Insider Trading Law
Insider trading refers to the act of trading securities, such as stocks, stock options, and bonds, based on information that is not available to the public. For example, a senior executive of a corporation might commit insider trading if he or she purchases a large amount of shares in the company after learning of news that is likely to drive the stock price up, but before that information becomes available to the public.
It is considered a criminal offense in most cases under the theory that it is not fair to investors who do not have the benefit of “inside” information. Unlike many types of investment fraud, insider trading does not target individual investors as victims. In the example above, the corporate executive is able to act on information that is not available to other investors, giving the executive an unfair advantage. The Securities and Exchange Commission (SEC) investigates and prosecutes insider trading and other forms of securities fraud, based on a wide range of federal statutes and regulations.
Who Is an “Insider”?
Federal law defines an “insider” as any officer or director of a publicly traded corporation, as well as beneficial owners of more than 10 percent of any class of a corporation’s stock. Corporate officers and directors owe a fiduciary duty to the corporation’s shareholders. The use of inside information for self-enrichment breaches that duty. People who have direct access to inside information, such as a person who receives a “tip” from an officer or director, are also considered “insiders” and may be subject to prosecution for insider trading.
Employees of a publicly traded corporation are permitted to trade securities of their own employer, even though they might have access to inside information, provided they meet various reporting requirements established by the SEC. Members of the U.S. Congress, who often have access to non-public information about public companies, are not subject to insider trading laws.
Burden of Proof in Insider Trading Cases
The government must prove that a defendant bought or sold one or more securities “on the basis of material nonpublic information about that security or issuer,” according to the SEC’s Rule 10b5-1, 17 C.F.R. § 240.10b5-1. Prosecutors must prove that the defendant actually received information, that the information was both “material” and “nonpublic,” and that the information directly influenced the defendant’s trade. A defendant may raise an affirmative defense that he or she was subject to a binding contract, entered in good faith, to purchase or sell specific amounts of the security in question and that the agreement took effect before he or she knew about the information.
Criticism of Criminalizing Insider Trading
Proponents of decriminalizing insider trading argue that allowing trades based on inside information gets new information into the market faster and therefore enables the market to determine the correct price of securities more efficiently. A quote commonly attributed to the Nobel Prize-winning economist Milton Friedman summarizes the concept: “You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that.”
Insider Trading Example: Martha Stewart
Perhaps the most famous recent case of insider trading involved the celebrity Martha Stewart. In December 2001, Stewart sold all of the nearly 4,000 shares she owned in the pharmaceutical company ImClone Systems. One day later, the U.S. Food and Drug Administration (FDA) announced that it was denying the company’s application for a new cancer drug. ImClone’s stock price dropped by about 18 percent on the first day of trading after the announcement.
The government charged Stewart and her former stockbroker in June 2003 on multiple counts of securities fraud, including insider trading. It claimed that they sold the ImClone shares based on advance notice of the FDA’s decision, while they claimed that they had already agreed to sell the stock if it dropped below a certain price. A jury convicted Stewart in May 2004.
