What Is Considered Illegal Insider Trading?

Insider trading involves buying or selling a public company’s stock based on confidential information. This practice is illegal because it gives individuals with privileged access an unfair advantage, allowing them to profit before information is available to the public. Federal securities laws are designed to create a level playing field, and their enforcement aims to ensure no participant has an undue edge, thereby maintaining public trust in the market’s integrity.

The Core Elements of Illegal Insider Trading

For a trade to be illegal, several elements must be present. The offense is a form of securities fraud governed by the Securities Exchange Act of 1934. The law does not prohibit all trading by corporate insiders but targets transactions that exploit an unfair informational advantage. Court decisions and rules from the Securities and Exchange Commission (SEC) have clarified who qualifies as an insider, what information is restricted, and what actions constitute a breach of duty.

The “Insider” and Fiduciary Duty

The term “insider” includes corporate officers, directors, and any shareholder who owns more than 10% of a company’s securities. These individuals owe a fiduciary duty, or a relationship of trust, to their company and its shareholders. This duty requires them to act in the company’s best interests, not for personal enrichment using confidential information.

The definition also extends to “temporary” or “constructive” insiders. This group includes attorneys, accountants, and consultants hired by the company who are given access to confidential information with the expectation of privacy. By accepting access to private data, they assume a temporary fiduciary duty equivalent to that of a traditional insider.

Material Nonpublic Information

Information must be both “material” and “nonpublic” to be the basis of an illegal trade. Material information is any data a reasonable investor would likely consider important when making an investment decision. Examples include unannounced earnings, pending mergers, clinical trial results, or significant cybersecurity breaches.

Information is “nonpublic” if it has not been disseminated to the general public through a press release or an SEC filing. Once the information is broadly available, insiders are free to trade because the informational advantage has been eliminated.

The “Trade or Tip”

The final element is the action taken based on the material nonpublic information. A violation occurs when an insider uses the information to trade in their company’s stock for personal profit or to avoid a loss. This act directly breaches the fiduciary duty owed to shareholders.

Liability also extends to “tipping,” where an insider (the “tipper”) discloses material nonpublic information to an outsider (the “tippee”) who then trades on it. The tipper is liable for breaching their fiduciary duty, and the tippee is liable if they knew or should have known the information was confidential and improperly disclosed.

The Misappropriation Theory of Insider Trading

Beyond the classic theory, courts have established the misappropriation theory, which extends liability to corporate “outsiders.” The violation occurs when a person misappropriates, or steals, confidential information for trading purposes in breach of a duty owed to the source of the information.

This concept was solidified in the Supreme Court case United States v. O’Hagan. A lawyer for a firm representing an acquiring company bought stock in the target company before the acquisition was public. While the lawyer owed no duty to the target company, he breached a duty of confidentiality to his law firm and its client by using their private information to trade.

The misappropriation theory applies in various contexts where individuals are entrusted with confidential information. For example, a family member who overhears a confidential business discussion and trades on it may be liable for breaching a duty of trust. The core of the violation is the deception of the person who entrusted them with the information.

Permissible Trading by Corporate Insiders

Insiders are permitted to buy and sell stock in their own companies, provided the transactions are not based on material nonpublic information and comply with reporting rules. These trades are often part of an insider’s compensation or long-term investment strategy. To avoid allegations of illegal activity, the SEC established a framework for pre-planned trades.

A primary tool is SEC Rule 10b5-1, which allows insiders to establish a formal, written trading plan when they are not in possession of material nonpublic information. The plan details the price, amount, and dates of future trades. Once the plan is in place, the trades can execute automatically, even if the insider later possesses sensitive information.

These Rule 10b5-1 plans serve as an affirmative defense against insider trading charges. To strengthen this defense, the SEC requires a “cooling-off” period for directors and officers. Trading under a new plan is prohibited until the completion of a waiting period that is the later of 90 days after the plan’s adoption or two business days following the company’s next earnings announcement, with the total period not to exceed 120 days.

Public Reporting Requirements for Insiders

To ensure transparency, federal securities laws mandate that corporate insiders publicly report their transactions in the company’s stock. These filings are available through the SEC’s EDGAR system, allowing investors to monitor the trading activity of a company’s leadership. This disclosure promotes fairness and accountability.

Form 3 (Initial Statement)

When an individual becomes a corporate insider, they must file a Form 3 within 10 calendar days. This applies to new officers, directors, or anyone who acquires more than 10% of a company’s securities. The form provides an initial snapshot of the insider’s holdings.

Form 4 (Statement of Changes)

A Form 4 must be filed whenever an insider executes a transaction, such as buying or selling company stock. The deadline for filing is within two business days following the transaction date. This prompt disclosure informs the public of the insider’s trading activity, including the number of shares and the price.

Form 5 (Annual Statement)

A Form 5 is an annual filing due within 45 days of the company’s fiscal year-end. It is used to report transactions that were exempt from Form 4 reporting or were not reported for other reasons, such as gifts or small acquisitions aggregating less than $10,000 in a six-month period.

Consequences of Violating Insider Trading Laws

Insider trading violations carry civil and criminal penalties enforced by the SEC and the Department of Justice (DOJ). An individual can face financial penalties from the SEC and prison time from a DOJ prosecution for the same act. The process often begins with an SEC investigation, which may be referred to the DOJ for criminal charges in more serious cases.

Civil Penalties

The SEC can impose a range of civil sanctions. A primary penalty is disgorgement, which requires the individual to pay back any profits gained or losses avoided. The SEC can also seek civil fines of up to three times the amount of the ill-gotten gains. Beyond monetary penalties, the SEC can seek injunctions to bar individuals from serving as an officer or director of a public company.

Criminal Penalties

Criminal penalties are reserved for willful violations and are prosecuted by the DOJ. A conviction can lead to prison sentences of up to 20 years for each violation. Fines in criminal cases can reach a maximum of $5 million for individuals and $25 million for corporations for each offense. High-profile cases, like that of hedge fund manager Raj Rajaratnam who was sentenced to 11 years in prison, underscore the severity of these consequences.