You’ve probably heard about the term "insider trading" or an "inside trader" in a negative context. But what exactly is an "insider" or a "trader," and why is there a negative connotation when these terms are used together?

Well, an "insider" generally refers to an individual who has access to "inside" information. What type of "inside" information? Here, we’re referring to the type of inside information that the general public doesn’t know about. And a "trader" generally refers to an individual that trades securities, like stocks or bonds. So, when you put the terms "inside" and "trader" together you get an individual that trades securities upon information not generally known to the public. In the United States (and many other countries), insider trading is highly illegal and violators face severe civil and criminal penalties.

In this article, we’ll take a look at what types of individuals are classified as "insiders," the differences between illegal and legal insider trading (yes, there is a such thing as legal insider trading), some famous insider trading cases, the differences between insider trading and misappropriation (an illegal activity related to insider trading), and how someone is "tipped off" to inside information. That’s a mouth full, so let’s begin.

Next, we’ll take a look at what is an "insider."

In short, an insider is an individual that is privy (i.e. with knowledge of) to certain information not generally known to the public. When communicating corporate information, an insider generally refers to the following types of individuals:

When a corporate insider accepts employment as an officer or director or becomes a controlling shareholder he or she automatically makes a legal contract with the corporation to put the shareholders’ best interests ahead of his or her personal interests. This is a basic tenant of corporate law, which has grown over time.

In the early 20th century, the U.S. Supreme Court determined that a corporation’s directors could not act on information that was otherwise not known to the shareholders. The court determined in multiple cases that directors have fiduciary duties to protect the interests of their shareholders. Then, President Franklin Roosevelt helped to pass the Securities Act of 1933 and Securities Act of 1934, which established the foundation for prohibitions against insider trading that we still use today. The Securities Act of 1934 also created the United States Securities and Exchange Commission, called the SEC, which monitors illegal insider trading.

With that brief bit of history, what is considered to be "inside" or "secret" information? Well, this is generally determined on a case-by-case basis depending on the specific facts. But, in general, "inside" information is generally considered to be material information that an insider could use for his or her benefit that the public (or that corporation’s shareholders) does not have access to. Let’s go over a brief example to clarify.

Assume Billy is director at ABC, Inc., a corporation that sells prescription drugs. One day, Billy and the directors are in a board meeting and hear from an expert at a drug company that ABC, Inc. just received a very poor review for one of its new drugs, and the drug company will release that information to the public in a few days. Billy, after hearing the bad news, decides to sell a million dollars of his ABC, Inc. stock before the drug company’s press conference because he knows the bad news will likely hurt the price of the stock. If Billy sells his stock before the press conference, he’ll have committed illegal insider trading because the public did not know about the bad information from the drug company. If the public did know, it’s likely that many of them would also sell their ABC, Inc. stock and Billy would be in the same position as them – for which Billy would not have committed illegal insider trading.

This is a very simplified example, but as you can see the purpose behind laws against insider trading is to keep the "playing field" as fair as possible for everyone who trades in securities. Insider trading is not generally easy to monitor by the SEC or others, and many times insiders get away with their acts.

Next, we’ll go over the differences between legal and illegal insider trading.

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.

So how does insider trading work in the real world? Well, let’s take a look at two fairly recent famous insider trading cases, one concerning Martha Stewart, and the other Mike Milken – both billionaires.

According to the SEC, Martha Stewart sold approximately 4,000 shares of ImClone stock (a biopharmaceutical company) on December 27, 2001, one day before the Food and Drug Administration ("FDA") announced that a drug made by ImClone failed to get approval. The day after she sold the stock, on December 28, 2001, the stock dropped in price by 18% and she avoided a loss of approximately $46,000. But Martha wasn’t the only one to sell around this time. In fact, many of the other insiders at ImClone also sold their stock around this time in December, including the Samuel Waksal (the founder of ImClone), Aliza Waksal, Jack Waksal, John Landes (ImClone’s lead attorney), Ronald Martell (Vice President), and Peter Bananovic, Martha Stewart’s broker. They all each sold millions of dollars worth of stock, only to watch the stock plummet shortly thereafter.

Martha Stewart denied the insider trading charges brought against her, and said she did nothing wrong. However, a jury found otherwise and convicted her of 4 criminal counts including making false statements, conspiracy, and obstruction of justice. But the insider trading charge was dropped. She was sentenced to five months in prison, and two years probation for her criminal acts.

Mike Milken, one of Forbe’s 500 richest people, was indicted on 98 counts for insider trading in 1989. Milken’s attorneys entered a plea bargain with the prosecution, and Milken plead guilty to 6 violations (none of which were insider trading) and was sentenced to 10 years in prison. However, after only 2 years he was released from prison for good behavior.

