No-one likes a cheater, and least of all, one that gets rich using an unfair advantage. That’s why insider trading rules exist. They stop privileged bosses and professionals making money unfairly on the stock market by using their secret knowledge. Learn what insider trading is, why it’s so bad and what the rules mean for you.
What is insider trading?
Insider trading is when someone in a privileged position, like an employee, uses secret information to help them make money on the stock market. They might know privileged financial information about a company that’s not publicly known and will affect the share price of the stock in the future. If they act on this information they could profit big time as they effectively have a crystal ball and can predict share price movements.
The problem is that making money from privileged insider information is illegal. Stock market trading needs to be a level playing field for investors, otherwise insiders can rip off other investors. They can buy or sell shares, knowing they are worth a different amount to what they have paid.
How does insider trading work?
Insider trading occurs when investors find out secret information that’s not known to the public. They then use this information to profit from buying and selling shares. They can make money because they know in advance which way the share price will move.
Trading as an insider includes tipping off others with information, like friends and family members. If a friend receives a tip-off from an employee and uses this information to profit on the stock market, they are both acting illegally and could be prosecuted.
What are the insider trading rules in the UK?
The UK insider trading rules are set out in the Criminal Justice Act 1993. According to the rules, an individual is committing a criminal offence if:
They use inside information in relation to shares
They buy or sell related to the inside information
The dealing takes place on a regulated market or through a broker
An insider may be able to defend themselves if the following applies:
They weren’t expecting to make a profit
They thought the information was widely known
They would have traded the shares even without knowing the private information
Is insider trading illegal?
Yes. Insider trading is a criminal offence in the UK. It’s illegal if the insiders made investing decisions based on information that isn’t public yet and would affect the share price.
For example, suppose someone works for a company and knows secret information that will affect the stock price in the future. They share it with a family member and then that family member acts on the information and buys or sells shares. In this example, both people are guilty of breaking the law.
Why is insider trading illegal?
Insider trading has been illegal in the UK since 1980 and is actually classed as a type of fraud. It’s illegal because it gives insiders an unfair advantage over other investors. They can use information to make money unfairly because they know secret information that will cause the share price to change once the information becomes public. It’s as if they had a crystal ball to predict future share prices.
What happens if you start insider trading?
If you start insider trading then you are breaking the law. If you get caught, you could get hit with a heavy fine or even a prison sentence.
If you’re a professional like a lawyer or an accountant, you could lose your professional qualification if you’re caught breaking the law.
What is an example of insider trading?
An example of insider trading is the case of American businesswoman and “domestic goddess” Martha Stewart. Her squeaky clean image came unstuck when she was prosecuted for insider trading.
She invested in pharmaceutical company ImClone and in 2001 received a tip-off that would affect the share price. Her stock broker, Peter Bacanovic, passed on information received illegally from CEO Samuel D. Waksal that the FDA wouldn’t approve a new cancer drug for pharmaceutical company ImClone. The share price for the company had been riding high because most experts expected the drug to be approved.
As a result, Martha Stewart sold around 4,000 shares and made nearly US$250,000 on the sale. The share price was riding high because most experts expected the FDA to approve the new cancer drug.
When ImClone announced the news, the share price of ImClone plunged from approximately US$60 to just over US$10 in the following months.
The American financial regulator, the SEC, discovered that insider trading had taken place and prosecuted Martha Stewart, Peter Bacanovic and Samuel D. Waksal. Waksal was sentenced to 7 years in prison and fined US$4.3 million, and a year later Stewart and Bacanovic were also found guilty. Stewart was sentenced to a minimum of 5 months in prison and fined US$30,000.
Can anyone insider trade?
Insider trading is usually associated with people who work for listed companies and get access to privileged information. They can use this information to make money on the stock market. But it is also possible for ordinary members of the public to break the law if they find out private information that would affect a share price.
Finding out secret information and using it to make a profit on the stock market is breaking the law, regardless of how you found out the information.
Can a CEO buy stocks in the company they work for?
Yes, a CEO can buy stocks in the company they work for. Not only that, but companies often offer share options to employees who work for them.
It’s not usually insider trading if a CEO or an employee buys or sells shares in the company they work for. If directors of the company purchase or sell shares and disclose their transactions legally then it’s not illegal as they are complying with the rules.
Insider trading gives the financial services industry a bad name. It’s when corrupt individuals aim to make money based on their special, privileged knowledge. Like any corruption, a few rotten individuals can spoil things for the rest of us. They can make money at the expense of other investors by cheating the system.
That’s why it’s important the financial regulators take a tough stance on insider trading and impose harsh penalties on investors who are found guilty.
Bottom line
Insider trading rules protect other investors and make sure that people can’t benefit unfairly from their privileged position. They mean it’s illegal to use secret information about a company to make money from buying or selling its shares. People who break the rules could face a hefty fine or even a prison sentence and professionals could be barred from practising again.
Frequently asked questions
In the US, the maximum penalty for illegal trading is 20 years in prison and the maximum fine for individuals is $5,000,000.
In the UK, trading as an insider can result in a fine or ban from working in financial services. It also carries a maximum penalty of 7 years.
Yes, it is illegal in the UK. You could get a criminal record or even a prison sentence if you’re caught by the financial authorities.
If you’re a professional, like an accountant or lawyer, you could lose your professional qualification if you abuse your position of trust to make money on the stock market.
In many countries, like the US, you can still be charged with insider trading if you lose money. That’s because the rules are concerned with breaches of confidence or trust, not just the amount of money an investor makes on a trade.
For example, an executive who uses privileged information to make decisions on their investments is breaching their duty towards the company and shareholders. Or an accountant that shares confidential information is breaking their professional code to act on behalf of the shareholders.
It’s difficult to know how often this type of illegal trading takes place, but sadly, it may be more common than we realise.
Researchers estimate that corrupt investors benefit from trading as an insider in as many as 1 in 20 quarterly earnings announcements and 1 in 5 merger deals. This means there may be at least 4 times more of this type of illegal trading than those that are prosecuted.
Financial authorities like the SEC use sophisticated tools to look for possible illegal insider trading. They pay special attention to suspicious activities when earnings reports or key financial information is announced.
Insider trading is illegal in many countries including the UK, the US, Australia, Canada, Germany, Norway and the European Union.
Some countries may have different laws so you should check the rules in your own country.
Alice Guy is a Suffolk-based finance writer, a busy mum of 4 older kids and a self-confessed personal finance geek. She trained as a chartered accountant with KPMG London before working for Tesco Plc as a business analyst. She loves to write about budgeting, saving, investing and building wealth.
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