What is insider trading?
Insider trading means buying and selling stocks or stock options on the open market based on information unavailable to the public. To qualify as illegal insider trading, the SEC says the information a trader uses must be both “nonpublic” and “material.”
“Nonpublic” means the information an insider trader uses has yet to be released to the general public. “Material” means this nonpublic intel will dramatically affect the company’s share price. It should be clear to any rational investor whether this information will move a stock’s price up or down.
How does insider trading work?
An inside trader will first learn confidential information (e.g., an early earnings report) before a publicly traded company plans to publish it. The trader will either buy, short, or sell the company’s stock without disclosing this information to the SEC.
Inside traders are often corporate officers, but sometimes this information leaks to friends, colleagues, or family members. There are also cases where journalists or TV personalities can be involved in insider trading.
For example, R. Foster Winans of the Wall Street Journal illegally leaked information on his stock picks before publishing his weekly column. Since the stocks Winans featured increased after his column hit the press, those who knew the companies he would profile had an unfair advantage. The SEC brought charges against Winans, who eventually served a few months in prison.
Anyone who uses material nonpublic information to buy or sell a security is involved in insider trading. If someone has an unfair advantage in the stock market, the SEC will investigate them for insider trading.
Why is insider trading illegal?
Insider trading laws aim to create an equal playing field for investors. Ideally, everyone involved in the public stock market should have the same information to base their investment decisions on.
The SEC hopes to encourage fair play in the equities market by prosecuting inside traders. Even if executives have material nonpublic information, they have a fiduciary duty to always act in the best interests of their investors.
What are the consequences of insider trading?
If the SEC suspects someone of insider trading, it can choose to bring a civil enforcement or felony charge against the trader. The SEC also allows stockholders to bring private lawsuits against an insider trader if they held shares during the trader’s alleged actions.
How much someone will pay for insider trading depends on the circumstances of the case. However, the SEC says it’ll seek three times the value of whatever profits a person made or losses they avoided as an insider trading penalty. It’s also possible for insider traders to face jail time for their actions.
When is insider trading legal?
Interestingly, not all insider trading is illegal. If companies follow the SEC’s guidelines and formally announce their stock purchases, they won’t face charges of insider trading violations. It’s only when traders withhold material nonpublic information and act on it that they can face these charges.
To create a fair and transparent stock market, the SEC requires executives to send detailed forms a few days before buying or selling shares. To qualify as legal insider trading, public companies must publish their stock purchasing plans online, so investors have enough time to digest this information.
Do insider trading laws apply to crypto trading?
There are debates in the legal community over whether cryptocurrencies should be subject to insider trading laws. With many coins and tokens, it’s difficult to pinpoint “inside information” that someone would be privy to.
For instance, Bitcoin is a decentralized payment network, so it doesn’t release quarterly earnings like a company. Not only does the true identity of Bitcoin inventor Satoshi Nakamoto continue to remain a mystery, but there’s also no centralized company behind this cryptocurrency.
Also, many large crypto projects like Ethereum have open source code and a public ledger. It’s not hard for blockchain analytics firms to view and report transaction data on various blockchains.
Despite these facts, there are cases where buying and selling digital assets can result in insider trading charges. Significantly, crypto projects that issue security tokens must abide by the SEC’s guidelines. Unlike other cryptocurrencies, security tokens represent partial ownership of a project or company, so they must register with the SEC.
It’s also common for centralized crypto exchanges and NFT (non-fungible tokens) markets to face insider trading charges. For example, the U.S. District Court in Southern New York went after an employee at the NFT market OpenSea for insider trading. According to this case, OpenSea employee Nathaniel Chastain bought and sold NFTs that he knew would be featured on the website’s homepage.
Are crypto “pump-and-dump” schemes insider trading?
The crypto market has a reputation for attracting many scammers due to its lack of regulations. One of the most widely reported strategies used by crypto fraudsters is the “pump-and-dump” scheme. Although some confuse this strategy with insider trading, it’s not the same.
Pump-and-dump schemes involve people who buy large quantities of crypto and then spread false information online to “pump” up the price. If the scammers get enough people to buy the crypto asset, the token price can rise dramatically. At this point, the fraudsters will “dump” their tokens on the open market at a profit, while investors who bought into the hype may suffer losses.
Most often, people who use this technique will target under-the-radar altcoins. Since these tokens don’t have a strong track record or community, they tend to be easier to manipulate. Also, the lower a token’s market cap, the less capital it takes to move its price.
Pump-and-dump schemes aren’t new to the crypto industry, but they’ve become increasingly common. Although the people behind these schemes have insider knowledge, they must actively spread false information. Insider traders simply act on whatever material information they have.
The most notable pump-and-dump profiteer was computer programmer John McAfee. The SEC charged McAfee with “securities fraud” in 2020 for his role in multiple schemes during the 2017 bull run.
What are real-life insider trading examples?
To better understand this topic, it may help to review a few examples of insider trading.
Martha Stewart’s ImClone Insider Trading Trial
Because of her celebrity status, Martha Stewart is one of the most discussed examples of inside stock trading.
In the early 2000s, Stewart held shares in ImClone, a biopharmaceutical company. During this time, investors were hopeful that the U.S. Food and Drugs Administration (FDA) would clear ImClone’s oncology drug Erbitux. However, at the end of 2001, the FDA didn’t approve Erbitux, which triggered a sell-off in ImClone’s shares.
The SEC found that many ImClone executives sold their positions shortly before revealing the FDA’s denial. Investigators discovered the company’s CEO Samuel Waksal told employees about the upcoming news and urged them to sell shares. Martha Stewart’s broker Peter Bacanovic also told her to sell her ImClone shares before the FDA news broke.
For her part in the insider trading scheme, Stewart paid $30,000 and spent five months in prison.
Coinbase’s Ishan Wahi Insider Trading Case
In 2022, the U.S. Attorney for the Southern District of New York launched an insider trading case against former Coinbase employee Ishan Wahi. According to this charge, Wahi knew which cryptocurrencies Coinbase would add to its trading platform before their official launch date. Allegedly, Wahi sent this information to his brother and a friend so they could buy significant positions in the tokens and sell them after the Coinbase announcement.
In September 2022, Wahi’s brother Nikhil Wahi pled guilty to charges of insider crypto trading.
Illegal insider trading is a severe offense in the U.S. stock market. Although there are questions about how insider trading relates to cryptocurrencies, some centralized crypto companies have already faced charges for this strategy. It’s also clear that security tokens are subject to the SEC’s insider trading laws.
Many fraudsters have used crypto’s lack of regulation to commit illegal trading practices like pump-and-dump schemes. New investors should be extra cautious about interacting with crypto websites or DeFi (decentralized finance) protocols that don’t have a strong reputation in the community.
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