Insider trading is buying or selling securities based on material non-public information.

Why Is Insider Trading Illegal?

If you know where the price of a share of stock is moving, you can make a trade in advance and capture some of that value. This is good. It provides an incentive for people to do research and work hard to find companies that deserve funding and companies that are frauds.

But sometimes your ability to predict a stock's movement isn't based on research and ingenuity, it's based on theft. Insiders, such as corporate executives, directors, or employees, have access to confidential information that can impact the value or price of securities. That information doesn't belong to them; it belongs to the company. When they trade on material, nonpublic information they harm the company, who owns the information, and they harm the markets more generally.

That's because investors are more likely to invest in the stock market if they believe it is a level playing field. If an insider is trading based on material, nonpublic information, there is someone on the other side of that trade. That person is trading shares with the insider at an unfair price, because the insider has access to information that the counterparty does not. This may make investors more weary to invest, harming the market as a whole.

Or maybe not? If the goal is for the markets to accurately reflect the value of a company, what better way to do that than to allow those that know the company best to trade. How long would fraudulent companies survive if their employees could trade on the knowledge that it is a scam? Insider trading might make prices more accurate, benefiting everyone. It's not clear, and plenty of financial scholars have taken each side.

How Does Insider Trading Work?

Insider trading involves trading based on material, nonpublic information. Information is material if it  would be significant to a person's decision to buy, sell or vote the shares. It is nonpublic if the market has not digested the information.

Insider trading can take different forms, including trading securities based on material, non-public information or tipping others about such information.

Most of the theories we'll study are enforceable by the SEC, the Department of Justice or by the counterpart to the trade. Two of the topics, Brophy insider trading claims and Section 16 short-swing profits claims, are enforced by shareholders of the corporation whose information was used.

Securities regulatory bodies and exchanges actively monitor and investigate potential instances of insider trading. They analyze trading activities, identify suspicious transactions and encourage individuals to report insider trading activities through whistleblower programs. The federal reporters are full of cases of brilliant CEOs throwing away a lifetime of hard work and sacrifice because just after a winning trade the SEC discovered in their search history, "How to not get caught insider trading."

What Are the Elements of Insider Trading?

Insider trading is a constellation of claims, rather than a single test. That's because the statutes never directly address it, so much of the law in this area is derived from cases squeezing insider trading into other violations, like the statutory prohibition on market manipulation or common law principles of fraud or fiduciary duties. We'll discuss several theories used to prosecute insider trading, which each have their own elements, potential parties and enforcement mechanisms.

First, Dirks explains the classical theory, which is based on duties the insider owes to the persons with whom the insider transacts. O'Hagan compares the classical theory and the misappropriation theory, which bases insider trading claims on the misuse of information in violation of a duty of confidentiality. Salman applies those theories to tippers and tippees, and clarifies the need for some personal benefit to the tipper. Then we'll learn Brophy insider trading claims, which don't rely on the securities acts at all, but instead derive from fiduciary duties. Finally, we'll consider a few legislative and regulatory fixes designed to reduce insider trading. Regulation FD, which is designed to prevent selective disclosure of material, nonpublic information. And Section 16, which is designed to prevent insiders from frequently buying and selling.

Further, the SEC recently successfully brought an insider trading case against an executive for trading on material nonpublic information about his company (Pfizer acquiring his biotech employer), and used such information to trade the stock of another similarly situated company (another biotech company in the same space), whereby he turned a quick profit of more than $100,000. This novel theory (although the SEC argues there is nothing novel about it), is known as "Shadow Trading". At the time of writing, potential appeals and additional litigation may overturn or expand on this idea, but for now, it is important to know that one may be liable under these circumstances. See Securities and Exchange Commission v. Matthew Panuwat, Case No. 3:21-cv-06322 (N.D. Cal. Aug. 17, 2021). We do not expand on Shadow Trading further in this book.