The Definition of Insider TradingInsider 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 1920s, 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 TradingDepending 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 TradingJust 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.