Insider trading

Based on Wikipedia: Insider trading

The Secret Trade

Imagine you're sitting in a restaurant, enjoying your dinner, when you overhear the conversation at the next table. The chief executive of a major corporation is telling his finance chief that their company is about to be acquired—news that will send the stock price soaring when it's announced tomorrow morning. You could buy shares right now. By tomorrow afternoon, you'd be significantly richer.

Should you?

More importantly: could you?

This question sits at the heart of one of the most contested areas of financial regulation. The answer depends on where you live, who you are, and how you came by that information—and it reveals something profound about how we think about fairness, markets, and the nature of information itself.

What Makes Trading "Insider"

At its core, insider trading means buying or selling a company's stock based on material, nonpublic information. Let's break that phrase apart, because every word matters.

"Material" means information significant enough to affect the stock price if it became public. A company's quarterly earnings, an impending merger, a major product recall—these are material. The CEO's lunch preferences are not.

"Nonpublic" is simpler: information that hasn't been disclosed to the general market. Once a company issues a press release, that information is public. Before that moment, it isn't.

But here's where it gets interesting. Not all trading on nonpublic information is illegal. In most of the world, the prohibition kicks in only when the trader has violated some duty—a responsibility to keep that information confidential or not exploit it for personal gain.

The Restaurant Question Answered

So what about our eavesdropper in the restaurant? In the United States and most non-European countries, you're probably in the clear. You had no relationship with the company. You didn't pay anyone for the tip. You just happened to be in the right place at the right time.

This might seem surprising. After all, you'd be profiting from information that other investors don't have. But American law generally requires something more: a breach of trust.

Europe takes a stricter view. Under the European Union's market abuse regulations, trading on any nonpublic information that would likely affect a stock's price can trigger civil and potentially criminal penalties. The question isn't whether you had a duty to keep the information secret—it's whether the information itself was material and nonpublic. The continental approach focuses less on betrayal and more on fairness to the market as a whole.

Who Counts as an "Insider"

The term "insider" conjures images of executives in corner offices, but the legal definition extends far wider than you might expect.

The obvious insiders are corporate officers, directors, and anyone who owns more than ten percent of a company's shares. These people have direct access to confidential information through their positions. When a CEO knows her company is about to announce disappointing earnings and sells her stock beforehand, the betrayal is clear: she's using information that belongs to the shareholders to protect herself at their expense.

But the web extends outward. A lawyer working on a merger. An accountant reviewing the books. A printer producing the documents for a stock offering. A secretary who happens to see a confidential memo. All of these people can become insiders if they gain material information through their work.

And it goes further still. Under something called the "misappropriation theory," now firmly established in American law, you don't need any direct connection to a company to commit insider trading. If you steal or trick someone into revealing confidential information, and then trade on it, you've misappropriated that information. The company whose stock you traded might be a complete stranger to you—what matters is that you obtained the information through deception.

The Tipping Problem

Some of the most fascinating insider trading cases involve not the person who made the trade, but the person who passed along the information.

Say a corporate executive learns that her company is about to be acquired. She doesn't buy any stock herself—too obvious, too risky. Instead, she mentions the news to her brother-in-law at a family barbecue. He buys the stock. When the acquisition is announced, he makes a fortune.

Is this insider trading? In the United States, the answer hinges on a surprisingly specific question: did the executive get something out of sharing the information?

The "tipper"—the person who shared the tip—can only be liable if they disclosed the information for some personal benefit. That benefit doesn't have to be money. Courts have found that the warm feeling of helping a close friend or relative can be enough. Maintaining a quid pro quo relationship—I'll scratch your back if you scratch mine—certainly qualifies.

The "tippee"—the person who received the tip—faces a related but distinct test. They're only liable if they knew, or should have known, that the insider shared the information for an improper purpose. Someone who receives a tip from a stranger with no idea of its source might be in the clear. Someone who pays for inside information, or receives it from an obviously conflicted source, cannot claim innocence.

This framework creates odd results. Information can flow from person to person like a game of telephone. By the time it reaches a trader several steps removed from the original source, it may be hard to trace—and hard to prove that the trader knew it originated from an improper breach.

