In August 2000, the Securities and Exchange Commission (SEC) adopted new rules regarding insider trading (made effective in October of the same year). Under Rule 10b5-1, the SEC defines insider trading as any securities transaction made when the person behind the trade is aware of nonpublic material information, and is hence violating his or her duty to maintain confidentiality of such knowledge. Information is defined as being material if its release could affect the company’s stock price.

The following are examples of material information:

  1. The announcement that the company will receive a tender offer.
  2. The declaration of a merger
  3. A positive earnings announcement.
  4. The release of the company’s discovery such as a new drug.
  5. An upcoming dividend announcement.
  6. An unreleased buy recommendation by an analyst.
  7. An imminent exclusive in a financial news column.

In a further effort to limit the possibility of insider trading, the SEC has also stated in Regulation Fair Disclosure (Reg FD), which was released at the same time as Rule10b5-1, that companies can no longer be selective as to how they release information. This means that analysts or institutional clients cannot be privy to information ahead of retail clients or the general public. Everyone who is not a part of the company is to receive information at the same time.

Partners in Crime
In insider trading that occurs as a result of information leaking outside of company walls, there is what is known as the “tipper” and the “tippee”. The tipper is the person who has broken his or her fiduciary duty when he or she has consciously revealed inside information. The tippee is the person who knowingly uses such information to make a trade (in turn also breaking his or her confidentiality). Both parties typically do so for a mutual monetary benefit. A tipper could be the spouse of a CEO who goes ahead and tells his neighbor inside information. If the neighbor in turn knowingly uses this inside information in a securities transaction, he or she is guilty of insider trading. Even if the tippee does not use the information to trade, the tipper can still be liable for releasing it.

It may be difficult for the SEC to prove whether or not a person is a tippee. The route of insider information and its influence over people’s trading is not so easy to track. Take for example a person who initiates a trade because his or her broker advised him or her to buy/sell a share. If the broker broker based the advice on material non-public information, the person who made the trade may or may not have had awareness of the broker’s knowledge – evidence to prove what the person knew before the trade may be hard to uncover.

Excuses, Excuses
Oftentimes, people accused of the crime claim that they just overheard someone talking. Take for example a neighbor who overhears a conversation between a CEO and her husband regarding confidential corporate information. If the neighbor then goes ahead and makes a trade based on what was overheard, he or she would be violating the law even though the information was just “innocently” overheard: the neighbor becomes an insider with a fiduciary duty and obligation to confidentiality the moment he or she comes to possess the nonpublic material information. Since, however, the CEO and her husband did not try to profit from their insider knowledge, they are not necessarily liable of insider trading. In their carelessness, they may, however, be in breach of their confidentiality.

Conclusion
Since illegal insider trading takes advantage not of skill but chance, it threatens investor confidence in the capital market. It is important for you to understand what illegal insider trading is because it may affect you as an investor and the company in which you are investing.

Read more: http://www.investopedia.com/articles/03/100803.asp#ixzz1lE2rT370

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