Archive for the ‘Insider Trading’ Category

Insider Trading – FAQ

April 23rd, 2011 5 comments

04.23.2011 original publish date
03.24.2014 minor updates

Insider Trading – FAQ

Investor Education Series written by Net Advisor

There are numerous regulators that are entrusted to enforce rules and regulations in the U.S. financial markets. There is broker licensing and regulation (FINRA), the Commodity & Futures Regulator (CFTC), and many others. However, the chief federal regulator for the U.S. securities markets is the Securities & Exchange Commission (SEC).

The SEC’s primary mission is:

“to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

— Source:

One important rule rarely gets by regulators and that is Insider Trading.

What is an “Insider?”
Under SEC’s rules, an “Insider” is one who has knowledge of non-public information about a publicly traded company.

Is it Illegal to be an Insider?
We first have to remind of our disclaimer that I or, nor our non-profit arm are not lawyers, so we can’t advise the legality of such. However, as a former Registered Principle & Securities Compliance Officer (Series 24, bio) I would argue that there is nothing wrong about being an insider. Technically speaking, if one works for a public company where there is stock that trades on a stock exchange, anyone working in or closely with the company could be deemed as an insider.

One Doesn’t Have to Work at a Company to be an “Insider”
Many people might think that one has to be a high level officer or corporate executive to be an insider. The fact is that one doesn’t have to be an insider to be charged with insider trading. What a person does with non-public information is where the line gets drawn.

So What Defines Insider Trading?
All you have to do is act on non-public information in the attempt to make a profit or avoid a loss. The SEC generally defines insider trading as:

“…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.”

— Source:

Example of What Might be Argued as “Insider Trading.”

John works for XYZ corp, where XYZ stock is traded on a securities exchange such as NYSE, or NASDAQ, etc. John is a regular employee who overheard talk from someone in the company who said they might be bought out by another company.

John comes home and runs into his neighbor Jim. In passing conversation John mentions to Jim that his company might be taken over in a merger or buyout.

Did anyone break the law here? The answer based on the above scenario is, “no.”  It would be better if John did not say anything to Jim even if it was a company rumor and may or may not be true.

Let’s take this a step further.

John’s neighbor Jim and his spouse Maria goes to a dinner party with Matt, Rose, Dave and Julie. At some point in conversation, Jim mentions that he heard that XYZ stock might be taken over in some merger or buyout. The next day or so Dave, an avid investor calls his broker to buy 1,000 XYZ stock at $30 per share.

Next Monday, XYZ stock opens up for trading at $55 following a morning news channel report that ABC company is buying XYZ stock for $58.00 per share. Rose saw the morning news on TV before work about the buyout of XYZ Corp. Rose then calls her broker to buy $5,000 worth of XYZ stock at $55.


Under SEC rules, which of the following may be deemed as an insider of XYZ stock?
(a) John Only
(b) Maria, Julie, Matt & Rose
(c) Jim and Dave
(d) all of the above
(e) none of the above

The answer is: (d) “all of the above” may be deemed as potential insiders. Anyone who heard non-public information from John or subsequent transmission of such information may be deemed as an insider. Again it it not illegal to have information, it is the subsequent action upon where information is improperly used is what counts. With that said,

Under SEC rules, which of the following may have committed insider trading in XYZ stock?
(a) John and Jim
(b) Maria, Julie, Matt & Rose
(c) Dave
(d) all of the above
(e) none of the above

The answer is: (c) Dave. Even though Dave is an avid investor, he acted on non-public information he heard from Jim. Jim also became an “insider” based on non-public information shared with him from his friend John (an (“insider”) employee of XYZ corp. Since John did not act for his benefit on his insider knowledge, he did not commit insider trading.

Rose may have been deemed as an insider, however she did not commit insider trading because she did not act on the non-public information she heard at the dinner party. She waited until the news was made public, THEN she bought the stock. This is perfectly OK. Had Rose bought XYZ stock before the news release and if she in fact relied on the information she got from Jim at the dinner party, then she would have committed insider trading along with Dave.

Why It’s Often Best Not to Immediately Buy a Stock After News of a Buyout or Merger
Generally in my experience, buying a stock after a buyout or merger announcement isn’t always the best move. Mergers and the alike can take months to up to a year and a lot can happen in between that time. The stock market could have a negative event, sending the stock down. Disappointing industry news could also impact the price of the stock near term. The merger could be hostile (an “unsolicited bid”) creating uncertainty if the deal may go through or not. A deal may also require regulatory approval which could take months or longer.

