What Is Illegal Insider Trading?

Illegal Insider trading occurs when a trade has been influenced by the possession of "material" and "non-public" information about the security. Because such information is not available to other investors, a person using it is trying to gain an unfair advantage over others.

Such insider trading violates transparency, which is the foundation of a capital market. Information in a transparent market is transferred in such a way that all persons involved in it have the chance to receive it at the same time. The capital market is a place where no one should have an unfair advantage. The only advantage possible is the one gained through better individual skill in analyzing and interpreting the information legally available about the market.

Insider trading supported by unfair advantage over other investors is disruptive to the market as it can lead to investors losing confidence in the market and no longer investing, which would eventually impede its functioning.

Legislation behind Insider Trading

In August 2000, the Securities and Exchange Commission (SEC) adopted new regulations regarding insider trading. Under Rule 10b5-1, the SEC defines illegal insider trading as any securities transaction made when the person involved in the trade has non-public, material information, and uses it to violate their duty to maintain the confidentiality of such knowledge by using it for financial gain.

Material Information

Insider information is defined as material if its release could affect the company's stock price. The examples of material information could include a pending merger, financial results different from current expectations, an upcoming dividend announcement, the announcement of winning or losing a major contract, the release of the company's discovery such as a new product, etc.

Insiders

For the purposes of defining illegal insider trading, a person is defined as an "insider" if they have access to information that has not yet been made public. Insiders are expected to act in the best interest of their companies and their shareholders.

Tipper and Tippee

Using non-public information is illegal for company insiders. But sometimes even people outside the company can act against the law by using significant confidential information to increase profit in trading shares. In these situations there is what is known as the tipper and the tippee. The tipper is a person who has intentionally revealed non-public information to someone outside the company. The tippee is the outsider who knowingly uses this non-public information for his or hers financial benefit. These can be for example insiderís friends or family or employees of service companies (banking, brokerage or printing companies) who came across non-public information and traded on it.

Bottom Line

It is illegal when insiders trade on knowledge that public investors do not have. It threatens transparency and influences investors' confidence in the market.