Insider trading happens when a person has a piece of confidential information and then trades based on that information. This type of trading is illegal unless the trader, or the company, makes public disclosure of the information within a certain period of time. Several different categories of insider trading are considered illegal by the Securities and Exchange Commission.
Insider Trading Basics
Insider trading law springs from the Securities and Exchange Act, Section 10b, and the Securities and Exchange Commission's Rule 10b-5. According to the SEC, confidential information is any information not available to the public, but not everyone who obtains confidential information is an insider under the law. Courts have defined insiders as those whose relationship with a particular company exposes them to confidential information. This would include not only a company's employees or executives, but also the company's attorneys and accountants. Some examples of confidential information include plans for a merger, takeover or other upcoming company change. Any insider who has confidential information and trades on it without disclosing the information to the public commits the most basic form of insider trading.
Misappropriation of Information
Misappropriation is a type of insider trading recognized by most federal judicial circuits. Misappropriation happens when you are not in a relationship with a company that makes you privy to confidential information, but you learn the information from someone who is, and you yourself owe a duty of confidentiality to that person. For instance, you are a lawyer and you learn confidential information about a company from your client, who is a company insider. If you then trade based on that confidential information when it hasn't been made public, you yourself may be guilty of insider trading under the misappropriation theory.
In addition to misappropriation, courts have recognized another type of insider trading liability, even for people who don't have a confidential relationship with an insider. When an insider gives you confidential information and you know that by giving you that information he has breached his duty of confidentiality to the company, you may not trade on that confidential information. In this situation, you would be a "tippee." Courts frown on this sort of behavior because it implies that you provided incentive for, or at least assisted, the insider to breach his duties to the company. The one exception is if the insider disclosed to you without expecting any profit from his disclosure; in this case, although the insider might face other types of censure, you would not be held liable for trading on the information.
When one has confidential information, the SEC's guidelines are very simple: disclose or abstain. Since mere possession of confidential information is not a crime on your part, in order to avoid insider trading liability, you can simply abstain from trading on the information. However, if you really want to trade, disclosure of the information in a public forum will also make the information public, rather than confidential. Trading can't be insider trading when that trading is based on public information. If you've come into possession of confidential information, you must either disclose the information or refrain from trading based on that information altogether.
Erika Johansen is a lifelong writer with a Master of Fine Arts from the Iowa Writers' Workshop and editorial experience in scholastic publication. She has written articles for various websites.