Legal insider trading happens all the time – contrary to popular belief. Legal insider trading simply means that an insider is trading a security, e.g. stock or bond, in the market. In public corporations (e.g. companies listed on a public exchange like the New York Stock Exchange), all insider trading must be reported to the SEC. But as long as the inside trade is reported to the SEC and not done based on secret or material information, the trade is generally legal. However, in the United States, if an insider merely has access to any private material information and then makes a trade, that alone is generally enough to find that insider in violation of the law. In other words, if the insider just simply heard about material information but did not act upon it, he or she could still be liable for his or her failure to promptly tell the public. This sounds like a harsh rule, right? Well, it’s designed to be a harsh rule to keep insiders within the law.

Some people claim that insider trading should be legal, such as the famous economist Milton Friedman. Friedman argues that insiders should be able to act on their inside information because it is in the best interest of the market. However, U.S. law says otherwise and some negative effects of insider trading include: (i) a basic unfairness, (ii) disincentives for shareholders to invest in a company (if they know that others can act on secret information they don’t have), and (iii) diverting the value of the corporation from its true owners, i.e. shareholders, to the insiders, e.g. officers, directors, and other insiders.

Next, we’ll take a look at some famous insider trading cases, including those of Martha Stewart and Mike Milken.