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When Does Insider Trading Become Criminal? Legal Guidelines
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When Does Insider Trading Become Criminal? Legal Guidelines
Insider trading is a big no-no in the financial world, but not all insider trading is illegal. So when does it cross the line into criminality? Let’s break it down.
First, what exactly is insider trading? It’s when someone uses non-public, confidential information to make trades in the stock market. This gives them an unfair advantage over other investors and undermines trust in the financial system.
Some common examples are:
- A CEO using confidential earnings data to trade their company’s stock before the numbers are made public
- An investment banker using knowledge of an upcoming merger to trade the stock of one of the companies involved
- An employee learning that their company is about to be acquired and buying up shares before the news is announced
You get the idea – using material, nonpublic information to get an edge on the market. But not all insider trading is illegal.
When Insider Trading Becomes a Crime
Insider trading crosses into illegality when it violates securities laws, like the Securities Exchange Act of 1934. There’s a few key factors:
- The information must be material – meaning it would significantly affect the company’s stock price once made public.
- The information must be nonpublic – not known to the general public.
- The person must have a duty not to use the information for personal benefit – like an executive or employee of the company.
Breaking any of these rules as you make trades based on confidential info is illegal insider trading. Let’s break them down:
The Materiality Test
The information used for trading must be important enough that it would impact investors’ decisions and likely affect the stock price once it got out. Things like earnings, mergers, new products, regulatory approvals, etc. Information that could move the needle. Immaterial info like an exec’s vacation plans doesn’t count.
Nonpublic Information
This means the info isn’t available to the general public. Once news hits the media and is widely disseminated, it’s public. But if you get confidential data before it’s announced and trade on it, that’s illegal.
Breach of Duty
This is where relationship matters. Certain people have a duty not to use inside knowledge for their own gain, including:
- Company executives – The CEO can’t trade before major news.
- Employees – An engineer can’t use project data to profit on the stock.
- Large shareholders – People with over 10% ownership have duties.
- Friends and family – Tippees who get confidential info from an insider.
When these folks use their insider access for personal profit, it’s an illegal breach of duty. That’s different than random stock pickers making educated guesses.
What About Legal Insider Trading?
Believe it or not, some insider trading is perfectly legal. Say a CEO wants to buy shares in their company. As long as they disclose the purchase and don’t trade around major announcements, it’s fine. Or if news leaks into the public domain through rumors, people can trade on it. The key is not using nonpublic info you have special access to.
Common Defenses Against Insider Trading Charges
If accused of insider trading, some common defenses include:
- Lack of materiality – Arguing the information wasn’t important enough to affect the stock price.
- Information wasn’t nonpublic – Saying the news was already known or speculated publicly.
- No fiduciary duty – Claiming you didn’t have a relationship implying a duty of confidentiality.
- No knowledge – Denying you knew the info was material, nonpublic, or obtained improperly.
Whether these defenses work depend on the specific facts and duty relationships in each case.
Penalties for Insider Trading
If charged and convicted, insider trading penalties can be severe:
- Up to 20 years in prison
- Fines of up to $5 million
- Having to give back any profits made
- Being barred from securities industry jobs
Plus you ruin your reputation and career. Not fun.
Recent Insider Trading Cases
Some notable recent insider trading cases include:
- Raj Rajaratnam – The hedge fund manager was convicted in 2011 of making $63 million on illegal tips. He got 11 years in prison, the longest sentence ever for insider trading at the time.
- Billy Walters – The famous sports gambler was sentenced to 5 years in 2017 for making over $40 million trading Dean Foods stock based on tips from the company’s chairman. Ouch.
- Sean Stewart – An investment banker leaked secrets about healthcare mergers to his father, who traded on the info. Sean got 3 years in prison in 2016.
The authorities take insider trading very seriously these days. Even minor cases can mean hard time.
Takeaways on Insider Trading Law
The main takeaways about when insider trading becomes criminal:
- It involves using confidential, market-moving information to trade stocks.
- Legal requirements relate to the info being important, nonpublic, and misused by insiders.
- Punishments can include lengthy prison, massive fines, and getting barred from finance.
- Defenses try to undermine the legal requirements but it’s tough once charged.
- Both Wall Street execs and friends/family tippees face prosecution today.
The bottom line is don’t use any nonpublic info you get from company insiders to trade stocks. Even if it seems harmless, it could turn into a felony. Better to steer clear of the whole insider trading mess.