Definition of Insider Trading

Insider trading is the trading of a security of a company (e.g., shares or options) by an insider, a person who knows information that is not accessible to the public. Most investors have heard and usually associate it with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC. For more information about this type of insider trading and the reports insiders must file, please read "Insider Trading Forms" in our Knowledge Central.

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.

There are rules against such illegal insider trading in most jurisdictions around the world, though the details and the efforts to enforce them vary considerably. In the United States, for example, there is no general federal law directly prohibiting insider trading. Authority to prosecute cases of insider trading came from the Supreme Court's interpretation of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, prohibiting fraud in connection with the purchase or sale of securities.

An example of illegal insider trading may be that you, as an assistant to the Chief Executive Officer, learn that your company is going to be taken over before it is announced to the stock exchange. Knowing that such a move is liable to cause the price to rise, you buy shares in the company and subsequently profit from the transaction.

Within a company, there are many people who might have access to information that might be construed as privileged to their position in the company. Nevertheless, they may wish to trade in the shares of their company (e.g., selling share options). To ensure that their employees can easily comply with the regulations, these companies will often publish dates when managers and senior staff members can trade in shares of the company without breaking the law.

In practice, prosecutions for insider trading tend to be rare and difficult to win for a variety of reasons. It can be difficult to prove what the accused actually knew at the time the trades were made -- and people may not even be told directly but merely advised to buy or sell with a nudge and wink. Proving that a particular individual was responsible for a trade can also be difficult, because a clever trader can hide behind a variety of nominees, companies, and proxies, some of which may be located offshore in jurisdictions that don't cooperate with the local authorities. Insider trading is usually performed by the already wealthy, who can afford the best lawyers available and have the resources to drag a case out and cost the prosecutors millions along the way. Finally, the details of insider trading can be highly confusing to non-experts, and convincing a randomly-selected jury, many with no experience of share trading, that a crime was committed can be difficult.