The Game of Proof

Catching insider traders is notoriously difficult.

The Securities and Exchange Commission, known as the SEC, prosecutes over fifty cases each year, and many more are settled quietly before ever reaching court. But these represent only a tiny fraction of illegal insider trading. The vast majority goes undetected.

Think about it from an enforcement perspective. To prove insider trading, you need to establish that someone possessed material nonpublic information and then traded on it. But how do you prove what someone knew? Absent a written confession or a wiretapped phone call, you're left with circumstantial evidence: suspicious timing, unusual trading patterns, connections between the trader and possible sources of information.

The SEC and stock exchanges maintain sophisticated surveillance systems that flag unusual trading activity. A sudden surge in options purchases on a stock, days before a surprise acquisition announcement, will attract attention. But smart traders find ways to obscure their tracks: trading through nominees, offshore shell companies, cryptocurrency, or simply having a friend of a friend place the actual trade.

The dark web has created new marketplaces for inside information. Websites using Bitcoin and other cryptocurrencies to obscure transactions have emerged where material nonpublic information is bought and sold like any other commodity. Some sites actively recruit corporate employees to become informants, offering payment for leaks that can be monetized through trading.

Why Bother Banning It?

Here's where things get philosophically interesting. Why do we prohibit insider trading at all?

The most intuitive argument is fairness. When insiders trade on secret information, they profit at the expense of ordinary investors who don't have access to that information. It's like playing poker against someone who can see your cards. The game feels rigged—and if people believe the stock market is rigged, they'll stop playing, depriving companies of the capital they need to grow.

A related argument focuses on trust. Corporate executives have a fiduciary duty to their shareholders. They're supposed to act in the shareholders' interests, not their own. When a CEO dumps stock before announcing bad news, she's betraying the very people she's supposed to serve. Even if no individual shareholder can point to a specific loss they suffered, the breach of trust damages the institution of public markets.

Economists have tried to quantify this harm. One influential study found that illegal insider trading raises the cost of capital for companies, because investors demand higher returns to compensate for the risk of trading against better-informed parties. Higher capital costs mean less investment, less growth, and ultimately a poorer society.

The Case for Legalization

Not everyone agrees that insider trading should be illegal. Some distinguished economists and legal scholars—including Milton Friedman, who won the Nobel Prize in Economics, and Henry Manne, a pioneering law-and-economics scholar—have argued for legalization.

Their argument turns the fairness concern on its head. Markets work best when prices accurately reflect all available information. When insiders trade on nonpublic information, they push prices toward their "true" values faster than would otherwise happen. The insider who sells before bad news causes the stock price to drift downward; the insider who buys before good news pushes it up. By the time the information becomes public, the price has already partially adjusted.

Friedman put it memorably: "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that."

Note what Friedman did not say. He didn't suggest that insiders should have to announce their trades publicly or explain their reasoning. The buying and selling pressure itself communicates information to the market, even if no one knows where it's coming from. Prices serve as signals, and insider trading makes those signals more accurate.

Others take a more libertarian approach. A stock trade is simply an exchange between a willing buyer and a willing seller. If I own stock and want to sell it, why should I be prohibited from doing so just because I know something the buyer doesn't? We don't apply this rule in other markets. If a geologist discovers oil is likely to be found under a farmer's land, the geologist is free to buy that land without disclosing the geological data. Why should stocks be different?

The Atlantic magazine has gone so far as to describe insider trading as "arguably the closest thing that modern finance has to a victimless crime."

Politicians and Their Portfolios

One of the most troubling frontiers of insider trading involves the people who make the laws themselves.

Members of Congress routinely receive nonpublic information in the course of their duties. A senator on the Armed Services Committee learns about a major defense contract before it's announced. A representative on the Health Committee discovers that a drug company's product will be approved—or rejected—by regulators. This information could be worth millions in the stock market.

For most of American history, there was no explicit prohibition on congressional insider trading. The theory was that members of Congress don't owe a fiduciary duty to anyone in the same way a corporate executive owes a duty to shareholders. They weren't "insiders" in the legal sense.

