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Understanding Insider Trading

Definition, History, and Punishment

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Insider trading is nothing new, yet it's become the talk of the media as a result of the Martha Stewart - ImClone insider trading scandal going on over the past several months. Despite all of the coverage, you may still be unsure of what insider trading is and how it is punishable.  This quick overview will give you some background on how it came to be illegal (it wasn't always this way) and why lawmakers want to punish it.

The Definition of Insider Trading

Insider trading occurs when someone makes an investment decision based on information that is not available to the general public. In some cases, the information allows them to profit, in others, avoid a loss. (In the Martha Stewart - ImClone scandal, the latter happened to be the case.)

Insider trading was not considered illegal at the beginning of the twentieth century; in fact, a Supreme Court ruling once called it a “perk” of being an executive. After the excesses of the 1920’s, the subsequent decade of depression, and the resulting shift in public opinion, it was banned, with serious penalties being imposed on those who engaged in the practice.

The Penalties for Insider Trading

Depending upon the severity of the case, insider trading penalties generally consist of a monetary penalty and jail time. In recent years, the Securities and Exchange Commission (SEC) has moved to ban insider trading violators from serving as an executive at any publicly traded company.

What Constitutes Criminal Insider Trading

Just what constitutes insider trading? The question is much trickier than it seems. In order for the SEC to prosecute someone for insider trading, they must prove that the defendant had a “fiduciary duty” to the company and / or intended to personally gain from buying or selling shares based upon the insider information.

This test of duty, however, was significantly weakened by the Supreme Court's United States vs. O'Hagan ruling. In 1988, James O'Hagan was a lawyer at the firm of Dorsey & Whitney. After the firm began representing Grand Metropolitan PLC, which planned to launch a tender offer for Pillsbury, Mr. O'Hagan acquired a large number of options in the company. Following the announcement of the tender offer, the options soared, resulting in a four million dollar gain. After being found guilty on fifty-seven charges, the conviction was overturned on appeal. The case eventually found its way to the Supreme Court where the conviction was reinstated (for more information, read Getting the Appropriate Misappropriators: An Analysis of the Supreme Court's Decision in United States vs. O'Hagan).

Barry Switzer, then-Oklahoma football coach, was prosecuted by the SEC in 1981 after he and his friends purchased shares in Phoenix Resources, an oil company. Switzer was at a track meeting when he overhead a conversation between executives concerning the liquidation of the business. He purchased the stock at around $42 per share, and later sold at $59, making around $98,000 in the process. The charges against him were later dismissed by a federal judge on a “lack of evidence”.

On the other hand, based on precedence in other cases, Switzer probably would have been fined and served jail time if one of his players was the son or daughter of the executives, and mentioned the tip to him off-handedly. The line between ‘criminal’ and ‘lucky’, it seems, is almost entirely blurred in such cases.

Section 16 Requirements: Safeguards Against Insider Trading

In order to prevent illegal insider trading, Section 16 of the Securities and Exchange Act of 1934 requires that when an "insider" (defined as all officers, directors and 10% owners) buys the corporation's stock and sells it within six months, all of the profits must go to the company. By making it impossible for insiders to gain from small moves, much of the temptation of insider trading is removed. Company insiders are also required to disclose changes in the ownership of their positions including all purchases and dispositions of shares.

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