What Is Insider Trading and Why Is It Illegal?

What Is Insider Trading?

Unless one knows how to identify market trends, and even then, there is a limit to which one can predict how a company’s stock is going to perform. The only way to be absolutely sure is when one has private information, from someone within the company, which isn’t publicly released. When this private information is used to trade an asset in the market, the phenomenon is called insider trading.

Who Is an Insider?

In order to understand the legal implications of being an insider and engaging in insider trading, you need to understand who an insider is. There are two ways someone can be classified as an insider.

Firstly, and more widely known, is when someone has access to sensitive non-public information about a company. Thus, they become an insider. Whether they were told this information about someone else or found out on their own, they will be called an insider either way.

Secondly, when someone owns more than 10% of a company's stock. As such, company directors and other high-level executives of a corporation become insiders.

Which Parties Are Involved in Insider Trading?

As with any other transaction, insider trading needs more than one party since it is a transaction of information. These parties can be divided into three, however, sometimes they overlap:

• There’s the company whose information has been compromised. Their securities or data or any other asset is the one being traded by the insider.
• There’s the insider, who is the person that holds secret information that they can use in their favor. They are also the ones who disclose the secret information that they possess.
• There’s the person who is the one to whom the information is disclosed. In the case of trading, this information is used to invest, and as such this third category is usually an investor. They are interested in the secret information that the insider holds.

Sometimes, the insider who holds the information uses it themselves for their own profit, so the second and third persons could very well be the same individual.

Types of Insider Trading

As mentioned in the beginning, insider trading can be both in compliance and in disobedience of the law. These are known as the two types of insider trading, although the more commonly known type is the illegal sort.

Legal Insider Trading

Legal insider trading is when the second type of insider (someone owning more than 10% of a company’s stock) trades. Thus, this type of trading is quite common and happens on a weekly basis in the stock market. As long as the company directors and/or executives report their trades to the Securities and Exchange Commission, their activities are legal. These reports include disclosing their stakes, their transactions, and any change of ownership of the stocks.

When a CEO of any company or enterprise buys back the shares of his or her firm, or when other workers of the same company acquire stock in the company where they work, it is deemed legal insider trading. The purchase of shares by a CEO may often impact the price fluctuation of the stock itself.

Warren Buffett trading shares of firms within the Berkshire Hathaway umbrella is an example of legal insider trading.

Illegal Insider Trading

When a piece of crucial information regarding a company is not public yet, insider trading is considered unlawful and carries severe penalties, including hefty fines and imprisonment. Any data that might have a significant influence on the company's stock value is considered significant information.

Obviously, having access to such knowledge might impact an investor's choice to purchase or sell a share, giving them an advantage over the general public, which is unfair according to the rules of the Securities and Exchange Commission, and is therefore illegal.

Martha Stewart's ImClone trades in 2001 are an excellent example of illegal insider trading.

Why Is It Illegal to Trade on Insider Information?

As defined by the U.S. Securities and Exchange Commission, the sort of insider trading that is illegal is “buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security.”

Quite obviously, insider trading is illegal because it provides some people an extremely unfair advantage compared to the rest. It allows the “insider” to be able to influence a company’s stock value, artificially.

Obviously, the reason that insider trading is considered unlawful or illegal is that it gives the insider an advantage, unfairly, in the stock market. It also puts the insider's interests above the interests of those to whom they owe a certain fiduciary duty and lets the insider influence the price value of a company's shares.

How Insider Trading Affects Cryptocurrency

The reason that tailgating is bad is that these front runners are exploiting cryptocurrency exchanges by soaking huge amounts of money, up to hundreds of millions of dollars, from Ethereum's trader transactions network.

What Does Front Running Mean?

When a trader takes full advantage of a "tip" from an insider or secret information about a forthcoming transaction that is going to have a significant impact on the price of a particular cryptocurrency, it is known as front running.

