Insider Trading: CNBC Explains

Just the mention of the words "insider trading" can stir up images of Wall Street 'tycoons' dragged off in handcuffs and paraded through a horde of flashing cameras for receiving ill-gotten gains.

Hans Neleman | Getty Images

But not all forms of insider trading are illegal. In fact, it happens all the time without anyone going to jail.

So what is insider trading? How does it work? Here are the details.

What is insider trading?

There are two kinds of insider trading.

Legal insider trading is when corporate insiders—officers, directors, and employees—play by the rules when they buy and sell stock in their own company.

These types of trades happen all the time as employees of publicly traded companies, more than likely the top management positions, often own stock in their firm or have stock options: the ability to trade a stock at a certain time for a set price.

This is considered a form of "insider trading" because company employees might have access to information not known to the public. This can be a new product, a merger with another company, a change of CEO, or a spectacular earnings report. Any of those news items could send the firm's stock price higher—or lower.

To keep their trades legal, these 'insiders' must report the trades to the Securities and Exchange Commission(SEC) within a certain time period after the sale or purchase. That's usually 10 days from the end of the month when the transaction took place.

And this is most important: company employees can only trade their stock when that 'insider' information is made public—when the insider has no direct advantage over other investors.

The information is made public by the company through a press release or some other type of general announcement.

There is one other person who can also do this type of legal insider trading—with the same restrictions. That's anyone who owns 10 percent of the company's stock.

When is it illegal?

It's illegal when insiders trade on knowledge the general public doesn't have.

Here's an example. In 2003, former ImClone CEO Samuel Waksal was sentenced to seven years in prison and fined $3 million after pleading guilty to insider trading and fraud.

What did he do? Waksal sold his ImClone stock after finding out the Federal Drug Administration had rejected an application for the company's new cancer drug , Erbitux. Waksal had the information before the public did and traded on it, which is what made it insider trading. The irony is the drug was later approved.

The ImClone case also shows how the definition of an insider goes beyond a company's employees, as we're about to see.

Who is an insider?

The SEC includes in its definition of insiders those who have "temporary" or "constructive" access to material information on a company. That includes anyone outside of the firm.

Let's go back to ImClone to see how this works.

Business woman Martha Stewart wasn't an employee of ImClone Systems, but she was convicted of insider trading for lying to investigators about selling some 3,000 shares of ImClone stock, in December of 2001.

Here's why she went to jail. Stewart got from her stock broker the same information that Sam Waksal had—the FDA's non-approval of Erbitux—and she was also told that Waksal was selling all his shares. That made her an insider by definition; she had information the public didn't.

The day after the sale, and the information became public, ImClone stock fell 16 percent. But Stewart avoided a $46,000 loss by selling her shares before the news was general knowledge.

Stewart denied trading the stock on the information but she was convicted and went to prison for five months and paid a $30,000 fine. Her broker, Peter Bacanovic, also went to jail.

The irony for Stewart (this case seems to have plenty of it) was that if she had simply held her ImClone stock,she would have had stock worth some $60,000 from the firm's takeover by Eli Lilly after Erbitux was approved.

So an insider can be anyone who has tradeable information the public doesn't. If Waksal had told his barber about the FDA's decision on Erbitux and the barber traded on it before it went public, the barber could be charged with a crime.

Who polices inside trading?

Because of the stock market crash of 1929, the Securities Act of 1933 set up the first laws against insider trading. A year later, Congress passed the Securities Exchange Act which formally created the SEC, giving it broad authority over all aspects of the securities industry.

In 1984, Congress passed the Insider Trading Sanctions Act or ITSA to help the SEC enforce insider trading laws. Before that, the SEC was limited to submitting injunctions to stop fraudulent actions and try to force payment back to victims of illicit profit taking.

With any case the SEC has found after 1984, it's handed over to the Justice Department to prosecute.

What are the penalties?

There can be both criminal and financial penalties. Individuals face up to 20 years in prison for criminal securities fraud. In addition, those suspected of insider trading are usually charged with mail and wire fraud, which can lead to a sentence of up to 20 years in prison.

They can also be charged with more general "securities fraud" (up to 25 years in prison), and possibly even racketeering, tax evasion, and/or obstruction of justice.

When it comes to financial penalties, the Securities Exchange Act of 1934 gives the SEC the authority to seek a court order requiring violators to give back their trading profits. The SEC can also ask the court to impose a penalty of up to three times the profit the violators realized from their insider trading.

The SEC Act of 1934 was amended by the Sarbanes-Oxley Act of 2002, to include a fine of up to $5 million for each "willful" violation of the act and the regulations under it.

There is one way to avoid prison, and only pay a fee. That would be if a defendant can demonstrate "no knowledge" of a rule or regulation that is violated. Corporations involved in insider trading face penalties of up to $25 million.

What are some famous cases of insider trading?

There have been plenty of insider trading cases over the years, some famous, some not so famous. Different forms of insider trading have occurred since the stock market began, but more have come to light after Congress passed the ITSA in 1984.

We've already mentioned Waksal/Stewart—so here's a look at some of the other well-known convictions in the last 25 years.

Galleon Group/Raj Rajaratnam

Raj Rajaratnam was the founder of the hedge fund firm Galleon Group. The firm fell apart after Rajaratnam was arrested in 2009 for conspiring to trade using insider information. The scheme could have brought in profits of some $20 million, according to the U.S. Government.

Rajaratnam was found guilty on 14 counts of conspiracy and securities fraud charges on May 11, 2011. The jury convicted Rajaratnam of nine counts of securities fraud and five counts of conspiracy for what prosecutors describe as the money manager's central role in the most sweeping probe of insider trading at hedge funds on record.

The Wall Street Journal/R. Foster Winans

The Wall Street Journal columnist R. Foster Winans was convicted in 1985 of giving information to two stockbrokers about stocks he was planning to write about in the "Heard On The Street" column.

They used the information to make about $690,000. Winans’ cut was $31,000. Winan was sentenced to 18 months in prison. The other players in the case, including stockbroker Kenneth Felis—and Winans’ roommate, David Carpenter—were also convicted. A second stockbroker, Peter Brant, plead guilty.

Ivan Boesky

Boesky is often described as an arbitrageur—a fancy word to describe a type of investor who attempts to profit in the market by making simultaneous trades that offset each other.

Boesky paid $100 million to the Securities and Exchange Commission to settle insider-trading charges that he netted $50 million in illegal profits from inside tips. Boesky pleaded guilty to a related charge and was sentenced to 3 1/2 years in prison in 1987.

Keefe, Bruyette & Woods/McDermott Jr.

Once the CEO of investment bank Keefe, Bruyette & Woods, James McDermott was convicted of insider trading in 2000 for giving information about pending bank industry mergers to his mistress, Kathryn Gannon, an adult-movie star, who went by the name Marilyn Star. McDermott was sentenced to eight months in prison, while Gannon received a three-month term. McDermott was fined $25,000.