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Understanding the Different Types of Insider Trading

Updated on 2012-11-17 by Guest





With the Securities and Exchange Commission (SEC) serious crusade against insider trading, it’s important to be clear on the types of insider trading. Contrary to popular notion, not all of insider trading activities are illegal. And just to on the safe side of the law we need to go into all the vague details that separate legal and illegal insider trading activities.


Legal vs. Illegal Insider Trading

Legal insider trading happens all the time. You’ve probably heard of employees of a publicly listed company trading equities of the company they’re working. Insider trading of this nature is perfectly legal as long as corporate insiders report their trades pursuant of the SEC regulation.

Illegal insider trading, however, refers to any trading activity that’s based on corporate information that’s not disclosed to the public. Such trading activity undermines everyone’s confidence in the integrity and fairness of the equities market. Additionally, it is deemed as a breach of trust and fiduciary duties of the employee to their company.

In most instances, the line that separates legal and illegal insider trades is clear and obvious. However, there are some cases when that line can be muddied up a bit. Take for example, when a trader overhears an important conversation between two executives of a company and proceeds to trade the company’s stock based on the information he heard. You can make an argument of that trade as being unethical and unfair since it does make use of information that’s not available to the general public. However, the law does not encompass this scenario; so it’s still considered legal.




Types of Illegal Insider Trading

Classic Insider Trading

Most widely understood illegal insider trading activities are classic ones: a top executive of a company knows undisclosed information of the corporation and buys/sells company stocks based on those non public materials. The details may vary a bit but in this instance, it’s a clear-cut illegal insider trading scenario.

One famous case of this nature is the case involving Martha Stewart and ImClone pharmaceutical company. ImClone’s drug Erbitux was not approved by the FDA which caused the company’s stock prices. Interestingly, those that were not affected were ImClone’s founder Samuel Waksal, his family and friends, as well as Martha Stewart. They sold their shares days before the rejection by the FDA was announced to the public. Waksal was sentenced to 7 years in prison and was ordered to pay a fine amounting to $4.3 million. The case caught much of public attention due to the involvement of Martha Stewart who was also sentenced to minimum of five months in prison and $30,000 fine.


Tipper and Tippee

Another common illegal insider trading scenario is when an employee of a company who is privy to essential nonpublic information does not trade directly the company’s stock. Instead, he passes the information to another person who will use the information to profit from it. In such cases, both the tipper and the tippee are liable for illegal insider trading activities.

One famous case, which is a complete example of this scenario is the case of Ivan Boesky who was an arbitrageur in the 1980s. Boesky became famous for his seemingly preternatural ability to stack his bets on takeovers days before an offer is made. Boesky was making a killing in the major deals involving Nabisco, Chevron, and Getty Oil, to name a few. It turns out that this his trades were not dictated by mere ability to pick out undervalued companies that would attract generous offers; rather, he went directly to mergers and acquisition arm of investment banks to acquire juicy tidbits of information that would guide his trades. Dennis Levine and Martin Siegel were also indicted for selling information to Boesky.


Misappropriation

Another illegal activity that’s closely related to insider trading is the misappropriation of a company’s information for personal gains. For example, an investor is being invited by an investment banker who is trying to reach a capital for a certain company. The investor was asked to sign a nondisclosure agreement. The banker proceeded to give the investor the state of the company and why it needed to raise capital. The investor refused to take part in the offer. But when the meeting is done, the investor called his broker to sell his shares of the company. The investor is guilty of misappropriating information given to him in trust and confidence.

The case of O’Hagan is one of the common examples of misappropriation. James O’Hagan was a partner at Dorsey and Whitney law firm. While working as a lawyer there, he learned that one of Dorsey’s clients, Grand Metropolitan PLC was on the verge of placing an offer for Pillsbury Company. Using this information, he bought stock options, which he sold after the offer was announced and profited a hefty sum of $4.3 million from that trade. While O’Hagan was not an insider of Grand Metropolitan or Pillsbury – and therefore do not have fiduciary duties to either company, the court ruled that he used confidential information for his personal gains and that breached confidence and trust.

One of the ethical tenets of the stocks market is that no trader should have any unfair advantage over everyone else. For this reason, not all legal trades can be considered ethical. And history will tell us that there will always be cunning individuals who’d tiptoe the thin line that separates ethics and legalities for substantial profits.









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