Insider Trading

Insider trading is a term we hear every so often in the media. Mark Cuban was charged with insider trading. Martha Stewart was charged with insider trading. Gordon Gekko, the antagonist from the 1980s movie “Wall Street,” was charged with insider trading. What precisely is insider trading?
The Securities and Exchange Act of 1934 was passed under FDR in the wake of dips in the stock market. Under Section 10 of the Act, “manipulative and deceptive” practices in connection with the purchase or sale of a securities are forbidden. Administratively, the Securities and Exchange Commission (“SEC”) has promulgated SEC Rule 10b-5 to articulate that insider trading is one of the “manipulative and deceptive” practices banned by the 1934 Act. The exact language of the regulation defines insider trading in the following way:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

Let’s translate. There must be an (1) intentional (2) misappropriation/deception of (3) material information in connection with the (4) actual purchase/sale of securities. The intent requirement means that an individual must consciously act with the malfeasance in mind; negligent insider trading is not actionable. There must be some sort of falsehood or device put in place to defraud. “Material” information is defined as information a reasonable investor would like to know (this is often a gray area; when Apple’s Steve Jobs took administrative leave for health reasons, was this “material” information that a shareholder or investor would want to know?). And, finally, the person must actually purchase or sell a security with this knowledge and mindset. One is not guilty of insider trading by simply having knowledge of insider information.
Further, if there are private investors who file a civil suit for damages from the insider trading, then he/she would have to prove that he/she actually relied on the information, and because of that reliance, suffered losses (e.g., think in “Wall Street 2” when Jacob Moore put out false information Bretton James’s company that he knew to be false; people relied on that information and sold securities because of it).
As such, there is both a civil and criminal aspect to insider trading. Investors can file civil suits to recover damages cause by the manipulative or deceptive practice. Criminally, the federal government would likely press charges. Although insider trading is a tough crime to prove (“materiality” and intent can be difficult to show), it’s not something you want to worry about.