Basically, traders purchase or sell a cryptocurrency based on prior, non-public data and information that they anticipate will influence its price. As such, the trader has an edge, not just over other traders, but over the market as a whole since the information that they're using to base their decision on is not public. This is why front running is a form of market manipulation and qualifies as Insider Trading.

In a traditional stock exchange, front running refers to the act of racing towards the front of the queue when a trader realizes a large transaction is coming up. That’s where the word front running came from.

So How Does Front Running Happen in a Cryptocurrency Exchange?

In the cryptocurrency world, the concept of front running is similar to the stock market. The approach, on the other hand, is different. Bots, which are computer programs, are used to automate trades in the cryptocurrency industry to make trading easier. Front running bots, in the scenario of tailgating, automatically synthesize and assess market information and do front running for investors.

Users who make use of the front running technique use bots to bypass the queue and charge a greater transaction fee for placing an order, and the trader who began the transaction has no choice but to pay a price that they didn't expect, thereby facing a loss at the hands of the front runner who bags a profit.

For example, if a cryptocurrency trader who front runs gets to know that someone (mostly a client/user of their company/exchange) is going to acquire $15 million worth of cryptocurrency, the front runner bot might execute a "buy" order exactly before that, such that when $15 million worth of cryptocurrency is bought, the bot would instantly put a "sell" order, allowing the front runner to acquire a huge profit.

How Can Front Running Be Avoided?

The allure of front running is the big margin for profit when large transactions are made. Instead of conducting many big transactions at once, users can partition their transactions, thus reducing the attraction of exchanges for front-running bots due to the decrease in value that can possibly be mined.

Examples of Insider Trading

Insider trading has affected the stock market, in the past, multiple times.

Martha Stewart

Source: NBC News

The Food and Medication Administration (FDA) declared in December 2001 that it will not authorize Erbitux, a potential cancer drug developed by the pharmaceutical firm ImClone. Because it had been predicted that this medicine would be authorized, it was an important part of ImClone's long-term business strategy. As a result, the shares of the firm plummeted. While many stockholders lost money as a result of the collapse, the family members and other friends of Samuel Waksal, Erbitux's CEO, were unaffected.

The Securities and Exchange Commission then revealed that, before the FDA's decision was announced, a number of executives had already sold their shares on Waksal's orders, and that Waksal had also sought to sell his personal shares.

In addition, Martha Stewart, who was an American retail businesswoman, had sold about 4,000 shares of the same firm just days prior to the announcement. The shares were still selling at a strong level at the time, and Stewart profited about $250,000 on the transaction. In the months that followed, the stock plummeted from over $60 to just a little over $10.

Stewart claimed that she had a pre-existing sell order with her stockbroker, but it was later found that her broker, Peter Bacanovic, had forewarned her that ImClone's stock would likely fall. Stewart later stepped down as CEO of Martha Stewart Living Omnimedia, her own firm. In 2003, Waksal was caught and sentenced to almost seven years in jail as well as a $4.3 million fine. Stewart and her stockbroker were convicted of insider trading in 2004. Stewart faced a fine of $30,000 and was sentenced to a minimum of just five months in jail.

Ivan Boesky

Source: Britannica

Ivan Boesky is an American trader of the stock market who rose to prominence in the 1980s as a result of his participation in an insider trading controversy. Many other corporate officials from prominent U.S. investment banks were also engaged in this scam, and they were giving Boesky the information about planned corporate takeovers. Ivan F. Boesky & Company was Boesky's stock brokerage, and he had made a lot of money gambling on corporate takeovers since 1975 when he first launched it.

The Securities and Exchange Commission (SEC) started to investigate Boesky in 1987 when a number of Boesky's company partners sued him for falsifying legal papers defining their association. Later, it was found that he drew his investment judgments from information obtained from business insiders.

