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Insider Trading

What is it? What are the penalties?


Insider Trading has been all over the news lately. First it was Enron and WorldCom. Then even the apparently squeaky clean Martha Stewart got pulled in. So just what is Insider Trading? How can you avoid problems with it, even if you are not classified as an insider?

Insider Trading
The illegal kind of Insider Trading is the trading in a security (buying or selling a stock) based on material information that is not available to the general public. It is prohibited by the US Securities and Exchange Commission (SEC) because it is unfair and would destroy the securities markets by destroying investor confidence.

An Insider
A company insider is someone who has access to the important information about a company that affects its stock price or might influence investors decisions. This is called material information.

The company executives obviously have material information. The Vice President of Sales, for example, knows how much the company has sold and whether it will meet the estimates it has provided to investors. Others within the company also have material information. The accountant who prepares the sales forecast spreadsheet and the administrative assistant who types up the press release also are insiders.

A public company, if it is smart, limits the number of people who have access to material information and, therefore, are considered insiders. This is done for a couple of reasons. First, they want to limit the likelihood that anyone will "leak" the information. Second, being an insider means being subject to severe limits on when you can trade in the company stock, usually only the middle month of each quarter.

The company's senior management are insiders. So are some of the financial analysts. The top sales people usually also are insiders, although a regional sales manager who only sees his or her own region's results may not be one. The individuals in Investor Relations and/or Public Relations who prepare the public announcements also are insiders.

If the company is developing a new product that could be a big seller, the key people in the Research & Development team would also be considered insiders, provided the information they have is material, as defined above.

Other individuals who are not employees, but with whom the company needs to share material information, are also insiders. This list could include brokers, bankers, lawyers, etc.

Not An Insider
So does that mean you are not an insider unless you are on the company's management team, financial or development teams, or someone hired to handle the material information? In a word, "No".

The SEC includes in its definition of insiders those who have "temporary" or "constructive" access to the material information. If the President of a company tells you that the company's best hope for a breakthrough product isn't going to get regulatory approval, you are now every bit as much an insider as he is, with respect to that information. It is illegal for him to trade based on that knowledge before it becomes public knowledge. It is equally illegal for you to do so because you are now a "temporary insider". This remains true regardless of how many times the information is passed. If the president tells his barber, who tells her baby sitter, who tells her doctor, who tells you, the barber, baby sitter, doctor and you are all "temporary insiders".

Anyone who has material information is prohibited from trading, based on that knowledge, until the information is available to the general public. The US Supreme Court ruled recently, that this even applies to someone with no ties to the company. Possession of material information makes you an insider, even if you stole the information.

Significant Penalties
Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 give the SEC the authority to seek a court order requiring violators to give back their trading profits. The SEC can also ask the court to impose a penalty of up to three times the profit the violators realized from their insider trading.

In addition to the financial penalties, there are criminal penalties. Many now feel those penalties are not strong enough and are working to increase them substantially. A bill in the US Senate, for instance, seeks to make defrauding shareholders a felony punishable by up to 10 years in prison.

Manage This Issue
Police your insiders yourself. Don't allow insider trading. Don't engage in it yourself. It is in your company's best interest to prevent insider trading so you don't have the SEC investigating you. Even if the company and all its officers eventually are cleared by the SEC of any wrong doing, the investigation itself can have lasting detrimental effects on the company.

Don't share material information with anyone who is not an insider. Make sure all insiders understand the responsibility this places on them. Make sure everyone in the company understands the circumstances under which they might become "temporary insiders' and how they must treat that situation.

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