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Insider Trading Regulations

The SEC Wants To Maintain a Level Playing Field For Individual Investors

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Insider trading is a very complex topic. The insiders of a corporation are considered the "inner circle" of any publicly traded company. The management of the company-its senior officers and directors-are insiders according to SEC rules.

Any large holder of the company's stock is also considered an insider. According to the Securities Exchange Act of 1934, Section 12, any person or entity owning at least 10 percent of the company's stock is an insider. Conduct rules for insiders are outlined in the Exchange Act of 1934 and more recent legislation.

Corporate management and officers, as well as other insiders, are described in Section 16 of the 1934 Securities Exchange Act. Insiders must register their status and ownership of shares with the SEC. The Sarbanes-Oxley Act (SOX), passed in 2002, requires that insiders file electronic statements about their shares. Liabilities borne by insiders for trading on inside information are described in Section 20 of the act. Insiders must not trade on information that isn't yet known by the public. Insiders caught in public trading scandals don't merely lose a reputation. They must disgorge any gains from insider trading.

Until 1984, insiders were protected by a legal loophole. They could trade over-the-counter options and derivatives or exchange-traded options instead of the "underlying" stock itself. The stand-in contracts weren't considered equity and insiders were absolved from insider trading issues. Legislation passed in 1984 closed the loophole, and investors cheered. The law passed in 1984 also raised the maximum fine for insider trading from $10,000 to $100,000.

Insiders must talk about internal matters of the company with care. For example, telling another investment professional (like an analyst) that the company may default on a bond issue isn't permitted. Until the company announces the internal issues about the default, an insider can't tell another party outside of the company about the problem. Even the company's investment bankers aren't allowed to know information that impacts the fortunes of the company until it's made public. If insiders disclose this information to outsiders, they've broken insider trading laws (such as Regulation FD).

After the anti-insider trading legislation passed in 1984, the Securities Fraud Enforcement Act of 1988 raised the criminal fines for breaking the law. Criminal fines for insider trading were increased to $1 million with fines as great as $2.5 million for anyone trading on inside information. Persons and entities found guilty of trading on inside information may be subject to a prison sentence of up to 10 years. There's good news for whistleblowers in this law: pointing enforcers to those who break the law can mean collecting up to 10 percent of recovered gains and fines.

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