How Insider Trading Works


Former Enron CEO Jeffrey Skilling received a 24-year prison sentence for insider trading and other crimes. See more money scam pictures.
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U.S. federal inmate number 29296-179 was once a very rich man. The prisoner, known to the world outside the Englewood low-security prison in Littleton, Colo., as Jeffrey Skilling, once had a net worth of around $100 million [source: Ahrens]. He served as CEO of the seventh-largest corporation in the United States [source: Ackman]. These days, still in the early years of his 24-year prison sentence, Skilling makes about one dollar an hour for menial labor like washing dishes in the prison cafeteria.

Skilling's downgrade from CEO to inmate was the result of his role as the mastermind of the largest corporate financial scandal in the history of the United States. (Despite convictions on 19 insider trading, conspiracy and fraud charges, Skilling maintains his innocence.) Skilling and his mentor, company founder Kenneth Lay, committed massive fraud against the shareholders of the Texas-based energy giant Enron.

The conspiracy was a sophisticated one; it included fraudulent accounting practices (the result of a dark alliance between the company and its independent auditors), which inflated the company's earnings and, hence, the share prices of Enron stock. Although many Enron executives, including Skilling and Lay, were fully aware of the company's financial troubles, this information was skillfully hidden by the earnings reports the company released. Enron encouraged its employees to buy stock in the company.

Just before news of the company's dire financial straits began to trickle out, beginning in April 2001, several executives -- with knowledge that the company's stock would soon fall -- sold much of their stock before it plummeted. By selling their shares (Skilling made $67 million in artificially inflated Enron stock between 1998 and 2001) despite knowing that the company's share price was about to take a dive, 29 executives engaged in what is known as insider trading [source: Moore, et al].

The 21,000 employees of Enron lost both their jobs and their retirement savings; the average employee had 62 percent of his or her 401(k) tied up in Enron stock [source: Lindstrom]. Every lost job and every lost dollar was the result of fraudulent accounting. But it was the insider trading that enriched the finances of the same executives who defrauded investors and employees alike that raised the collective ire of the media and the public.

What precisely is insider trading and why is it viewed as such a violation of the public trust?

What is Insider Trading?

Following the crash of 1929, the federal government formed the SEC as part of finance reform.
Following the crash of 1929, the federal government formed the SEC as part of finance reform.
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People aware of scandals like Enron's and the one that landed Martha Stewart in federal prison may be surprised that there are actually two types of insider trading: legal and illegal.

Any time a company executive or employee buys or sells stock in the company that person works for, an inside trade has occurred. It's a common occurrence that happens every day, according to the Securities and Exchange Commission (SEC) -- the federal agency charged with regulating stock trading in the United States.

The SEC enforces some strict guidelines that create the line between legal and illegal insider trading. The premise is simple: When a person with knowledge that can impact a company's stock price -- be it positive or negative -- makes a trade based on that knowledge, he or she has engaged in illegal insider trading. The concept is based on fairness; having information that isn't available to everyone else trading on the market gives the insider, well, an inside advantage.

Prior to the SEC's creation in 1934, insider trading was still considered nefarious. It was up to state prosecutors in the superior courts to try insiders accused of unfair trading. Once Congress passed the Securities Exchange Act of 1934, both federal and state prosecutors had a lot more ammunition to convict inside traders. Section 10b5 of this act defines exactly what constitutes illegal insider trading.

Sections 10b5-1 and 10b5-2 were expanded in October 2000. They now lay out who can be an insider and under what circumstances illegal trading takes place. Certainly, officers of a corporation are insiders. These high-level employees must fill out a form detailing any trading of their company's stock every time they buy or sell it. Insider status also extends to employees of a company: An employee who learns that their company will announce higher than expected quarterly revenue and purchases shares in their company has just engaged in illegal insider trading.

But what if an employee tells his or her spouse about the impending news, and the spouse buys some shares? According to the SEC, the spouse is a crook as well. The same goes for friends, bankers or lawyers contracted by the company in question -- even employees of the SEC. Anyone with awareness of material information that's not publicly available can be found guilty of illegal insider trading if that person acts on that information and either dumps or purchases securities.

Catching Inside Traders

Faith in the SEC's ability to catch crooked business transactions isn't full among all people in the United States.
Faith in the SEC's ability to catch crooked business transactions isn't full among all people in the United States.
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You may have picked up on the basis of the SEC's regulations on insider trading -- they're based on time rather than intent. It's hard to prove that an inside trader intended to use privileged information for personal gain; it's much easier to pin down whether a person traded with material knowledge before that information went public. If an executive's company compiles its quarterly earnings results at time point A and it publicly issues the earnings report at time point B, any trades made by the executive within that time frame are probably illegal and subject to investigation by the SEC.

To protect executives and entry level employees alike from investigation by the SEC, some corporations have compliance officers to observe the Sarbanes-Oxley Act of 2002, legislation that arose from the Enron scandal. One section of this act creates blackout windows; during these windows, all trading of company stock is prohibited. These windows generally surround major announcements, like earnings reports, decisions on bankruptcy and mergers and acquisitions.

