Insider trading is generally defined as the act of buying or selling securities while knowingly in possession of material non-public information related to those securities. It is a form of fraud, making it both a crime and a tort: something for which one can be arrested and sued. Securities fraud, of which insider trading is one type, is generally defined in Section 10(b) of the Securities Exchange Act of 1934*:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange... to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Those "rules" are mainly found in SEC Rule 10b-5:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
1. To employ any device, scheme, or artifice to defraud,

2. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

3. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.

Who can be liable

As a general rule, if you make a trade or help make a trade while in possession of material non-public information, you are committing insider trading. This means that if you have material non-public information about a company, you should either:

  1. broadcast it to the world, or
  2. zip your mouth shut and keep your grubby little Gordon Gekko mitts off of E*Trade.

Possession vs. use

The definition given above is that a person must knowingly be in possession of material non-public information. This is the opinion of the SEC and has been followed by the Second Circuit, the federal appeals court in New York which holds great sway over securities law. But the Ninth Circuit has ruled that the government must prove that the information was actually used in order to win a conviction. (I guess this means that if you're going to be insider trading, you might want to base yourself in California.)

There are a small number of affirmative defenses to insider trading in SEC Rule 10b5-1, applying to people who make contracts to trade before acquiring the information, and to employees of entities where the entity's managers might know what's going on but the employee doesn't. In either case, the operative question remains whether the information was known to the trader "when the button was pushed" to execute the trade.

Trading vs. aiding

Besides trading on inside information, it's also considered insider trading if you "tip" other traders for personal benefit. That benefit may be anything: money, favors, or reputation. The Supreme Court even held that the "satisfaction" of helping out a friend counts as a benefit to a tipper.

The person being tipped can also be hit for insider trading if they have reason to know that the tipper was passing on material non-public information.


As mentioned above, insider trading is fraud, meaning that it leads to both civil and criminal liability, depending upon who decides to take it to court. Civil liability is the most complicated side of the liability question, because it can arise in a number of ways based on circumstances.

If the insider is a director, officer or key employee of the corporation being traded, the shareholders may bring suit on the grounds that the insider breached their fiduciary duty to the corporation by hiding material information from the shareholders.

A more complicated theory is misappropriation. If a person is entrusted with material non-public information, and then trades based on that information, the person who gave them the information can sue on the basis that the information was essentially "stolen" for the trader's personal benefit. This cause of action only works when there is some expectation of confidentiality between the parties: say, a client giving information to their lawyer, or an investment bank giving information to an employee.

Under Section 20A of the Exchange Act, an insider can also be liable to "contemporaneous traders," including their counterparty in the trade which used insider information, for any financial harm arising from that trade. However, such liability is limited to the net amount profited by the insider, minus any disgorgement levied by the SEC.

Paying fines and going to jail

Which brings us to the other side of insider trading liability. The Securities and Exchange Commission can, under Section 21A of the Exchange Act, hit insiders with civil penalties of up to three times their profit from the illegal transactions, so long as they meet the statutory or regulatory definition of the crime.

Criminal insider trading cases are brought by United States Attorneys attached to Department of Justice offices around the country. Because it's impossible to put a corporation in jail, the DoJ will usually only go after individual defendants, and then only in the most heinous of cases. Companies are likely to dodge criminal fines by entering "deferred prosecution" arrangements with the DoJ in which they agree to pay some restitution and clean up their act.

vuo asked a valid question about this: "Now that you mention corporate citizenship, how could a corporation, independently of the criminals themselves, do insider trading? Isn't it always people who do crimes?"

Answer: Section 32 of the Act provides that "any person who willfully violates any provision of this chapter... shall upon conviction be fined not more than $5,000,000, or imprisoned not more than 20 years, or both, except that when such person is a person other than a natural person, a fine not exceeding $25,000,000 may be imposed...

Sentencing for insider trading is based upon the Federal Sentencing Guidelines, so it involves a good deal of math and prayer to get right. But take a look at some of these examples:

Of course, white-collar criminals are likely to get out early for good behavior...

* US-centric, I know; deal with it.

No part of this writeup constitutes legal advice. ESPECIALLY that bit about California.

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