In 1986, at the height of a bull market, Dennis Levine, a Wall Street investment banker, was caught red-handed in insider trading. He was trading stocks and handing 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 many others accused of insider trading. One recent example is that of 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 it can be avoided.
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 buy or sell stocks based on material, non-public information (MNPI). This is also known as "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 impact someone's decision on whether to buy or sell a stock given that if that information was made public, the share price of that stock could potentially 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 with insider trading by the SEC.
Still, investors should be very careful handling MNPI and make sure they're following 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 frames during which shares of public companies can be sold by the management of those companies.
Or, they must pre-clear their trading intentions with internal compliance officers, especially if they are directors or managers in the company. This can also include the exercise of stock options to buy or sell those publicly traded shares.
Clearing your intentions can be done by following a 10b5-1 trading plan, which some companies offer. A 10b5-1 trading plan 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 the dates the buying or selling will be 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 disclose 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 buy or sell that stock until that MNPI becomes public knowledge.
This also means public companies have obligations to protect that MNPI or make it public. They must disclose any 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 before buying or selling the stock. That is especially the case if you have any questions about what exactly you should do when handling non-public information regularly.
