Insider Information: Definition, Examples & Legal Implications

Insider information, also called inside information, refers to non-public facts regarding a publicly traded companyPrivate vs Public CompanyThe main difference between a private vs public company is that the shares of a public company are traded on a stock exchange, while a private company's shares are not. that can provide a financial advantage in the markets. In other words, insider information is knowledge and information on the operations, products/services pipeline, affairs, financial position, etc., of a company that is not accessible to the public.

Attempting to benefit from insider information is a criminal offense. In the United States, the Securities and Exchange Commission (SEC)Securities and Exchange Commission (SEC)The US Securities and Exchange Commission, or SEC, is an independent agency of the US federal government that is responsible for implementing federal securities laws and proposing securities rules. It is also in charge of maintaining the securities industry and stock and options exchanges is in charge of prosecuting individuals who use insider information to execute illegal trades.

Understanding Insider Information

Insider information is regarded as material, non-public information. Trading based on insider information, called insider tradingInsider TradingInsider trading refers to the practice of purchasing or selling a publicly-traded company’s securities while in possession of material information that is, without filing the appropriate forms with the SEC, is illegal. It is important to note that a person who possesses the information may not necessarily be a person who works for the company. The information can be passed from a person working within the company to outside individuals who trade based on the information.

Insider Trading with Insider Information

Insider trading goes hand-in-hand with insider information and is the practice of using non-public information to execute trades.

For example:

• The chair of the board knows that a merger is about to be announced that would substantially increase the share price of the company. He purchases 500 shares of the company under his dad’s name so he can generate a profit, without reporting the trade to the SEC.
• An employee overhears that the CFO is going to report dismal results in the upcoming earnings call. The employee notifies his friend to sell all of his shares before the earnings call.
• A Member of Parliament realizes that a new regulation will be passed soon, which would significantly benefit a specific company. He secretly purchases shares of the company and pushes for the regulation to pass as soon as possible.

The SEC’s Role in Preventing Insider Trading

The SEC oversees instances of insider trading. However, prosecuting those who are involved in insider trading is very difficult. Direct evidence of insider trading is rare. The SEC can track insider trading through various methods such as:

1. Market surveillance activities: Using sophisticated tools and big data
2. Tips and complaints: Receiving complaints from investors and/or traders on the losing side of a trade

Example of Insider Information and Trading

A classic case of using insider information to execute illegal trades is the case involving American businesswoman and media personality Martha Stewart. Ms. Stewart sold 4,000 shares in ImClone Systems one day before the U.S. Food and Drug Administration (FDA) refused to review the company’s cancer drug Erbitux. The share price of ImClone tumbled following the FDA’s announcement.

Investigations into the matter revealed that Sam Waksal, the CEO of ImClone and a close friend of Stewart, told his broker to transfer $4.9 million in stock to the account of his daughter. Waksal’s daughter then requested that the broker sell $2.5 million of her ImClone stock. The broker gave the information to Stewart, who also sold her shares in the company.

When questioned about the sale, Martha Stewart made false statements. As a result, she was sentenced to five months in prison, five months of home confinement, and two years of probation.

Additional Resources

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• Earnings GuidanceEarnings GuidanceAn earnings guidance is the information provided by the management of a publicly traded company regarding its expected future results, including estimates
• Sarbanes Oxley ActSarbanes Oxley ActThe Sarbanes-Oxley Act is a U.S. federal law that aimed to protect investors by making corporate disclosures more reliable and accurate.
• The 1933 Securities ActThe 1933 Securities ActThe 1933 Securities Act was the first major federal securities law passed following the stock market crash of 1929. The law is also referred to as the Truth in Securities Act, the Federal Securities Act, or the 1933 Act. It was enacted on May 27, 1933 during the Great Depression. ...the law was aimed at correcting some of the wrongdoings
• Types of SEC FilingsTypes of SEC FilingsThe US SEC makes it mandatory for publicly traded companies to submit different types of SEC filings, forms include 10-K, 10-Q, S-1, S-4, see examples. If you are a serious investor or finance professional, knowing and being able to interpret the various types of SEC filings will help you in making informed investment decisions.