Catching an insider involved in illegal trading has grown increasingly sophisticated in the 21st century. In decades past, the SEC relied on tips and human data analysis to catch insider trading. An executive is required to file a report on all company stock trades, but what if that executive fails to follow that requirement? With thousands of publicly traded companies in the United States and a ratio of less than one employee per company in the entire SEC, the Commission has historically had trouble catching insider trading violations. When you take into account all of the investment banks, accounting firms and the circles of friends, families, executives and employees at each company, it becomes clear that regulating trade is a Herculean task for the SEC. The threat of a random audit of executives' trades and a standing offer of rewards for whistleblowers are pretty much the only tools the SEC has had to keep traders honest.

With the advent of the Internet and fast computing, however, the SEC can cast a wider net to catch illegal inside traders. The use of computers to analyze trading activity in relation to major events like earning reports and mergers is called complex events processing. The results have been self-evident: From April 2006 to August 2007, the SEC filed more than a dozen insider trading lawsuits -- more than it filed throughout the entirety of the 1990s [source: Rodier].

Impact of Insider Trading on Markets

Martha Stewart was sentenced to five months in prison for obstruction of justice and making false statements, stemming from a questionable inside trade of 4,000 shares of stock in 2001
Martha Stewart was sentenced to five months in prison for obstruction of justice and making false statements, stemming from a questionable inside trade of 4,000 shares of stock in 2001
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It can seem like an exercise in futility for the SEC to use complex event processing and countless hours of investigation to yield just a dozen cases each year. What's more, a free market system that promotes fierce competition can make the idea of prosecuting inside traders a bit counterintuitive. Proponents of market regulation point out problems can arise when insiders are left to their own devices. One can also say that the biggest difficulty created by insider trading is a lack of faith in the exchange markets where these illegal trades take place.

Publicly-traded companies rely on large numbers of people to purchase shares of their stock. The money invested by shareholders is used for product research and development, capital improvements and overseas expansion. In lean times, investor funds are used to keep a company afloat. These investors are ostensibly rewarded with increased values of their shares and dividends if the company succeeds.

Trust is implicit in this arrangement between a company and its investors. The corporation's officers are supposed to act in the best interest of the company's shareholders. Insider trading is a betrayal of that trust; by acting on information that shareholders aren't privy to for financial gain, officers of a corporation are acting purely in their own best interests.

It's hard enough to regain trust when officers of a single company trade illegally. When illegal insider trading encompasses several companies, as the scandal surrounding Enron, its auditors and the entire system of accounting checks and balances did, the broken trust can be far-reaching. It took direct Congressional involvement, in the form of the Sarbanes-Oxley Act of 2002, to restore public confidence. The act, which holds officers directly accountable for any errors, omissions or dishonesty in corporate reporting, is widely believed to have helped public confidence in the markets following the Enron scandal. Between July 31, 2002 and July 31, 2007, the New York Stock Exchange grew 67 percent, about $4.2 trillion [source: Healey].

When entire markets are widely perceived to be tainted by insider trading, average people who are also potential investors will avoid markets altogether. Prior to the 1990s, when the European Economic Community made its member states adopt measures to combat illegal insider trading, the common perception among Europeans was that their markets were rife with insider trading. As a result, Europe saw its markets increase in value and trading activity after anti-insider trading policies spread [source: SEC].

Using Insider Trading for Investment Analysis

Financial analysts use inside trade data as one tool to predict the health of a company's stock.
Financial analysts use inside trade data as one tool to predict the health of a company's stock.
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Government regulatory bodies pay a great deal of attention to illegal insider trading, but securities analysts watch it even more. Remember that American company officers must file a report with the SEC every time they buy or sell shares in his or her employer. Those reports are a matter of public record, and financial analysts pore over them with near-religious fervor.

Analysts make their money digesting financial data and issuing projections that amounts to the sum of this data, held together by educated guesses. An analyst with a history of being more right than wrong commands a higher salary; any analyst worth his or her salt will look for as much information as possible to lead to the best guess. This includes legal insider trading activity by a company's officers.

Major purchases of company stock by a company's officers can indicate vitality in a corporation. Large sell-offs can mean the opposite. An analyst (or a dedicated individual investor) with an eye on corporate officers' individual SEC filings can find a treasure trove of inside information about a corporation and its executives. Their inside trades don't necessarily come from having illegal access to unreleased earnings information. An executive with a loss of faith in the company's direction or a new product launch can give outsiders legal, between-the-lines information about a company's outlook.

Analysts who watch for inside trades warn that investors trolling for information need more than just SEC filings before acting on data. Executives can always simply need to pay a few bills and may have surplus stock in their companies [source: Curtis]. Like the complex event processing software the SEC uses, analysts suggest gathering supporting data before making a purchase or sale. Are the purchases or sales substantial relative to the executive's salary or holdings? Are several officers in the corporation making similar sales or purchases of company stock at the same time? When data points like these converge, you have reason to act -- whether you're an individual investor or an SEC investigator.

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Sources

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