What is Insider Trading?

'Insider trading' can refer to two separate financial transactions--one being perfectly legal and the other being subject to massive civil fines and possible prison time. The legal form of insider trading involves the sale of securities or stocks by officers of a company or stockholders who own more than 10% of the company.

Any stockholder is free to buy or sell their shares based on public information about the company's current or future financial outlook. A company president can sell off his shares if news of an impending bankruptcy filing is announced in the Wall Street Journal, for example. The company president is considered an insider, obviously, but his decision to sell his stock was based on information any other stockholder could have discovered.

The illegal form of insider trading involves information NOT readily available to the rest of the stockholders. Whenever an individual becomes a major stockholder or a senior officer in a company, he or she must agree to keep certain events absolutely secret, even if these events could spell financial disaster for stockholders. The Security and Exchange Commission (SEC) watches for signs of insider trading whenever companies experience huge losses or gains.

If, for example, a vice-president of a drug company learned that the Food and Drug Administration would not be approving his company's newest drug treatment for diabetes, he could not legally sell off his own shares or advise his friends and family to sell off their holdings. The decision to sell off stocks in a company that is about to receive devastating news would be based on privileged information. The vice-president of that company and anyone he told about the FDA decision could be charged with insider trading.

Insider trading is not a new white-collar crime; the use of privileged information for financial gain has been around since the inception of stock trading. Most stockholders are free to make buying or selling decisions based on anything from a strong hunch to the latest pop culture trends. However, executives and major stockholders have an obligation to avoid the use of insider trading even if it means personal financial losses. Without stiff penalties for insider trading, corporate executives everywhere could unfairly profit from their personal knowledge. Regular stockholders without access to this information would not be able to sell off their stock in a failing company or reap the benefits of a company poised for success.