From former presidents to finance moguls, insider trading has brought down some of the most powerful people in business, but what is insider trading, and what happens when someone is convicted? Keep reading to find out.
What Is Insider Trading?
Insider trading is the trading of a company's stocks or assets by people with access to confidential information about the company or organization. So, why is that a bad thing?
In many companies, the employment structure includes an understanding – and often a contractual obligation – to perform their duties ethically. Upper management and C-suite executives usually handle sensitive information about the company. Because of this, they have a fiduciary duty to use their privileges for the company's benefit, NOT personal gain.
Stocks allow the public to invest in a company and get a little slice of the corporate pie, but if someone with insider information trades these stocks, it violates the individual investor's right to partake in a free market.
Some economists and finance researchers see insider trading as a direct threat to the economy. They say that trading alone increases the cost of the stock, making it harder to buy or sell on the stock market, which eventually depresses the economy.
Quid Pro Quo
The saying "scratch my back, and I'll scratch yours" is a modernized take on the Latin term "quid pro quo." Both expressions refer to the idea of doing a favor in exchange for something. In mob movies, you might see the boss discussing paying off the police in exchange for not investigating a crime; this is quid pro quo in action.
Insider trading often starts like this: "I'll do you a favor, and you can pay me back later." Directors may spill some private information about the company to their friends, so they are more likely to invest, increasing its value.
On the other hand, an insider may pass on information that the company is struggling so their friend won't lose money. Either way, the integrity of the market is gone.
While it might seem like a nice thing to do, giving an acquaintance or relative sensitive information related to company stocks is considered unethical under the law. No amount of love or friendship will get you out of an insider trading charge.
Insider Trading Example: Enron
Early Success
For those unfamiliar with former Wall Street darling Enron, it was an energy and natural gas company in the 80s and 90s. Enron itself wasn't exactly the epicenter of controversy – it was a branch called Enron Finance Corporation run by Jeffrey Skilling.
The tech bubble and the internet were in full swing, and the Nasdaq hit all-time highs as dot com corporations took hold of the public's interest. As a company with control over vast segments of the energy market, Enron stood to take over the entire industry.
Missteps
However, one of the first pitfalls for the company came when Skilling changed the accounting method. This allowed Enron to receive approval from the Securities and Exchange Commission. While it doesn't sound like much, this decision would be the foundation of unethical fiduciary practices later on.
The accounting format knows as a market-to-market or MTM is based on fair value, not actual value. This allows Skilling and others to manipulate their financial records to appear more profitable.
Illegal Activities
As the market became crowded and success took a turn for Enron, they started building power plants and immediately claiming them as assets even though they were barely operational. These "assets" would be kept in a separate book if they didn't perform as planned.
Leadership began to hide debt in illegal SPEs or special purpose entities. Accountants Arthur Andersen and Andrew Fastow oversaw Enron's accounts – and facilitated their criminal activities.
Downfall
As Enron entered financial freefall in the early 2000s, the company changed the employee pension plan so employees couldn't sell their shares for at least 30 days. Enron would file for bankruptcy in 2001, and the criminal investigation began.
Andersen was the first to be investigated and charged with obstructing justice, a charge that was eventually overturned but continued to haunt him for years. Executives were charged with insider training and fraud because they had lied on the books and forced investors to hold based on false promises.
Criminal Process
Like most white-collar crimes, insider trading is often paired with another charge like fraud, wire fraud, or conspiracy. This makes things complicated because these crimes are charged per instance. In other words, for wire fraud, every email, phone call, text, or letter is one count. That means the charges start to pile up quickly.
Because each case is unique and the number of peripheral crimes (like wire fraud) varies between cases, insider trading punishments may differ. The SEC says that the maximum sentence for insider trading is 20 years with a fine of $5 million.
As mentioned earlier, this sentence may increase depending on the number of contributing factors in the case.
Takeaway
Insider trading is the practice of encouraging or discouraging investors based on insider information about the company. Some executives may feel the need to warn their friends or partners if the company is in trouble, but doing so could land them in prison if convicted of insider trading.
Stay tuned for our next installment in the White-Collar Crimes series: wire fraud!