In 1986, at the height of a bull market, Dennis Levine, a Wall Street investment banker, was caught red-handed in insider trading. He traded stocks and handed out tips on stocks involved in merger and acquisition activity. Levine pled guilty and cooperated with the U.S. government to bring down a host of insider trading activity across Wall Street.
Since then, there have been others accused of insider trading – most recently British billionaire Joe Lewis, who pled guilty to insider trading charges in early 2024. This often brings activity in this arena to national attention.
But what is inside trading exactly? Let's look at why this type of activity is prohibited, what authorities consider insider trading and how to avoid it.
What is insider trading and why is it important?
The Securities and Exchange Commission (SEC) says:
While the law concerning "insider trading" is not static, it generally prohibits: (1) trading by an insider while in possession of material, non-public information; (2) trading by non-insiders while in possession of material, non-public information, where the information was either disclosed to the non-insider in violation of an insider’s duty to keep it confidential or was misappropriated; and (3) communicating material, non-public information to others.
The prohibition of insider trading is based on the idea that no one should be allowed to trade stocks based on material, non-public information (MNPI), or "inside" information.
Doing so gives the trader or investor an information advantage. They can effectively commit fraud against the general investing public by taking money from others in the markets.
The definition of material, non-public information about a publicly traded company is sometimes the subject of lawsuits. It is generally seen as information that can substantially affect an investor's decision on whether to buy or sell a stock given that if that information was made public, the price of the stock could make a dramatic move up or down.
There are certainly exceptions to the definition of material, non-public information. In just one example, Mark Cuban won a very famous case when he was charged by the SEC with insider trading.
Still, investors should be very careful handling MNPI and follow SEC rules.
What is considered insider trading?
People who work for public companies often cannot avoid gaining inside information. As a result, they must follow the SEC's rules and their own company's procedures when buying or selling shares.
For instance, most public companies have various blackout trading periods and "windows" or time periods during which shares of public companies can be sold by management of those companies.
Or, they must pre-clear their trading intentions with internal compliance officers, especially if they are directors or management of the company. This also includes the exercise of stock options to buy or sell those publicly traded shares.
This can be done by following a 10b5-1 trading plan, which is offered by some companies. This is a pre-scheduled purchase or sale of public stock performed by an outside broker and done without interference from the insider.
The key is that when the plan is set up, the insider (manager, employee, etc.) must not possess material, non-public insider information. Moreover, the price, number of shares and dates the buying or selling is done must be declared and set in advance.
How best to avoid insider trading accusations
Investors who gain MNPI must be careful to avoid sharing any of this information to others. No one is allowed to share this information unless it has already been made public through regulatory filings, etc., since it could be of interest to regular Joes making an investment decision on that particular stock.
Anyone who trades on information that has not yet been made public could potentially be subject to SEC and U.S. rules and laws relating to insider trading. So, if your friend who is a senior manager at a public company tells you something during a golf session that you suspect is insider knowledge, it's best to not go out and trade in that stock until that MNPI becomes public knowledge.
Obviously, this also means public companies have obligations to protect that MNPI or make it public. They have an obligation to disclose any such confidential information that a person might normally consider when making investment decisions, unless they have defensible reasons to keep it private.
This also means companies should update their prior disclosures, especially if over time, prior disclosures become misleading or outdated based on new developments.
The bottom line is to treat material, non-public information on a company very carefully. If you work for a publicly traded firm, it's best to consult a legal counsel and/or tax adviser. That is especially the case if you have any questions about what exactly you should do when handling non-public information on a regular basis.
