Insider trading refers to the buying and selling of stocks using valuable information that is not available to the public. Many countries have laws against insider trading. In the United States, the Securities and Exchange Commission (SEC)—a government agency that aims to ensure a fair and orderly stock market—forbids the practice [see Securities and Exchange Commission (SEC) ]. Nevertheless, research has shown that insider trading has become more common over time.
Insider trading often occurs prior to a public announcement of important corporate news. For example, suppose a company plans to unveil a new product, which it has developed secretly, at an upcoming trade show. Before the announcement, someone with access to inside information buys the stock. After the announcement, the news causes the stock price to increase. The insider could then sell the stock, earning a fast profit.
Insider trading is also common when one company merges (combines) with or acquires another. In these corporate take-overs, the stock price of one or both companies often increases, especially that of a smaller company that has become a take-over target. Therefore, an insider who knows of an upcoming merger before it is made public has an unfair advantage over others in the market.
There are three main kinds of insiders: (1) registered insiders, (2) temporary insiders, and (3) outside insiders. Registered insiders include company officials, employees, and major shareholders. Because of their roles within the company, registered insiders often have valuable information not available to ordinary people. Their names are listed with the government agency that regulates stock trading—in the United States, the SEC. Many temporary insiders are accountants, attorneys, or investment bankers who provide services to the company. Although they are not permanent employees of the company, their work often gives them access to private information. Most outside insiders are relatives, friends, and acquaintances who receive tips from registered or temporary insiders. Another group of outside insiders that came under scrutiny in the early 2000’s includes members of Congress and employees of the executive branch. Historically, trading by this group, whose members routinely come across material nonpublic information, had not fallen under the insider trading laws. Information is considered material if its release can cause stock prices to move up or down. The passage of the Stop Trading on Congressional Knowledge (STOCK) Act in 2012 was designed to discourage insider trading by this government group.
Insider trading is harmful because it reduces investors’ confidence in the stock market. Noninsiders may feel that they are unfairly at a disadvantage in the market and that they are therefore less likely to make a profit. A healthy economy relies on money from investors to finance business expansion, and investors will not invest in a market that they do not trust.
Not all insider trading is illegal. Legal trades by insiders are common in the case of employees of publicly traded companies, who often receive stock or stock options. These trades are made public in the United States through SEC filings.