Boesky had been bribing workers of the financial institution Drexel Burnham Lambert's mergers and acquisitions (M&A) office for information that would assist him in his purchases. Getty Oil, Gulf Oil, Nabisco, Texaco, and Chevron were among the many companies that Boesky profited from throughout the 1980s.

Boesky eventually became an informant for the Securities and Exchange Commission (SEC), providing the SEC with evidence that led to the lawsuit against financier, Michael Milken. In 1986, Boesky was found guilty of insider trading and sentenced to 3.5 years in jail and a $100 million fine. Despite the fact that he was released after only two years, the SEC has permanently barred Boesky from dealing with securities.

Albert H. Wiggin

Source: Earn2Trade Blog

Following the 1929 Wall Street Crash, it was discovered that Albert H. Wiggin, the renowned CEO of Chase National Bank, had shorted almost 40,000 shares of his own business. Wiggin established a position that provided him a personal interest in pushing his firm into the grave by using companies controlled by his family to mask the trades.

There were no formal restrictions against short selling your own company's shares at the time, and therefore Wiggin lawfully profited nearly $4 million in the events of the 1929 crisis, when many financiers liquidated their holdings in Chase National Bank stock at the very same time.

Wiggin had received a $100,000 a year for life pension from the bank in addition to the gains he generated through short-selling his own company's shares. As a consequence of public and media uproar, he eventually refused the pension. The Securities and Exchange Act of 1934 was enacted in part as a response to the widespread corruption that emerged in the aftermath of the disaster. Wiggin was not the only corrupt figure at the time. The goal of the SEC Act of 1934 was to improve financial market transparency and reduce instances of fraud and manipulation. In fact, it has been suggested that the Act's drafters dubbed Section 16, which handles different provisions aimed at preventing and prosecuting insider trading instances, the anti-Wiggin section.

R. Foster Winans

Source: Esquire Classic

R. Foster Winans was one of the Wall Street Journal columnists. He produced the "Heard on the Street" column. He would feature a certain stock in each column, and the stocks covered in the piece frequently moved up or down, according to Winans' judgment.

Winans made an agreement with a group of brokers to release the information of his column, specifically the stock he was about to disclose. Before the piece was printed, the stockbrokers would buy stakes in the stock. After the brokers made their own profits, they reportedly handed Winans a portion of their winnings in exchange for his information.

The SEC ultimately caught up with Winans. His argument was complicated by the fact that the piece was Winans' subjective view rather than actual insider knowledge. The SEC finally found Winans guilty based on the assertion that the information regarding the securities in the column was owned by The Wall Street Journal, not by Winans himself.

Examples of Insider Trading in Crypto

The stock market is not the only trading platform plagued with illegal insider trading. Similar instances of front running have been noted in crypto trading as well.

Nate Chastain

Source: Blockworks

Chastain resigned as the Head of Product at OpenSea.io, which is an online gallery/auction house for NFTs, on that same Thursday. OpenSea, by far the largest participant in the market, has seen sales of art-themed NFTs soar this year, reaching $1 billion in trading activity. OpenSea is the place to go if one wants to pay $18,000 or more for an image of a bored-looking monkey to use as an avatar on Twitter. However, the rapidly escalating issue around Chastain's alleged behavior strained relations between crypto-artists and the network that serves as their center.

No law enforcement agency has charged Chastain with any wrongdoing, and he has made no public attempt to explain what transpired. However, he might be in legal trouble at the very least. While the SEC has yet to rule on whether NFTs qualify as securities under the 1933 Act, Gensler may try to argue that this amounted to securities fraud and initiate a civil action against him. Even if the SEC decides not to pursue the issue, other federal authorities may be interested in looking into Chastain's case.

Conclusion

While insider trading is an obvious threat to the stock market, it is less obvious to the cryptocurrency exchange while still existing. Perhaps that is owed to the recent age of crypto in general, or perhaps that is owed to the security and decentralization offered by blockchains. Either way, insider trading can plague any market that allows trade.