Insider trading

If you’ve paid any attention to the finance industry, you’ve probably heard the term insider trading. Insider trading means buying or selling a security while in possession of material, non-public information.

• Material information is information that a reasonable investor would consider important when deciding whether to buy, sell, or hold a security.
• Non-public information is information that isn’t widely available to the public.

Insiders at publicly traded companies often have access to large amounts of material, non-public information. For example, executives at a biotechnology company may learn about a new medical product before the company announces it publicly. If the product is groundbreaking, those executives might be tempted to buy shares before the announcement. Once the news becomes public, demand for the stock could rise, pushing up the price and creating a profit for the insiders.

That’s exactly the kind of situation the SEC investigates. Insiders may learn and discuss confidential company information as part of their jobs, but they can’t trade on it. Once a trade is made using inside information, both:

• the person who provides the information (the tipper), and
• the person who receives it and trades on it (the tippee)

can face serious consequences.

The SEC treats insider trading as a major violation, regardless of how large the profit was or how much loss was avoided. In civil court, perpetrators can be sued for up to three times the profit gained or loss avoided. These are called treble damages. Investors who traded the security around the same time (called contemporaneous traders) may sue those responsible for insider trading for up to this amount.

Insider trading can also lead to criminal charges and fines. An individual found guilty may be fined up to $5 million and sentenced to up to 20 years in prison. If insider trading is widespread within a financial firm, the firm itself can be fined up to $25 million. Collected fines are typically distributed through the SEC’s Fair Fund, which holds and distributes money to victims of financial fraud.

If a registered representative receives information from a customer that they believe may be inside information, they should promptly notify a supervisor. They must also avoid using the information for personal gain, since they could be subject to the penalties described above. Remember: both the tipper and the tippee can be held liable.