What Is Insider Trading?
Illegal insider trading is an ever-present risk for any publicly traded company. While company insiders—corporate officers, directors, 10% stockholders, and other individuals with nonpublic company knowledge—are allowed to buy and sell stock, they are not allowed to make trading decisions based on material nonpublic information. Use of material nonpublic information may be illegal—whether by the company insider themselves or someone with whom they shared the information.
Insider trading laws are one way the United Securities and Exchange Commission attempts to keep the marketplace fair and corruption-free. By barring insiders from using exclusive information in their trades, it eliminates unfair advantages, undue profits, and loss aversion. Essentially, the laws seek to level the playing field for all investors.
Insider trading isn’t just limited to corporate executives, either. It can involve anyone with material nonpublic information—from front line operations staff to the Board of Directors. Here are a few ways illegal inside trades can occur:
- A business executive learns his company’s (unreleased) quarterly earnings are not looking good. Wanting to avoid a loss, he promptly sells several shares of the company’s stock before the information hits the markets.
- An employee of XYZ Corporation overhears that the company is going to be acquired, but the announcement is not yet public. He tips off a friend about the acquisition, leading the friend to purchase stock in the company.
- Company A swaps insider information with Company B as part of a “mutually beneficial exchange.”
- A member of Congress trades stock based on information from a private government briefing. Not only that, but she fails to disclose her financial transaction, as required by the STOCK Act of 2012.
What Causes Insider Trading?
While greed might be the go-to explanation for inside trades, the reality is much more complicated than that. Take it from Tipper X, a former hedge fund analyst convicted of insider trading. Tipper X, whose real name is Tom Hardin, began working with the FBI to nab Wall Street criminals and is now a well-known crusader against insider trading. According to Hardin, there are several different factors that may contribute to illegal trades.
Following the Crowd
The only thing worse than acts of misconduct is normalized acts of misconduct. In Hardin’s experience, many insiders tried to justify their illegal trades because they believed “everyone was doing it.” In many cases, insiders would even talk openly about their illicit trades and tip off friends, family, and colleagues with nonpublic information. However, it’s important to keep in mind that what’s popular isn’t always the right thing to do. As your mother might say, “if everyone jumped off a bridge, would you?”
Assuming Insider Trading is a Victimless Crime
Insider trading is easy to rationalize because perpetrators can’t see the impact it has on others directly. While insider trading may not produce victims in the “traditional” sense, it can still harm everyday people with its unfair impact on the market. Essentially, illegal trades manipulate the market, lower market liquidity, and allow the elite and well-connected to profit at the expense of regular stock traders. In addition, insider trading leads to a major loss of trust in your business and the market as a whole. In order to preserve fairness and trust in your company, employees need to understand that insider trading is not a victimless crime.
The decision to buy and sell stock can be boiled down to two main factors: gaining profits and avoiding losses. However, loss aversion is often tied to more than just money. Many employees get sucked into shady trading because they fear losing their jobs or social reputations. In Hardin’s case, he wound up taking an inside trading tip because his boss told him the company would not survive without some major cash inflow. “It was also made clear to me my job was on the line,” Hardin says, “That if I didn’t start to produce, I’d be fired.” When the pressure to generate short-term profits outweighs the company’s long-term investment in ethics, employees often turn to unethical practices as an act of self-preservation.
Like an ostrich, many employees choose to bury their heads in the sand and ignore misconduct rather than put a stop to it. This mentality can be easy to justify—after all, if you’re not directly involved and the business is profiting, what’s the harm? The problem is that willful ignorance allows misconduct to grow and spread freely across an organization. According to Hardin, management needs to be especially vigilant and willing to question dubious ethics. Otherwise, it sends a message to employees that says, “‘Don’t tell me. I really don’t want to know whatever it is you’re doing.’”
Weak Compliance Cultures
Perhaps the #1 reason businesses get caught up in insider trading? The company’s overall compliance culture is weak. Companies need to put ethics and compliance at the forefront of all their decision-making. Otherwise, employees will implicitly understand that compliance isn’t a priority, opening the door for more compliance risks down the road. Creating a robust policy against illegal insider trading, investing in training, and regularly measuring training results are good first steps towards creating a more compliant work culture.
Insider Trading Compliance Training
Insider trading is a slippery slope. Even an off-handed comment about company earning reports can spiral into a chain of tips and illegal trades. To reduce their risk, companies should consider investing in insider trading compliance training. A strong training program will teach and test for understanding in a few key areas:
- Defining insider trading
- Identifying material nonpublic information
- Consequences of insider trading
- Proper handling of confidential information
- What to do if you suspect insider trading
- Reporting procedures and compliance resources
Even if you’re confident your business isn’t at risk for insider trading, it’s always a smart idea to invest in compliance training. After all, according to Tipper X himself, “We’re all a few small decisions away from going down our own slippery slope.”