That changed in 2012 with the STOCK Act—the Stop Trading on Congressional Knowledge Act—which explicitly prohibited members and employees of Congress from trading on nonpublic information obtained through their official positions. The law also imposed disclosure requirements for trades.

But studies have found that the law hasn't eliminated the problem. Research shows that political insider trading persists, with some evidence that it actually increases when Congress is in session—precisely when members have the greatest access to material information. Periods of heightened geopolitical risk, when politicians have access to sensitive briefings unavailable to ordinary citizens, also correlate with increased trading activity by those in the know.

The information asymmetry enjoyed by politicians remains high. One study found that this reality conflicts with the predictions of social contract theory—the idea that democratic government should operate transparently for the benefit of citizens. When the people who make the rules can profit from their privileged information, it creates conflicts of interest and erodes public trust in institutions.

The Compliance Regime

Most insider trading that makes headlines involves people breaking the law. But there's an entire parallel universe of legal insider trading that happens every day.

Corporate executives and significant shareholders trade in their own company's stock all the time. They exercise stock options, sell shares to diversify their portfolios, or buy more because they believe in the company's future. This is all legal—so long as they're not trading on material nonpublic information.

In the United States, insiders must report their trades to the SEC within a few business days by filing what's called a Form 4. These filings are public, allowing anyone to see when executives are buying or selling. Academic researchers have compiled databases of these filings, and entire investment strategies have been built around tracking what insiders do with their money.

But how can an executive ever be sure they're not trading on inside information? After all, corporate officers always know things that haven't been disclosed publicly. The solution is something called a 10b5-1 plan.

Here's how it works. An executive creates a written, binding plan for future trades while they possess no material nonpublic information. The plan might specify selling a certain number of shares on the first trading day of each month, or selling whenever the stock reaches a specified price. Once the plan is in place, the trades happen automatically—even if the executive later learns nonpublic information that would make them want to change their plans.

The logic is straightforward. If your trade was set in motion before you learned the inside information, you can't have traded on that information. The plan provides an affirmative defense—a complete answer to any allegation of insider trading.

Of course, the system depends on people setting up these plans honestly. An executive who creates a 10b5-1 plan while secretly possessing inside information is simply using the compliance framework as cover for illegal activity. Regulators and prosecutors have grown increasingly skeptical of suspiciously timed plans.

The Tender Offer Exception

There's one area where American law takes an unusually strict approach: tender offers.

A tender offer is a public proposal to buy a company's shares, usually at a premium to the current market price. Tender offers typically happen in the context of acquisitions and mergers. Someone who learns about an upcoming tender offer before it's announced possesses extraordinarily valuable information—the stock is virtually guaranteed to rise when the offer becomes public.

The SEC has created special rules for tender offer information. Unlike the general insider trading framework, these rules don't require any breach of duty. If you possess material nonpublic information about a tender offer—obtained directly or indirectly, from any source—you must either disclose it publicly or refrain from trading. Full stop.

This "disclose or abstain" rule represents the high-water mark of insider trading regulation. It applies regardless of your relationship to the companies involved, regardless of how you came by the information, regardless of whether anyone breached a duty to you. The information itself creates the obligation.

Commodities and the Limits of "Inside"

One puzzle about insider trading law is why it applies so vigorously to stocks but barely exists in commodity markets.

Think about what it means to be an "insider" with respect to wheat, or crude oil, or copper. These commodities aren't issued by companies. There's no CEO with privileged information about the commodity's "true value." Information that affects commodity prices—weather patterns, geopolitical events, supply disruptions—is inherently different from information about a corporation's internal affairs.

This doesn't mean commodity markets are the Wild West. There are rules against related forms of market manipulation. Front running, for instance, is illegal: a commodity broker who receives a large client order cannot place trades for their own account first, profiting from the price movement they know is coming. But the insider trading framework, built around the concept of fiduciary duty to shareholders, doesn't translate easily to markets where there are no shareholders.

The Enforcement Divide

While insider trading is prohibited nearly everywhere, the intensity of enforcement varies dramatically.