If such takeover or merger fails, the stock could tank back to the pre-merger price and often times even lower than that. This move can happen overnight or in an instant, thus not giving anyone a special advantage to sell before the news hits. When material news is pending, a company’s stock is often halted (stops trading) until the news is out.  After the news is out, the stock is repriced based on the demand verses buy and sell orders, then re-opens at the new price reflecting the news and any change in demand for the stock.

Is Acting on Published Rumors Insider Trading?
No. If the TV media, newspapers, Internet press or even a guest appears on TV, radio, or any public form and says they think (for example) HHH Corp is a good takeover candidate, is undervalued, or published reports say there are rumors circuiting about HHH stock, anyone acting at that point to buy or sell the security would not likely be deemed to be doing any insider trading. Why? The rumor has been broadcasted in the public domain, and thus is no longer privately or exclusively known.

Trading Rumors. For most people, best not.
People in the press will properly (and should) disclaim that company rumors are not known facts, that they are just rumors, and the press is not reporting any specific facts of a buyout, etc. At this point, the investor buying or selling into these widely and publicly broadcasted rumors is just speculating. No one has any specific knowledge obtained from a inside source.

Rumors circulate all day on trading desks, on the Internet and elsewhere. In my experience 99% of the rumors are wrong. The stock gets hyped, news media may comment on the rumor, note increased trading volume, or price movement. The general public gets in looking to cash in on what seems to be easy and fast profits, and the professionals who got in earlier, cash out. Try not to get sucked into rumors.

Now, if the say buyout rumor was proven to be true, the SEC might look into the trading before the stock moved. The SEC may also look into trading in the options market for recent activity. The SEC might look for unusual trading volume, individual purchases of stock options.

It is really hard to prove an insider trading case based on grandma putting her life savings into say HHH stock after hearing the rumor on the TV news and it turns out a week layer the stock soars on a buyout. Grandma just got lucky. It doesn’t usually happen like this.

Why Rumors Are Usually Wrong
In the event the rumor was real, and the stock climbed in anticipation of an unknown event, the acquiring company would end up having to pay more for the stock than they would without the rumor. Thus it is important for insiders to refrain for disseminating any potential non-public information.

Many times if the rumor does not happen within a day, a few days to say a week or so, often what happens is the stock falls back down to where it was before the rumor was circulated, or even a bit lower. Watch for trading volume. If the trading volume in a stock declines after a rumor, and the stock goes nowhere, the next move for the stock could be lower.

It is best not to trade on rumors because they are just rumor – gossip and chatter, and one could quickly end up losing that trade. Professional traders with full-time attention on the markets watching every tick and with the right technology (which anyone can subscribe), can move in and out of positions quicker than someone not paying close and active attention to the markets.

Disseminating False Rumors
It should also be noted that spreading false rumors in public markets can be deemed as market manipulation and may be be subject to civil penalties or worse.

In 2008,

the SEC “charged Paul S. Berliner, a Wall Street trader formerly associated with Schottenfeld Group LLC, with securities fraud and market manipulation for intentionally spreading false rumors about The Blackstone Group’s acquisition of Alliance Data Systems (ADS) while selling ADS short.”

(Berliner settled with the SEC, and agreed to) “disgorge $26,129 in profits and interest, pay a maximum third-tier penalty of $130,000, and consent to the entry of a Commission Order barring him from association with any broker or dealer.”

— Source: (Official SEC Complaint)

Penalties for Insider Trading
Penalties for insider trading can also be stiff. They can involve either civil fines or jail time (criminal enforcement) or both. Criminal proscription tends to be in more serious and high dollar cases, where the SEC will seek to make a public example out of someone. In most cases, the SEC can seek civil fines against the violator if convicted in a court of law. Cases are sometimes settled to reduce the cost of ongoing legal fees, court time, etc.

“(Civil Fines) …shall not exceed the greater of $1,000,000, or three times the amount of the profit gained or loss avoided as a result of such controlled person‘s violation.”

— Source: Securities & Exchange Act of 1934, Section 21A

Stock brokers and other licensed financial industry people subject to SEC and other regulatory supervision  can also lose all their securities licenses and worse, be banned (or “barred”) from working within the financial/ securities industry for life if convicted for more serious securities violations.

For everyone else, its usually a fine large enough making insider trading a risky proposition.

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