales figures are released and stock prices do indeed tumble, the cousin feels very happy that she sold when she did and avoided a financial catastrophe.
In doing so, however, she has broken the law—and so has the employee who tipped her off. The employee is guilty of “insider tipping,” and the cousin is guilty of insider trading by being what the SEC refers to as the “tippee.” If they are caught, both can be fined or even imprisoned for their actions.
Difference Between Legal and Illegal Insider Trading
Insider trading can be split into legal and illegal categories. It is important for individuals to understand the difference between the two to avoid illegal activity.
The key difference is how transactions are handled. Insiders must register every transaction through the SEC, and this must be done via advanced filings. The SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system gives detailed information on this process, which can help ensure an individual handles transactions legally.
Consider the following scenarios of legal insider trading in action:
- A CEO of a corporation buys 2,000 shares of the company’s stock. The trade is correctly reported to the SEC.
- A board member of a corporation sells 3,000 shares of company stock. The trade is correctly reported to the SEC via Rule 10b5-1, which allows the board member to set up a trading plan.
- A corporate employee buys 250 shares of stock in the company that employs him.
Conversely, illegal insider trading occurs when an individual uses any material information not publicly disclosed for profitability purposes. While this type of insider trading typically gets associated with company executives, anyone can engage in the practice—and face consequences if caught.
Illegal insider trading situations include the following:
- A lawyer who represents the CEO of a company learns in confidence that the company will experience a substantial revenue decline. The lawyer reacts by selling off his stock the next day, because he knows the stock price will go down when the company releases its quarterly earnings.
- A corporate board member knows that a lawsuit is about to be levied against her company. She realizes this lawsuit will have a negative impact on the company’s stock performance as soon as the lawsuit goes public. Within 24 hours, she not only sells off her stock, she urges her husband and parents to sell off their stock.
- A government employee hears of a new rollout plan to incentivize the implementation of solar panels in partnership with a solar panel manufacturer. This rollout will officially be announced in two weeks. The employee, equipped with knowledge of the rollout, buys 500 shares of the manufacturer’s stock.
These examples clearly show the difference between legal and illegal insider trading. Anyone may trade as long as it is not done underhandedly. The line can be blurry sometimes, but if the intent is pure, corporate executives should usually be able to keep themselves out of legal trouble.
Consequences of Insider Trading
In times past, corporate executives could probably get away with a questionable trade here and there without anyone noticing. Today, however, the SEC is working to harness technology to detect irregular activities. The Analysis and Detection Center of the SEC’s Market Abuse Unit, which was formed in 2010, sifts through billions of rows of trading data going back 15 years. It can identify people who have made many well-timed trades just ahead of corporate news.
An example of the SEC’s capabilities is Dayakar Mallu, a former pharmaceutical information technology (IT) manager who illicitly gained $8 million through securities trading. The charges against Mallu in 2021 stated that he received nonpublic information from a friend who was an insider at the pharmaceutical company Mylan, where he previously worked.
This information concerned unannounced earnings, U.S. Food and Drug Administration (FDA) drug approvals, and an impending merger with another pharmaceutical company. If convicted, Mallu faces civil penalties and a permanent bar from acting as an officer or a director of a public company.
A second example from 2021 saw the SEC charge Holly Hand and Chad Calice for illegally trading stock for Neuralstem, the pharmaceutical company that employed Hand. According to the charges, Hand tipped off Calice about the negative efficacy results of a clinical drug trial.
This action prompted Calice to sell their company stocks. It also led Calice to pass the illicit information to his uncle, who in turn sold all his company stocks. The SEC’s ruling led to Calice and Hand paying a combined amount of more than $325,000 in penalties.
Executives would do well to understand this trend and behave accordingly. They must refrain from any hint of insider trading or insider tipping. Being aware of the regulations—and the pitfalls—is an important first step to avoiding a potentially career-ending misstep.
Lead Through Ethical Behavior
Striving for a C-suite position means seeking to become an insider. Because of this correlation, it is important that all who aspire to attain such a goal be conscientious about handling the buying and selling of their company’s stock legally. This will not only keep them from being subject to fines and potential imprisonment but also enable them to set an ethical example for the rest of the organization.
Washington State University’s Online Executive Master of Business Administration program helps students prepare to lead companies in an ethical manner. Our program’s curriculum is designed to equip you with the tactics, knowledge, skills, strategies, and other MBA resources wielded by today’s high-profile business leaders—the tools you need to lead a company with confidence. Learn how we can help you get ready for the rest of your career.
Recommended Reading
The Growth of Analytics: Four C-Suite Needs
Navigating Ethics Across National Borders
Sources:
Business Insider, “What Is Insider Trading and When Is It Illegal?”
CNL Securities, Big Data Is Watching You
Investopedia, “How the SEC Tracks Insider Trading”
Investopedia, “Insider Trading”
Investopedia, “What Is Insider Trading and Is It Illegal?”
U.S. Securities and Exchange Commission, EDGAR - Search and Access