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Defining Illegal Insider Trading

2012-10-30 11:47:51

September 25 2010| Filed Under Laws and Regulation, Stocks

When hearing news stories about illegal insider trading activity, investors

usually take notice because it's an activity that affects them. Although there

are legal forms of insider trading (which you can learn more about in the

articles Uncovering Insider Trading and When Insiders Buy, Should You Join

Them?) , the better you understand why illegal insider trading is a crime, the

better you'll understand how the market works. Here we discuss what an illegal

insider is, how it compromises the essential conditions of a capital market and

what defines an insider.

What Is It and Why Is It Harmful?

Insider trading occurs when a trade has been influenced by the privileged

possession of corporate information that has not yet been made public. Because

the information is not available to other investors, a person using such

knowledge is trying to gain an unfair advantage over the rest of the market.

Using nonpublic information for making a trade violates transparency, which is

the basis of a capital market. Information in a transparent market is

disseminated in a manner by which all market participants receive it at more or

less the same time. Under these conditions, one investor can gain an advantage

over another only through acquiring skill in analyzing and interpreting

available information. This skill is based on individual merit and awareness.

If one person trades with nonpublic information, he or she gains an advantage

that is impossible for the rest of the public. This is not only unfair but

disruptive to a properly functioning market: if insider trading were allowed,

investors would lose confidence in their disadvantaged position (in comparison

to insiders) and would no longer invest.

The Law

In August 2000, the Securities and Exchange Commission (SEC) adopted new rules

regarding insider trading (made effective in October of the same year). Under

Rule 10b5-1, the SEC defines insider trading as any securities transaction made

when the person behind the trade is aware of nonpublic material information,

and is hence violating his or her duty to maintain confidentiality of such

knowledge.

Information is defined as being material if its release could affect the

company's stock price. The following are examples of material information: the

announcement that the company will receive a tender offer, the declaration of a

merger, a positive earnings announcement, the release of the company's

discovery such as a new drug, an upcoming dividend announcement, an unreleased

buy recommendation by an analyst and finally, an imminent exclusive in a

financial news column.

In a further effort to limit the possibility of insider trading, the SEC has

also stated in Regulation Fair Disclosure (Reg FD), which was released at the

same time as Rule10b5-1, that companies can no longer be selective as to how

they release information. This means that analysts or institutional clients

cannot be privy to information ahead of retail clients or the general public.

Everyone who is not a part of the company is to receive information at the same

time.

Who Is an Insider?

For the purposes of defining illegal insider trading, a corporate insider is

someone who is privy to information that has yet to be released to the public.

If a person is an insider, he or she is expected to maintain a fiduciary duty

to the company and to the shareholders and is obligated to retain in confidence

the possession of the nonpublic material information. A person is liable of

insider trading when he or she has acted on privileged knowledge in the attempt

to make a profit.

Sometimes it is easy to identify who insiders are: CEOs, executives and

directors are of course directly exposed to material information before it's

made public. However, according to the misappropriation theory of insider

trading cases, certain other relationships automatically give rise to

confidentiality. In the second part of Rule 10b5-2, the SEC has outlined three

nonexclusive instances that call for a duty of trust or confidentiality:

When a person expresses his or her agreement to maintain confidentiality

When history, pattern and/or practice show that a relationship has mutual

confidentiality

When a person hears information from a spouse, parent, child or sibling (unless

it can be proven that such a relationship has not and does not give rise to

confidentiality).

Partners in Crime

In insider trading that occurs as a result of information leaking outside of

company walls, there is what is known as the "tipper" and the "tippee". The

tipper is the person who has broken his or her fiduciary duty when he or she

has consciously revealed inside information. The tippee is the person who

knowingly uses such information to make a trade (in turn also breaking his or

her confidentiality). Both parties typically do so for a mutual monetary

benefit. A tipper could be the spouse of a CEO who goes ahead and tells his

neighbor inside information. If the neighbor in turn knowingly uses this inside

information in a securities transaction, he or she is guilty of insider

trading. Even if the tippee does not use the information to trade, the tipper

can still be liable for releasing it.

It may be difficult for the SEC to prove whether or not a person is a tippee.

The route of insider information and its influence over people's trading is not

so easy to track. Take for example a person who initiates a trade because his

or her broker advised him or her to buy/sell a share. If the broker broker

based the advice on material non-public information, the person who made the

trade may or may not have had awareness of the broker's knowledge - evidence to

prove what the person knew before the trade may be hard to uncover.

Excuses, Excuses

Oftentimes, people accused of the crime claim that they just overheard someone

talking. Take for example a neighbor who overhears a conversation between a CEO

and her husband regarding confidential corporate information. If the neighbor

then goes ahead and makes a trade based on what was overheard, he or she would

be violating the law even though the information was just "innocently"

overheard: the neighbor becomes an insider with a fiduciary duty and obligation

to confidentiality the moment he or she comes to possess the nonpublic material

information. Since, however, the CEO and her husband did not try to profit from

their insider knowledge, they are not necessarily liable of insider trading. In

their carelessness, they may, however, be in breach of their confidentiality.

Conclusion

Since illegal insider trading takes advantage not of skill but chance, it

threatens investor confidence in the capital market. It is important for you to

understand what illegal insider trading is because it may affect you as an

investor and the company in which you are investing.

by Reem Heakal