Insider trading is the act of trading a security related to a public company using non-public information, such as information about a company that only employees of that company have access to.
Insider trading is generally illegal, as it weakens the overall sense of trust and fairness that underpins the operations of modern capital markets.
However, the precise determination of what does or does not constitute insider trading can be vague, nuanced, complex and contentious.
Defining ‘Insider’ and ‘Information’
The application of insider trading laws and regulations revolve around the twin core issues of what constitutes an ‘insider’ and what constitutes ‘material information’.
Many employees own shares or other securities of the companies that they work for and many executive-level compensation packages feature a large proportion of securities-based rewards.
Therefore, it is natural that employees of a company will be trading in the securities of the company that they work for.
Moreover, different employees have access to a wide variety of different sources of potentially relevant information, making it realistically impossible that the trading decisions of employees are not influenced by their professional knowledge.
Therefore, regulators seek out the most egregious cases of insider trading that demonstrate a clear intent to defraud or benefit from non-public information.
In these cases the information must be considered ‘material’, which means of significant enough importance that it could have a major impact on the price of the security, and the suspected ‘insider’ must have privileged access to that information.
Obviously the exact details of each case needs to be examined to determine whether the action constitutes insider trading as defined by statute, and whether it requires civil and/or criminal remedy.
Insider Trading Examples
A pair of examples will help to tease out the exact meaning of insider trading and differentiate between acts that are fraudulent and those that are not.
First let’s examine a clear example of insider trading.
Take for example a company that is testing a promising new product line.
This product line has been touted by analysts and industry-insiders as transformative, and the share price of the company has increased accordingly as a result of the expected revenue growth from the introduction of this promising new product.
Now imagine that one of the lead scientists involved in product development discovers that some aspect of the product line is mechanically unfeasible, and the cost of production will actually far outweigh any potential sales revenue.
This scientist then sells his shares before his discovery becomes public knowledge to avoid the accompanying drop in share price upon the public release of this information.
The scientist was an insider in that he had access to privileged information and the information was material in that it would have an obvious impact on the price of the company’s shares.
Therefore, this is a clear case of insider trading, with both the requirements for a clear insider and the use of material information being met.
Now let’s turn to a clear example of what is not insider trading.
Suppose that a company employee has noticed a steady decline in company morale, activity and cohesiveness over the last 6 months. He observes that the rate of conflicts and disagreements has risen while deadlines continue to be missed and projects are cancelled for performance issues.
The employee believes that the company is in a dire position, and forecasts that the shares of the company are likely to suffer accordingly in the coming months. He, therefore, sells his shares in the company before they drop in value.
In this case although the employee is nominally an insider and has access to information that not all members of the public may have, in contrast to the information contained in a press release for example, it is clearly not a case of insider trading.
The employee did not have privileged access to information, but rather his own subjective opinion of the general state of the company.
In addition, the information used was not material in the sense that it was not a simple fact or set of facts that had a direct causal relationship with the price of the shares.
Final Thoughts
The laws and regulations against insider trading are important for maintaining the faith and trust that underpins modern capital markets.
While some cases of insider trading may seem harmless or lack a sense of being fraudulent, other cases of insider trading are blatantly criminal. These cases impact the trust of investors and financial professionals in the orderly and fair operation of the capital markets.
That is why cases of insider trading are pursued so vigorously by the financial regulators and criminal authorities.