Legal vs. Illegal Insider Trading: What's the Difference?

Why the insider trades in public filings are legal, what makes insider trading illegal, how the six-month short-swing rule works, and how the STOCK Act applies to Congress.

"Insider trading" sounds like a crime, yet this site is full of articles about reading insider trades. Both are true because the phrase covers two very different things.

Legal insider trading

When a director, officer or large shareholder buys or sells their own company's stock and reports it on time, that is legal insider trading. It is what Form 4 exists to disclose. The rules require:

• Timely reporting. Within two business days.
• No use of material nonpublic information.
• Compliance with company policy, which usually includes blackout periods around earnings.

Illegal insider trading

Illegal insider trading means buying or selling a security while in possession of material, nonpublic information (MNPI) in breach of a duty of trust or confidence, or tipping others who then trade.

• Material means a reasonable investor would likely consider it important, for example unreleased earnings or a pending acquisition.
• Nonpublic means it has not been broadly disseminated.
• Breach of duty covers corporate insiders but also lawyers, bankers or anyone who misappropriates confidential information.

Under the misappropriation theory, a person who is not an employee can still be liable if they trade on confidential information they obtained in breach of a duty.

The six-month rule

Section 16(b) of the Securities Exchange Act is a separate rule. If an insider makes a purchase and a sale (or the reverse) within less than six months, the company can recover the profit, whether or not the insider had any inside information. That is one reason insiders do not flip shares quickly.

Where Rule 10b5-1 plans fit

A pre-arranged 10b5-1 plan lets insiders trade on a schedule while protected by an affirmative defense, provided the plan was adopted when they did not have MNPI.

Congress and the STOCK Act

The 2012 STOCK Act confirmed that members of Congress and staff are not exempt from insider-trading prohibitions and that they owe a duty of trust and confidence regarding information they obtain through their work. It also created the disclosure requirement that makes congressional trades public.

What the filings can and cannot show

A filing shows that a trade happened. It never shows whether the person had inside information. A purchase before good news is not proof of wrongdoing, and most are coincidence or ordinary confidence. Enforcement depends on investigators connecting the trade to specific information.

This article is general education, not legal advice.

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