Podcast included: In addition to reading this article, you can listen to our podcast on preventing insider trading and tipping.
After reading this article, test your knowledge with a fun, interactive quiz on insider trading and tipping.

Everyone knows that owning company stock carries financial risks. However, it comes as a surprise to many employees that trading company stock can actually get you into serious legal trouble, including criminal liability. Two major ways in which you can, even accidentally, break the securities laws are called insider trading and insider tipping. This article explains what you need to know to stay out of trouble when you trade any company's stock.

Alert: The SEC and the US Department of Justice (DOJ) are watching closely for insider trading related to company performance and stock-market volatility amid the Covid-19 pandemic. They expect to pursue enforcement activities, according to a statement from the co-directors of the SEC Enforcement Division. For guidance on insider-trading prevention amid the market volatility of the Covid-19 pandemic, see articles from the law firms Ropes & Gray, Bass Berry, Wilmer Hale, and Blank Rome.

Insider Trading And Tipping: The Basics

Insider trading is illegal. It occurs when someone trades stock or other securities on the basis of what is termed material nonpublic information (MNPI). MNPI is confidential, proprietary information about a company that will affect its stock price either positively or negatively when the information is made public. Insider tipping is also illegal. It means sharing MNPI with others. The laws against insider trading and tipping apply to everybody. They do not apply only to company insiders or executives, though their positions tend to put them at more risk than ordinary employees.

The laws against insider trading and tipping apply to everybody, not just executives and other company insiders. You can get into serious trouble even accidentally, without any intent to violate the laws.

Insider trading and tipping are considered violations of securities law because they give certain people an unfair investment advantage over other investors and therefore undermine the fair operation of the capital markets. If the capital markets were to lose public trust and confidence, investment would fall, to the detriment of companies and the economy (see a related FAQ for more on that topic).

Pursuing insider-trading violations is a high priority of the US Securities and Exchange Commission (SEC), the federal agency that regulates and enforces securities laws in the United States. Also, the SEC has agreements with many countries throughout the world, giving it access to people who violate US securities law outside the US. Insider-trading law has grown extensively out of the general antifraud provision of Rule 10b-5 in the famous Securities Exchange Act of 1934. In addition to stocks and bonds, which are clearly securities covered by insider-trading law, the SEC has expanded the interpretation of the law to include more sophisticated financial instruments, such as credit default swaps.

What Constitutes Insider Trading?

The insider-trading laws apply to MNPI not only about a company you work for but also about any company you may know through a professional or personal relationship, e.g. through a family member who works for that company, or through a vendor, supplier, or client of your company.

The SEC now wields a formidable array of digital technology to spot, track, and examine links between people involved or connected with suspicious stock-trading activities. As explained in a 2019 speech by SEC Chair Jay Clayton, the SEC uses sophisticated data analytics, including pattern recognition, to detect suspicious stock trading. For example, he noted, the SEC's ATLAS tool lets the agency's staff harness multiple streams of data, including blue sheets, pricing, and public announcements. The tool is routinely used to look for insider trading before a major equity event, detect serial insider trading, and research historical securities prices for litigation. In 2018, these data analytics led to SEC charges against an investment banker who allegedly misused access to confidential information.

The SEC wields a formidable array of digital technology to spot, track, and examine links between people involved or connected with suspicious stock-trading activities.

Meanwhile, the SEC and prosecutors continue to develop legal theories to reach nonemployees who trade on a company's misused MNPI. These include the "misappropriation" and "temporary insider" theories. The SEC is now routinely scrutinizing hedge funds for evidence of insider trading. The SEC may pursue you for insider trading even if secret inside information did not influence your decision to trade.

Alert: An insider-trading case in 2016 involving professional golfer Phil Mickelson and a corporate director (see the related SEC press release and SEC public statement) shows that when the SEC finds insider trading somewhere in a chain of events, all who profited will be forced to pay back their gains, even if they did not know that the information in question was tainted. In the SEC's action, Mr. Mickelson was named as a "relief defendant," i.e an individual who must turn over ill-gotten gains arising from schemes perpetrated by others.

Another risk for officers and directors is that they can be liable as controlling persons if they are reckless in not preventing insider trading by their employees.

Insider Tipping: Loose Lips Sink Ships

Insider tipping is illegal, and is closely related to insider trading. It means sharing MNPI about a public company that may motivate the recipient to trade that company's securities (e.g. shares or call options). This is illegal because the tipped-off trader gains an unfair advantage over other investors from the movement of the stock price that will occur when the information is made public.

Insider tipping can occur in person, by phone, through mail, by email, or on the internet. The tipping is illegal if:

  • the person who receives the inside information knows, or has a reason to believe, that the tipper is breaching a fiduciary duty
  • the tipper gets some tangible or indirect benefit from the tipping
  • the tipper passes on the tip with the expectation that the recipient will try to profit from it

When you tip someone—e.g. a relative or a friend—who then trades securities according to the inside information, you may be held accountable for up to three times the profit gained or loss avoided, plus disgorgement of the trading gains if your tippee cannot pay.

Tipper Liability Taken Seriously By The SEC And Prosecutors

Even if you merely pass on MNPI and do not trade for yourself, you can still be accused of insider tipping. Some recent SEC cases show how seriously the SEC and federal prosecutors take tipping when they bring insider-trading actions.

Even if you commit insider trading or tipping in the US capital markets from outside the United States, the SEC can still nab you.

In 2012, amid the largest insider-trading case ever brought by the SEC, a neurology professor at the University of Michigan was accused of tipping confidential pharmaceutical information to a portfolio manager at a firm that advises hedge funds. In another case addressed by a 2018 SEC enforcement action, an executive tipped his brothers in advance of his company's announcement of poor financial results, thus helping them avoid losses of over half a million dollars. Although the executive did not trade, after 17 years at the company he resigned and is barred from serving as an officer or director of any SEC-reporting company for two years, along with paying a $581,170 penalty.

It also does not matter whether the violation occurred inside or outside the United States. In 2010, the SEC launched criminal and civil proceedings against a French doctor living in Paris, who was arrested in the US after tipping an American hedge fund about confidential impending bad news for a pharmaceutical company where the hedge fund held shares.

Cybersecurity Breaches

In guidance on cybersecurity disclosures that it issued in 2018, the SEC formally expanded its definition of MNPI to include knowledge about cybersecurity risks and incidents, including vulnerabilities and breaches (see pages 20–21). The SEC enforcement action and Justice Department criminal action against a former Equifax CIO for insider trading shows that they view knowledge of a massive cyber-intrusion and data breach as material information. In a commentary on his law firm's blog, an attorney at McGuireWoods points out that while the defendant was not told that Equifax had a data breach, the SEC and DOJ alleged that for corporate insiders it is enough to have "constructive knowledge" (i.e. strong suspicions based on information learned at work) of nonpublic material information, and that "actual knowledge" (i.e. direct awareness) is not needed.

As detailed in an SEC legal complaint and the related press release, the SEC has brought an insider-trading case against an Equifax software engineer under the same theory of "insider guessing." The employee was not told that a data breach had occurred but purchased put options on Equifax stock and sold them for a profit of $75,000.

Company Rules And Prearranged Plans

In addition to the laws against insider trading and tipping, companies typically have their own rules about trading stock, including blackout and window periods for stock trades. If you frequently possess MNPI but also want to sell stock regularly for cash to meet expenses, you can set up a prearranged sales under a Rule 10b5-1 trading plan.