Insider trading is the practice of trading a company’s shares based on material information that is not available to the general public. Illegal insider trading often includes the trading of financial instruments by officers, directors, or any individual with access to sensitive information about the company.The Securities and Exchange Commission (SEC) prohibits insider trading because it can give unfair advantages to those who have access to material, non-public information about a company. Insider trading is a serious violation of securities laws and SEC regulations. This may make it harder for other investors to compete and drive down stock prices. A violation of the SEC’s insider trading rules can result in civil liability and potential criminal penalties depending on the circumstances. A thorough understanding of insider trading and its implications is valuable. Knowledge of this act of wrongdoing is also essential to know when it is happening so that you can potentially become a whistleblower who exposes Insider Trading to the SEC and potentially earn a monetary reward.
What Constitutes Insider Trading?
Insider trading occurs when someone uses non-public information (i.e. something that isn't available to the general public) to purchase or sell shares of a company. This includes buying or selling stocks, bonds, and other investments. Insider trading may also occur when non-insiders (such as family members or friends of insiders) use material non-public information to trade the company’s securities. This information can include a company’s earnings, revenues, projected sales, regulatory approvals, or pending mergers and acquisitions. Acts of insider trading are often applied to a variety of other trading activities that violate Securities and Exchange Commission (SEC) rules and regulations. The SEC defines insider trading as trading on the basis of material, non-public information about a company. Non-public information includes information that has not been made public, is not available to the general public, and has not been disclosed to the SEC. This includes information about a company’s management, products, services, finances, and future plans that is not available to the general public.
Two common types of illegal insider trading are:
“Tipping,” which involves passing non-public information to others who may then trade on it. This may be done informally, or it may involve a written communication. Giving preferential treatment to others who may then trade on that information may be insider trading.
And,
“Front running,” which occurs when a person who has access to non-public information about a company’s purchase of its own stock (called a “buy” order) passes that information to brokers to purchase the shares from the company before the company’s order is executed. This allows the person to profit from the advance knowledge that the company’s order will drive up the price of the stock.
The SEC may charge anyone who uses material, non-public information in violation of insider trading rules. This includes officers, directors, and any other individual with access to sensitive information about a company.
There are two types of insider trading: legal and illegal. Legal insider trading is when insiders trade on information that is not material, non-public information. Illegal insider trading is when insiders trade on material, non-public information. Illegal insider trading is a violation of SEC rules and US laws.
Material, non-public information is any information that could reasonably be expected to have an effect on a company’s stock price. This includes both positive and negative information. For example, if a company is about to announce a new product, this would be considered material, non-public information. If a company is experiencing financial difficulties, this would also be considered material, non-public information.
It is important to remember that not all insider trading is illegal. If a company’s insiders trade on information that is not material, non-public information, then this is considered legal insider trading.
Rule 10b-5 and the Duty to Disclose
Rule 10b-5 is the main federal rule that prohibits insider trading. If a public company makes false or misleading statements about their business, this may be considered a violation of Rule 10b-5. The SEC also has rules about the disclosure of material non-public information by public company officers and directors. These rules are meant to protect investors by preventing officers and directors from trading company securities based on information that has not been disclosed to investors. A director or officer may be liable for insider trading if they fail to disclose material non-public information that they know, or should have known, would have a significant impact on the company’s stock price.
Violations of Rule 10b-5 can include:
insider trading on the basis of material, non-public information
failing to disclose material, non-public information
making false or misleading statements about a company’s business
If a person is found guilty of violating Rule 10b-5, they may be subject to civil and criminal penalties. Civil penalties can include fines and disgorgement (giving up ill-gotten gains). Criminal penalties can include jail time.
Securities Fraud: Defining Fraud and Breaches of Trust
The SEC’s mission is to “protect investors, maintain fair and orderly markets, and facilitate capital formation.” An integral part of this mission is preventing securities fraud. There are numerous ways in which a company or its officials can violate securities laws, but among the most common are insider trading and securities fraud. Securities fraud is a deceptive act committed by a company or its officials that results in a violation of the Securities Exchange Act of 1934 or Securities Act of 1933. Assets such as stocks, bonds, and other investments are called “securities” because people rely on them for their future value. The ability to trust that securities are safe and secure is vital for economic growth.
When companies or their officials engage in securities fraud, they undermine this trust and jeopardize the stability of our markets.
Penalties for Insider Trading
Violations of the SEC’s insider trading rules can result in civil liability and potential criminal penalties depending on the circumstances. Civil penalties for insider trading can include disgorgement (i.e. giving up ill-gotten gains), monetary fines, and a lifetime ban from serving as an officer or director of a public company. Criminal penalties for insider trading can include up to 20 years in prison and/or a $5 million fine.
The Bottom Line
The SEC’s mission is to protect investors, maintain fair and orderly markets, and facilitate capital formation. Insider trading and securities fraud violate these standards and negatively impact investors. When investing, it is important to know where information is coming from to ensure that it is accurate and verifiable. Ensure that the source of your information is reliable and that you do not have any type of conflict of interest before making any investment decisions. And if you know about some act of insider trading not known to the SEC, contact an attorney to discuss your reporting options. The SEC relies heavily on whistleblowers to help identify potential securities fraud. Your information could potentially make you eligible for a whistleblower reward if reported the correct way.