Is Insider Trading Legal? Legal vs Illegal Insider Trading

Officers, directors, and large holders own stock and are allowed to trade it. The law requires them to report each trade within two business days and forbids trading while holding information that the public does not have and would care about. Many insiders use 10b5-1 plans to schedule trades in advance so they never have to judge the timing themselves.

Rule 10b-5 makes it fraud to trade on material non-public information in breach of a duty, or to tip someone who does. "Material" means a reasonable investor would consider it important. "Non-public" means it has not been broadly released. It applies to insiders, to people they tip, and to outsiders who misappropriate information, for example a lawyer trading on a client's pending deal.

Everything on a Form 4, a Schedule 13D, a 13F, or a STOCK Act report is public by definition. Reading those filings and acting on them is research, not insider trading. InsiderWatch uses only public government and market sources, never material non-public information, and says so on every alert.

Under the classical theory, an insider who trades their own company's stock on material non-public information defrauds the shareholders on the other side of the trade, because the insider owes them a duty. Under the misappropriation theory, an outsider who takes confidential information from a source that trusted them, a lawyer from a client or a printer from a bidder, and trades on it defrauds the source. Together the two theories cover insiders, the people they tip, and outsiders who steal information. A stranger who overhears a conversation in a lift and has no duty to anyone is the famous gap, and the reason "possessing inside information" is not by itself illegal.

Passing material non-public information to someone who trades is treated like trading yourself if the tipper received a personal benefit, which can be money, a favour, or simply making a gift of the information to a friend or relative. The tippee is liable if they knew or should have known the information came from a breach. Chains of tips have been prosecuted several people removed from the source.

Information is material if a reasonable investor would consider it important in deciding whether to trade, or if it would significantly change the mix of available information. Earnings before they are announced, a pending merger, a drug trial result, a large contract win or loss, and a coming offering are the standard examples. Information is non-public until it has been disclosed in a way that reaches the market generally, such as a press release, an SEC filing or a public webcast, and the market has had a reasonable time to absorb it. A rumor in a chat room is not public disclosure; a filing on EDGAR is.

Civil cases brought by the SEC can result in disgorgement of profits, a penalty of up to three times the profit gained or loss avoided, and bars from serving as an officer or director. Criminal cases brought by the Department of Justice carry prison sentences of up to 20 years and fines in the millions. Companies can also be liable for failing to prevent trading by their people. Members of Congress and their staff are covered explicitly since the STOCK Act, and federal employees generally through their agencies' rules.

Reading public filings is not insider trading. Buying a stock because its chief executive just filed a Form 4 showing a large purchase is legal, ordinary and common; the purchase itself was legal, the filing is public, and the reader has no duty to anyone. The same holds for acting on a 13D, a 13F, a Congress disclosure, an FDA document or an 8-K. What an alert service sells is speed and filtering over public information, and it can never lawfully sell anything else. InsiderWatch states on every alert that it uses only public sources.