These were both very brief overviews of some famous individuals who were at least indicted for insider trading. But neither Stewart nor Milken were actually convicted of insider trading, even with all the evidence that the prosecution had against both individuals. As you can see, in real court cases, where most insiders are wealthy, it’s not easy to prove that insider trading occurred.

Next, let’s explore the differences between insider trading and misappropriation.

There is another illegal activity that is closely related to insider trading – it’s called misappropriation. Misappropriation occurs when a non-insider steals material company information and uses that information for his or her personal benefit. This law is a fairly recent one, stemming from the case U.S. v. O’Hagan, 521 U.S. 642 (1997). In O’Hagan, a lawyer represented a corporation and became aware of inside information in his role as the lawyer for the company. The lawyer then bought a few million dollars worth of stock based on the inside information, and was found guilty of misappropriation. Why? Because the lawyer took private material company information and used it for his own personal benefit to the detriment of the corporation’s shareholders.

So, how is misappropriation different than insider trading? In O’Hagan, the lawyer was not an insider, or at least a traditional insider. The lawyer was not a director, officer, or even a shareholder of the corporation where he learned about the inside information. In other words, the lawyer did not owe any fiduciary duties to the corporation. However, according to the court that didn’t matter. The lawyer used private information that he was aware of for his own personal benefit to the detriment of others – and that’s called misappropriation.

The key to remember is that even individuals who are not insiders can be convicted of misappropriation. As another example, if an accountant learns of private material information through a discussion with a company’s board of directors, then uses that information to sell or purchase a stock (which he or she wouldn’t have otherwise done), then that could constitute a misappropriation of the information. The accountant had no fiduciary duty to the company, but the accountant’s use of that information breached the board of director’s fiduciary duties to their shareholders – and that could be enough to be held liable under the concept of misappropriation.

Another thing to remember is that a non-insider can generally only be held liable for misappropriation if he or she acts upon that information, such as purchasing or selling a stock. In contrast, insiders can be held liable for private material information that they learn of and do nothing about. In other words, insiders have fiduciary duties to the corporation’s shareholders to tell them about private material information, while non-insiders that hear that information simply must refrain from acting upon it. This is a very subtle difference in the law, but an important one to remember. The law is all about subtle distinctions!

Next, let’s take a look at how someone can be "tipped off" to inside information.

With this subtitle, you’re probably going, huh? "Tippers and Tippees," what’s that? Well, now that you have a basic understanding about insider trading and misappropriation, and the differences between the two, let’s put this all together in a situation where someone is ""tipped off" about inside information.

What does it mean to be "tipped off?" It means that one person tells another person about inside information. It can happen in different ways and through a chain a people – where one person tells another person and that person tells another person, etc. With that said, keep in mind that every person in the "chain" is either a tipper or tippee, or both. Let’s take a look at tippers and tippees.

If Billy buys stock based on the inside information he heard at the meeting, he would be liable for insider trading because he’s an insider (e.g. he’s a director). Now, assume Billy tells his wife about the inside information and she acts on that inside information (e.g. buys or sells stocks). Here, Billy's wife would be liable for misappropriation. That’s because Billy’s wife is not an insider.

Billy is a "tipper" in this example because he told his wife about the inside information. Billy’s wife is "tippee" because she acted on the inside information.

Now, assume that Billy's wife tells her friend Allison, and Allison also act on the inside information and buys some stock. Here, Billy's wife would be both a tipper and tippee. That’s because Billy’s wife received information from Billy as a tippee and gave inside information to her friend Allison as a tipper. And Alllison is only a tippee. That’s because Allison only received inside information and she didn’t tell anyone else.

Okay, so that’s probably a mouth full! Now, you can probably imagine how a law school exam on this stuff might go… But if you followed everything (or mostly everything) in this article you now know more than the vast majority of people on how "tipping" works in insider trading situations. And if there’s anything to learn from all this – it pays not to gossip!

Finally, let’s wrap up this article with some key points to keep in mind.

In this article, we covered a number of topics, including, what constitutes an insider, the differences between legal and illegal insider trading, some famous insider trading cases, the differences between insider trading and misappropriation, and how "tipping" someone off works with tippers and tippees.

Some key points to keep in mind are that insiders have fiduciary duties to their shareholders to refrain from acting on inside information, and have the duty to report inside information promptly to their shareholders. Also, even if you’re not an insider, you can be held liable as a misappropriator of inside information.

So, if you ever hear about inside information dealing with a public corporation, you should first assess if that information is readily available to the company’s shareholders. If not, you may want to keep your mouth shut or seek a lawyer for advice on how to proceed. And remember, it pays not to gossip!