The United States is generally considered to have the most aggressive approach. The SEC has substantial resources and expertise, and prosecutors at the Department of Justice regularly bring criminal cases against particularly egregious offenders. Civil penalties can be devastating: disgorgement of all profits (plus interest), fines up to three times the profits gained or losses avoided, and bans from serving as an officer or director of a public company. Criminal convictions can mean years in prison.

European enforcement has historically been less vigorous, despite laws that are in some ways stricter than American ones. The European approach focuses more on civil remedies than criminal prosecution. But this is changing. The European Union has harmonized market abuse regulation across member states, and authorities like the United Kingdom's Financial Conduct Authority have become increasingly active.

In many other countries, insider trading laws exist on the books but are rarely enforced. A comprehensive study by financial economists found that while most countries prohibit insider trading, fewer than half have ever prosecuted a case. The gap between law and practice can be enormous.

The Disgorgement Calculation

When insider traders are caught, one of the key remedies is disgorgement—forcing them to give up their ill-gotten gains.

This sounds simple enough. If you made a profit by trading illegally, you should have to hand over that profit. But calculating the actual amount can be surprisingly complex.

Consider someone who bought stock based on inside information about an upcoming acquisition. The stock price jumped when the acquisition was announced, and the trader sold at a profit. But how much of that profit was due to the inside information versus general market movements? What if the trader held the stock for months after the announcement—do later gains count too?

Financial mathematician Marcello Minenna developed an innovative approach using probability theory to answer these questions. By analyzing the specific time periods of the trades and comparing them to what would have happened in the absence of the inside information, his method attempts to isolate the precise advantage gained from the illegal activity.

Courts can also waive or reduce disgorgement if a defendant demonstrates inability to pay. In settled cases, the SEC may recommend waiver if appropriate. The goal, after all, is to deter future misconduct and restore some measure of fairness—not to squeeze blood from stones.

What Free Speech Has to Do With It

Some defenders of insider trading raise an unexpected objection: prosecuting insider trading violates free speech.

The argument goes like this. When insider trading law prohibits someone from communicating material information to a friend or family member, it's punishing speech. When it prevents someone from acting on information by trading, it's punishing people for knowing things. This feels uncomfortably close to censorship.

It's a thought-provoking argument, if not ultimately persuasive to most courts. The First Amendment protects freedom of speech, but it doesn't protect all conduct that involves communication. Securities fraud prosecutions regularly involve spoken or written statements, and no one seriously argues that the First Amendment shields fraudsters. The insider trading prohibition targets not the speech itself but the breach of duty and harm to market integrity that accompanies it.

Still, the free speech objection highlights something important about insider trading law. We're punishing people not for doing something harmful in any obvious physical sense, but for possessing and acting on information. That's an unusual form of prohibition, and it's worth understanding why we've chosen to treat information itself as a kind of property that can be misappropriated.

The Eternal Debate

After more than a century of regulation and prosecution, the debate over insider trading remains unresolved. Scholars continue to argue about whether the practice actually harms anyone in a legally meaningful sense. Some contend that people who trade against insiders don't suffer true "losses"—they would have made the same trades anyway, regardless of what the insider did. Others argue that even if individual harm is hard to identify, the systemic effects on market confidence justify the prohibition.

Perhaps the most striking thing about insider trading law is how it illuminates our complicated relationship with information. We live in an economy where information is the most valuable commodity of all—where knowing something before someone else knows it can mean the difference between fortune and failure. We've built intricate legal structures around who can possess certain information, how it can be used, and what obligations come with knowing things.

In the stock market, we've decided that certain information advantages cross a line. But the line isn't drawn where you might expect. It's not about fairness in any simple sense—otherwise we'd prohibit all trading on unequal information, not just trading that involves a breach of duty. It's about trust, and the special responsibilities that come with special access.

When you accept a position that gives you access to a company's secrets, you take on an obligation to the people who entrusted you with that access. Insider trading law, at its core, is about enforcing that obligation. The company's information belongs to its shareholders, not to the executives who happen to encounter it. The government's information belongs to the citizens, not to the politicians who learn it in classified briefings.

Whether this framework is the best way to organize financial markets remains an open question. But as long as information is valuable, and as long as some people have access to information that others don't, we'll be arguing about insider trading.