Insider trading is the buying and selling of stocks by people who have inside information about a company where that material information is not known to the public and which will probably have a significant effect on the stock price when the information becomes public. Insiders include the corporation's directors, officers, managers, and other employees, and also any people with inside information because of their relationship with the company, such as technicians, auditors, and suppliers, and anyone who owns more than 10% of the outstanding stock, and any of the relatives of these people.
Insider trading is prohibited by the Securities Exchange Act of 1934 (SEA) to prevent unfair profits by corporate insiders at the expense of the public. It also requires that:
- corporate insiders must report any change in their holdings of company stock within 10 days after the end of the month in which there was a change;
- insiders are not permitted to sell short their company stock;
- stockholders are entitled to recover any speculative short-swing profits or losses avoided within a 6-month period because of insider trading.
The Insider Trading Sanctions Act of 1984 (ITSA) amended the SEA to give the Securities and Exchange Commission (SEC) the authority to ask the courts to impose penalties on inside traders and on those who passed material inside information to 3rd parties of up to 3 times the amount of gains or losses avoided because of the trades. The maximum criminal penalty was also increased from $10,000 to $100,000.
The Insider Trading and Securities Fraud Enforcement Act of 1988 extended ITSA to include punishment of controlling persons of the corporation who could have or should have prevented insider trading by the corporation's employees. It also expanded the SEC's authority to provide assistance to foreign regulators by allowing it to use its compulsory powers to compel testimony and production of documents to obtain information at the request of a foreign securities authority.
The Stop Trading on Congressional Knowledge (STOCK) Act of 2012 extended insider-trading laws to government officials who acquire insider information from their duties. Similar to the law barring corporate executives from using material, nonpublic information for personal financial gain, the STOCK Act assesses criminal and civil penalties against lawmakers using nonpublic, material information for personal financial gain. The information must be material and nonpublic, but known to the trader. Government employees can also be prosecuted for insider-trading under mail and wire fraud statutes. The STOCK Act imposes a fiduciary duty to all members of Congress, staffers, and government employees.
Rule 10b5-1 provides an affirmative defense against insider-trading if a formal plan is established, not based on inside information, to use a pre-established formula to trigger stock sales. The plan may also be modified if it was not based on inside information. However, this rule weakens insider-trading law because modifications do not have to be disclosed to the SEC or to the public and because planned trades can be canceled, even if the cancellation was based on inside information.
Insider-trading case law further restricts people with insider information from telling anyone else to trade based on the insider information or lying about the trades to authorities who question it. The SEC can also sue government officials in a civil case, which has a lower standard of proof, if the SEC believes the STOCK Act has been violated. Additionally, Congress can conduct ethics investigations.
The SEC requires public companies to set rules to discourage insider trading by its employees; otherwise, the companies can be held liable for their insider trades. Companies require employees to consult the company’s general counsel to minimize the risk of being charged with insider trading.
One rule that most companies have adopted is by setting blackout periods during which insiders may not trade their company stock except under special circumstances. Blackout periods most commonly extend from the end of the earnings quarter to when those earnings are reported or to when a 10-Q or 10-K is filed, when it is most likely employees will have material non-public information (MNPI). These blackout periods apply to top company executives, but they may also extend to lower ranking employees, especially at smaller companies.
Companies encourage executives to trade during what some call open windows, a certain amount of time after earnings are reported to the public. Presumably, any bad information would be reported as part of quarterly earnings and as disclosures to analysts. However, as time progresses, executives will learn new information about the company that may affect the stock price, and since this insider information accumulates with time until it is reported in the next earnings statement, most companies set their blackout periods during that time. Note that open windows and blackout periods are not legal terms; they are not enshrined in law; they are simply policies that most companies have established to avoid insider trading charges.
Sources of Insider Trading Information on the Web
Nasdaq provides extensive information on insider trading by company executives, which can be found by searching for a specific company, then selecting Insider Activity in the left sidebar. These reports provide a total number of insider trades and the number of shares traded in the last 3 months and in the last 12 months as well as listing the total number of buys and the total number of sells in those time periods. Following these 2 tables are details by each insider, which can also be filtered for buys or for sells.
Morningstar provides an Insider Trading Overview, listing the top companies bought and the top companies sold and also provides an Insider Search form to search for specific companies.
Insider buying is usually a strong bullish signal, but selling is not necessarily a bearish signal, since executives can sell for many reasons, such as needing cash. However, if most executives of the company are selling within a short span, then this may be a bearish signal. Another way to check whether selling is a bearish signal is to check insider trading among different companies in the same industry. If most executives in the industry are selling, then it may be because they expect their stock price to decline because the industry is not doing too well.
WhatsApp and Signal are encrypted messaging services that allow many people who work on Wall Street to exchange insider information outside of the communications network of the firms for which they work, which are monitored and recorded. Therefore, encrypted communications will make it more difficult to prevent and prosecute insider-trading. As technology evolves, insider trading will probably become more prevalent, to the detriment of the average investor!