Insider trading: How to get burned on a hot tip

Think you can make a killing in the stock market because you received a hot tip about a public company? Think again. If you act on secret information, it could be considered insider trading and possibly land you in prison.

Insider trading undermines investor confidence and market integrity. Regulators continuously work to create and enforce laws to create an even playing field for all investors. Even with high-profile prosecutions such as those of Ivan Boesky and Raj Rajaratnam for insider trading, individuals still try to game the system.

Not all insider action is illegal, though. And knowing the difference can keep you on the right side of the law.

What is insider trading?

The Securities and Exchange Commission (SEC), the federal agency in charge of regulating the securities industry, considers insider trading as the buying and selling of securities based on material, nonpublic information—the type of information that would likely affect the share price of a company once that information is made public.

Information is considered material if a typical investor would factor it into making an investment decision. That can include changes in expected earnings, upcoming product launches, proposed mergers and acquisitions, major lawsuits, management changes, or new securities offerings.

Individuals qualify as insiders based on the positions they hold, including:

• Officers and directors
• Shareholders who own more than 10% of a company’s stock
• Employees with access to material, nonpublic company information
• Professionals, such as lawyers or consultants, who receive material, nonpublic information as part of their work
• Government officials who learn confidential information through their positions
• Anyone who has received material, nonpublic information from an insider and trades on it

The SEC also extends insider trading prohibitions to family members and individuals who live with an insider; family members who live elsewhere but whose securities transactions are influenced by someone with insider information; and trusts or other entities whose investments are directed by an insider.

Insider trading laws

The SEC Rule 10b-5, which was enacted as part of the Securities Exchange Act of 1934, prohibits insiders from using confidential corporate information to profit from or avoid a loss by trading the company’s stock. Not all insider actions are illegal; publicly traded companies often encourage officers, directors, and employees to own company stock. But insider transactions must follow rules established to prevent abuse, such as relying on public information or using approved trading plans. 

Types of insider trading schemes

• Classic insider trading refers to company executives and others who learn confidential information and trade on it before it becomes public. The SEC lists many such cases in its enforcement actions.
• Tips coming from insiders who don’t trade themselves but pass along information to friends, family members, or other associates, who then trade on it.
• Shadow trading is when someone uses material, nonpublic information about one company to trade in the stock of a related or competing company. For example, an investor might buy shares of a competitor after learning confidentially that a merger is in the works.
• Expert networks mean employees who leak confidential information to investment firms while posing as consultants, without their employers’ knowledge.
• Hackers are individuals who break into corporate networks or email systems to steal material, nonpublic information and trade on that data before it’s made public.

How insider trading is detected

The SEC uses numerous tools to detect insider trading, even as individuals or organizations seek more sophisticated ways to get around detection, such as through encrypted communication or offshore accounts. The agency monitors brokerage records, trading data, investor tips and complaints, self-regulatory organizations, and media reports to uncover suspicious activity.

To encourage whistleblowers, the SEC rewards individuals who provide original information that leads to an SEC enforcement action resulting in fines exceeding $1 million. Awards typically range from 10% to 30% of the money collected.

The SEC’s enforcement division works with the Department of Justice on insider trading cases, which can result in both civil and criminal fines for individuals and entities. In civil cases, individuals found liable may be ordered to return any profits gained or pay an amount equal to the losses they avoided, up to three times the amount involved. The SEC may also prohibit individuals from serving as officers or directors of public companies.

Criminal penalties can be more severe. Individuals convicted of criminal insider trading may face a maximum of 20 years in prison and a fine of up to $5 million. Entities can face maximum fines of $25 million.

Famous insider trading cases

Insider trading has led to some of the most high-profile enforcement actions in financial history, including these notable cases.

Ivan Boesky

A prominent Wall Street arbitrageur of the 1980s, Boesky became a symbol of insider trading excess. The SEC investigated him after he received tips from corporate insiders about potential takeover targets and bought stocks in those companies, often just days before the news became public. Boesky, who famously declared that “greed is healthy”—a line that inspired the “greed is good” speech in the movie Wall Street—pleaded guilty in November 1986 to one felony count of securities fraud. He served two years in prison, paid a $100 million fine, and was permanently barred from the securities industry.

Michael Milken

Known as the “junk bond king,” Milken rose to prominence as the head of Drexel Burnham Lambert’s bond-trading department. Boesky’s cooperation led federal investigators to Milken, implicating him and the firm in widespread securities fraud. In 1990, Milken pleaded guilty to six counts of securities violations. He was sentenced to 10 years in prison, fined $600 million, and permanently barred from the securities industry. His sentence was reduced to time served in 1993.

Raj Rajaratnam

The founder of the Galleon Group hedge fund, Rajaratnam was convicted in 2011 of securities fraud and conspiracy in the first major insider trading case to use wiretaps. At his criminal trial, prosecutors played recordings of phone conversations in which he received or discussed inside information and advised others on how to disguise stock trades. He was sentenced to 11 years in prison, fined $10 million, and ordered to forfeit $53.8 million in profits. In a separate civil case, the SEC ordered him to pay $92.8 million.

Martha Stewart

In 2004, the lifestyle maven settled insider trading charges with the SEC after selling shares of biopharmaceutical company ImClone Systems, which was owned by her friend Samuel Waksal, a day before negative public news caused the stock’s price to drop. Stewart paid $58,062, which included the losses avoided from her insider trading plus interest, and $137,019—three times the amount of losses avoided—in civil penalties. She was barred for five years from serving as a director of a public company. In a separate criminal trial, Stewart was convicted of obstruction of justice and lying to investigators. She served five months in prison, followed by five months of home detention.

The bottom line

Insider trading undermines market integrity by eroding investor confidence in fair and transparent public markets. It involves trading on material, nonpublic information that could affect a company’s value once disclosed. No matter how tempting it may seem, acting on insider information risks severe penalties, and the consequences aren’t worth it.