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Investing Glossary – Insider Trading

The following is either adapted or copied from Wikipedia. Some small adjustments and additions may have been made by Investor in the Family staff. For more, see our Investing Glossary.

Insider trading is the trading of a public company‘s stock or other securities (such as bonds or stock options) by individuals with access to non-public information about the company. In various countries, insider trading based on inside information is illegal. This is because it is seen as unfair to other investors who do not have access to the information.

The authors of one study claim that illegal insider trading raises the cost of capital for securities issuers, thus decreasing overall economic growth. However, some economists have argued that insider trading should be allowed and could, in fact, benefit markets. Noted economist Milton Friedman has been quoted as saying “You want more insider trading, not less”.

Trading by specific insiders, such as employees, is commonly permitted as long as it does not rely on material information not in the public domain. However most jurisdictions require such trading be reported so that these can be monitored. In the United States and several other jurisdictions, trading conducted by corporate officers, key employees, directors, or significant shareholders must be reported to the regulator or publicly disclosed, usually within a few business days of the trade.

The rules around insider trading are complex and vary significantly from country to country and enforcement is mixed. The definition of insider can be very wide and may not only cover insiders themselves but also any person related to them such as brokers, associates and even family members. Any person who becomes aware of non-public information and trades on that basis may be guilty.

Legal trades by insiders are common, as employees of publicly traded corporations often have stock or stock options. These trades are made public in the United States through Securities and Exchange Commission filings, mainly Form 4.

SEC Rule 10b5-1 clarified that the prohibition against insider trading does not require proof that an insider actually used material nonpublic information when conducting a trade; possession of such information alone is sufficient to violate the provision, and the SEC would infer that an insider in possession of material nonpublic information used this information when conducting a trade. However, SEC Rule 10b5-1 also created for insiders an affirmative defense if the insider can demonstrate that the trades conducted on behalf of the insider were conducted as part of a pre-existing contract or written binding plan for trading in the future.

For example, if an insider expects to retire after a specific period of time and, as part of retirement planning, the insider has adopted a written binding plan to sell a specific amount of the company’s stock every month for two years and later comes into possession of material nonpublic information about the company, trades based on the original plan might not constitute prohibited insider trading.

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