What is Insider Trading? The Good, Bad and Ugly

Insider trading is a complex topic to understand, and many people don’t know much about it other than the fact that it can be illegal. However, insider trading also has circumstances that make it legal; the legality of insider trading depends on how the person investing got their information and if that information is public. If someone is found guilty of insider trading, they can face up to 20 years in prison and be forced to pay hefty fines. This article will discuss what insider trading is and when it’s considered legal and illegal, examples of insider trading, and the damage it can do. 

What is Insider Trading?

Insider trading occurs when a company’s stock is traded by someone who has information about the company that isn’t public. In many cases, a seller of the stock has material information that the stock prices are about to plummet, so they might sell their shares. Insider trading can be legal or illegal, and it all depends on when the insider (the person trading the stock) trades the stock. 

Insider trading is considered illegal when the information that made the person sell their stock is not public, even if the company plans to make it public within the near future. An insider trader can either be a buyer or seller of stock.

How Insider Trading Works

The US Securities and Exchange Commission (SEC) defines material information as information that could impact an investor’s decision to trade a stock, whether that’s buying or selling it. Non-public information is information that hasn’t been shared with the public and is private, meaning the company may or may not intend to share that information with the public. All stock trading is tracked by the SEC, and you’ll need to report your earnings every year on your annual tax returns using tax software to ensure you’re complying with the marketplace guidelines and those of the IRS.  

People with access to insider information have an unfair advantage over other investors, so it’s the SEC’s job to ensure the marketplace is fair for everyone. Illegal insider trading can also include someone with non-public information tipping off others, such as those that don’t work within the company, so they’ll buy or sell their stocks. 

Insider trading is legal in some cases, though. Legal insider trading occurs when the company’s directors buy or sell shares, but they must lawfully disclose their transactions. 

The SEC provides guidelines for protecting themselves from insider trading, such as that it doesn’t matter how the information got out or that the person works for a particular company where the information came from. For example, someone can learn insider information from a friend and share it with another friend. If that last friend uses that information to make money within the market, all people involved could be prosecuted and face prison time. 

Insider Trading Examples

As we’ve just mentioned, anyone can be found guilty of insider trading when they use material information that isn’t public to make decisions about stocks. However, there have been some recent events that you may remember to help you better understand insider trading, including Martha Stewart.

Martha Stewart was convicted of insider trading, among other things, in the early 2000s. Martha Stewart ended up selling thousands of shares of a company based on information she received from a broker after the CEO of the company sold all of his shares. Ultimately, Martha Stewart was able to save herself from losing tens of thousands of dollars, but she sold those shares based on a tip that was not public information. 

Of course, many people aren’t celebrities, so it can be difficult to understand exactly what insider trading is from the Martha Stewart example. Other examples are:

A lawyer representing a CEO learns that the CEO is under suspicion of fraud. The lawyer chooses to sell his shares in the company because he knows stock prices will plummet once the news becomes public. In this case, while the news will eventually become public, it’s not public at the time the lawyer sells his shares, making it illegal insider trading. 

Another example is an employee overhearing a meeting about the company going to go bankrupt. That employee tells his friend, and his friend sells his shares of the company. In this case, both the employee and the friend are guilty of insider trading. 

Why is Insider Trading a Problem?

Insider trading may sound like a white-collar, victimless crime, but it isn’t. By trading stocks with information that isn’t public, inside traders impact the financial market by benefiting at the expense of others. Insider trading ultimately makes financial costs higher while reducing returns. Here are the ways insider trading can negatively impact individuals and businesses. 

More Expensive

Insider trading makes it more expensive for companies to issue stocks because if investors believe insiders are trading stocks or bonds, they will want a higher return to compensate for it, ultimately increasing the costs to the companies. This can affect the companies because since trading their stocks will become more expensive, they’ll have fewer resources to hire more workers or invest in the products they need to keep their business running. 

Damages Reputation 

Insider trading can damage a company’s reputation in more ways than one. For example, if a CEO is found guilty of insider trading, it harms the business because the public will no longer have trust in them, even if no one else is involved. There are ways for companies to protect themselves from the financial impact of insider trading, such as some forms of business insurance. Additionally, some companies may be able to prevent insider trading by improving cyber security so material information can’t get into the hands of the wrong people. 

However, there’s no insurance for a damaged reputation. Ultimately, insider trading is bad publicity for the company, which can hurt stock prices and internal morale. 

Discourages Investments

Insider trading benefits people with material information and hurts those who are ordinary investors participating in the stock market. What’s worse is that insider trading can be difficult to prove, even though the SEC has ways of figuring it out. So, in many cases, insider trading goes unnoticed. The people with information profit while the average investors lose money on their investments, making regular people less likely to continue trading, and sending money to investments, and companies will have more difficulty raising capital. 

Final Thoughts

Insider trading makes average investors less likely to trust the system, believing it’s rigged to only help the rich. However, this mindset can harm the economy. When regular people stop investing in companies, those companies can’t raise enough capital to hire more workers or increase production. Insider trading ultimately hurts everyone, including those guilty of the crime. Of course, there are some instances when insider trading is legal, but there’s no reason to trade stocks based on material information when the rewards don’t outweigh the risks. 

Ashley Nielsen

Ashley Nielsen earned a B.S. degree in Business Administration Marketing at Point Loma Nazarene University. She is a contributing writer at 365businesstips.com where she shares knowledge about general business, marketing, lifestyle, and financial tips. During her free time, she enjoys being outside, staying active, reading a book, or diving deep into her favorite music.