What Is Insider Trading?

Every day, individuals have the opportunity to invest in more than 15,000 U.S. stocks. But such a huge opportunity is also hugely confusing. Tracking the stocks whose insiders are trading; i.e buying and selling their own company’s stock freely on the open market, is one of the greatest ways to get a sense of what the management of a company thinks of their own stock.

Value Investors may start by looking for stocks with low price/earnings or price/book value ratios.

Growth Investors usually head to the quarterly financial results in a newspaper looking for stocks with great year-over-year earnings comparisons.

Momentum Investors probably prefer to look at the “percentage gainers” list, and stocks with large trading volume increases.

Republicans and Democrats of the House Financial Services Committee advocated new restrictions on insider trading to help lift waning public trust in Congress on Tuesday, December 6, 2011. Prior efforts to pass restrictions on insider trading never advanced in Congress. The concern resurfaced after a report last month by “60 Minutes,” which claimed that members of Congress bought stock in companies during debates on legislation that might affect the businesses.

The report claims that none of the investments by members of Congress was illegal.

The committee’s chairman, Spencer Bachus, an Alabama Republican, said the panel would vote on legislation next week. “It is absolutely essential that we do restore the public’s trust,” Mr. Bachus said. “If this is the answer, so be it.”

Mr. Bachus was among the lawmakers mentioned in the “60 Minutes” report.

In the segment on Nov. 13, CBS reported that, during the 2008 financial crisis, Mr. Bachus, then the ranking Republican on the Financial Services Committee, bet stock prices would fall while being briefed privately that a global crisis might be imminent.

In a statement at the time, Mr. Bachus’s office said he never traded on nonpublic information.

Representative Tim Walz, a Minnesota Democrat, is sponsoring legislation to explicitly ban insider trading. The proposed bill would label as securities fraud any trading on legislative information by lawmakers or their staff members. The bill would require any trades of more than $1,000 to be reported within 90 days.

The bill would require regulators to draft rules barring individuals and political intelligence firms, which use their contacts in Washington to provide financial firms with market-related information, from selling nonpublic information obtained from federal employees. It also would require firms or individuals involved in political intelligence to register in the same way as federal lobbyists.

The Senate’s Homeland Security Committee, meanwhile, is examining bipartisan proposals to restrict certain trading by lawmakers and their aides, who often have access to nonpublic information as part of their jobs.

So you ask: What is Insider Trading?

Insider trading, as defined by the SEC, includes not just corporate insiders such as company executives and key employees, but also directors and large shareholders that have access to non-public information.

Large shareholders are defined by the SEC for this purpose are those that having beneficial ownership of ten percent of more of the firm’s equity securities (including institutional investors). Also, in the U.S., “insiders” are not just limited to corporate officials and major shareholders, but also when a corporate insider “tips” a friend about material non-public information, the duty the corporate insider owes the company is now imputed to the friend who is now in violation of a duty to the company if he or she trades on the basis of that information.

The U.S. is generally viewed as having the strictest laws against illegal insider trading, and makes the most serious efforts to enforce them.

Insider trading is only illegal when a person bases their trade of stocks in a public company on information that the public does not know. It is illegal to trade your own stock in a company based on this information but it is also illegal to give someone that information, a tip, so they can trade their stock.

While most insider trading is legal, the term is commonly used to refer to the illegal kind when a corporate insider trades based on material non-public information that can have an effect on the company’s share price. By law, insiders are prohibited from trading based on nonpublic information, but most believe that such trading does occur around the edges.

The thinking goes that corporate insiders, because of their access, have the most up-to-date information on the health of their companies and the industries they operate in. Investors, as a result, can benefit from the timely knowledge of insider transactions.

One University of Michigan study found that when executives bought shares in their own companies, the stocks tended to outperform the total market by 8.9% over the next 12 months. Conversely, when they sold shares, the stock underperformed by 5.4%.

Timeliness of Information:

Like in the 13-D and 13-G filings for Institutions, the SEC Forms 3 and 4 on insider filings are extremely timely, and hence of greater significance, as they must be reported within two business days of the trade.

Insider Buying More Informative than Selling:

As a rule, insider buys are more informative than sells. This is because insiders sell often, and they sell for a variety of reasons that may be completely unrelated to the health of the company, including, for example, to diversity their holdings or to pay for an upcoming personal expense. In contrast, insider buying is relatively uncommon, and since they have an exclusive window into their own company’s performance, it is reasonable to presume that they probably have good reasons based on information at their disposal when they are risking their own assets to buy company stock.

Regular and Automatic Trades:

Insider trades maybe regular trades, or they may be automatic trades made under SEC Rule 10b5-1. It is generally believed that regular insider share purchases and sales carry more predictive value as they are made voluntarily by the insiders. Conversely, trades made under SEC Rule 10b5-1, called “Automatic Buys” and “Automatic Sells”, are part of a pre-determined plan or contract, and it is assumed that the plan was created before the insider had any privileged non-public information. Generally, almost all automatic trades are sells, not buys.

Furthermore, even automated trades made under 10b5-1 have some informative or predictive value due to loopholes in the rule that, for example, allow the insider to cancel the trading plan without any penalty or legal liability. So, the insider could set up a 10b5-1 trading plan before they have inside information (for example, from a quarterly report and guidance) while retaining the option to later cancel the plan based on the inside information. So, in effect, the execution of an automated trade also carries some predictive value as insiders retain the option under the existing rules to cancel their trades without penalty or legal liability.

Why Is Insider Trading Illegal?

The SEC’s job is to make sure that all investors are making decisions based on the same information. Insider trading can be illegal because it destroys this level playing field.

Punishments and Rewards Associated With Insider Trading

According to the SEC website there are almost 500 civil enforcement actions each year against individuals and companies that break securities laws. Insider trading is one of the most common laws broken. The punishment for illegal insider trading depends on the situation. The person can be fined, banned from sitting on the executive or board of directors of a public company and even jailed.

The Securities Exchange Act of 1934 in the United States allows the Securities and Exchange Commission to give a person a reward “a bounty” to someone who gives the Commission information that results in a fine of insider trading.

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