When does insider trading become illegal? What are the penalties?

When Does Insider Trading Become Illegal? What are the Penalties?

Insider trading is a complex issue that involves using non-public, confidential information to make stock trades in order to gain an unfair advantage and make a profit. But when does this practice actually become illegal? Let’s break it down.

What Constitutes Illegal Insider Trading

At its core, illegal insider trading involves violating a fiduciary duty or other relationship of trust and confidence by trading on material, nonpublic information about a company. This gives certain individuals an unfair advantage over other investors and undermines market integrity.

Some key things to understand about insider trading laws:

• They apply to company insiders like executives, directors, and large shareholders who owe a fiduciary duty to the company and its shareholders. If these insiders trade based on confidential information before it’s made public, it’s likely illegal.
• They also apply to outsiders like lawyers, investment bankers, or friends of executives who obtain confidential information and use it to trade. This is considered “tipping” and it’s illegal too.
• The information must be material, meaning it would significantly impact the stock price once made public. Things like earnings reports, regulatory approvals/denials, mergers, etc.
• It doesn’t matter if the insider actually profited from the trades. Just the act of improperly trading on confidential information breaches their duty and trust.

Potential Defenses

If accused of insider trading, there are a few defenses people attempt to make:

• Claim the information wasn’t really material or nonpublic. But this can be hard to prove if there’s evidence it would have changed the stock price.
• Argue they didn’t actually have a fiduciary duty to keep the information confidential at the time. This might work for some outsiders like friends or neighbors.
• Say they obtained the information legally and weren’t the actual source of any leaks. But the SEC still needs to prove intent to trade improperly.

Penalties for Insider Trading

The penalties for insider trading can be severe, including:

• Civil fines up to 3 times the profit gained or loss avoided
• Criminal charges like wire fraud or securities fraud
• Prison sentences up to 20 years
• Permanent trading bans or bars

Large hedge funds and high profile cases often result in big settlements. For example, in 2022 Raj Rajaratnam paid over $150 million and got an 11 year prison sentence.

But even smaller retail traders are at risk if they improperly trade on inside information from a friend or family member. Fines can easily be 6 or 7 figures.

Recent Trends and Issues

Insider trading laws attempt to balance corporate transparency, fairness, and trust in markets with the rights of investors. Recent trends like more active retail trading, social media rumors, and AI analytics make things more complex.

Some critical issues include:

• How to handle “soft information” like supply chain issues or market rumors that don’t come from official filings but still influence stocks. This information gets shared easily on social media or expert networks.
• Defining boundaries for data analytics and alternative data sets that might legally or questionably reveal confidential information.
• Updated rules around duties of trust for outsiders like friends or family who receive tips. And also for insiders who may have come across information more casually vs deliberately.

The legal boundaries around insider trading continue to evolve with technology and market changes. But at its core, the laws aim to promote fair access to information and prevent various forms of cheating or self-dealing in markets.

Conclusion

Insider trading laws attempt to ensure stock trading is based on publicly available information that all investors have access to. Company executives, directors, lawyers and other insiders are prohibited from using confidential information still unknown to general shareholders.

Exactly what constitutes breaching duties or relationships of trust continues to be clarified by regulators and in courts. But in general, deliberately trading on nonpublic, market-moving information crosses ethical and legal boundaries. And both civil fines plus criminal charges can result based on the scope of profits, losses avoided, and damage to market integrity.