You may have heard the term “insider trading” thrown around in financial dramas on television or in the movies, but what exactly does it mean? Insider trading involves the trading of a public security, such as a stock or a bond, by someone with material non-public information that impacts the value of the security.

Here’s what else you should know about insider trading including when it can happen legally.

What is insider trading?

The Securities and Exchange Commission, or SEC, defines illegal insider trading as the “buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security.”

The rule also applies to those people who pass along the information or tip off others so that they can benefit from the information. People who trade on the tipped information may also be in violation of insider trading laws.

Insider trading laws exist to preserve trust and faith in the securities markets. When some people are able to trade with advantaged information, it undermines the public’s trust in the financial system.

Information is considered material if it could impact the value of a security and it’s considered non-public if it hasn’t been publicly announced or shared widely. Companies typically announce material information such as earnings announcements or news about corporate mergers in press releases or SEC filings.

When is insider trading illegal?

Insider trading is illegal when a person or entity buys or sells a security when they are in possession of material nonpublic information. If the information has been made public, it’s no longer illegal to trade on it because you wouldn’t have an unfair advantage.

For example, say you work in the accounting department of a publicly traded company and help prepare the company’s financial statements each quarter. If you notice that the company’s results are particularly strong for the current quarter and purchase shares before the earnings have been announced, you’d be in violation of insider trading laws and would be subject to fines and possible jail time.

At the same time, if you passed that information along to someone else, you could both be prosecuted for illegal insider trading.

When is insider trading legal?

Insider trading isn’t always illegal. It also refers to the buying and selling of shares by a company’s executives or directors. These trades must be disclosed to the SEC shortly after they are made and are sometimes planned months in advance.

These SEC forms involve insider trading:

  • Form 3: This form must be filed within 10 days of someone becoming an “insider,” which is defined as an officer or director of the company. It shows the insider’s initial stake in the firm.
  • Form 4: When an insider trades in the company’s securities, they must disclose the transactions within two business days of the date of the trades.
  • Form 5: This form is similar to Form 4, but covers transactions over the prior year that had not been previously disclosed because of an exemption or a failure to report. Some transactions don’t have to be reported immediately on a Form 4, but do have to be included on Form 5.

Examples of well-known insider trading scandals

Martha Stewart

In 2003, Martha Stewart and her Merrill Lynch broker were charged with securities fraud related to insider trading of ImClone shares in 2001. The CEO of ImClone, a biopharmaceutical company, was also a client of Stewart’s broker and had sold all the shares held by him and his daughter at Merrill Lynch in anticipation of the FDA rejecting an ImClone cancer treatment.

Stewart’s broker tipped her off and she was able to avoid losses of $45,673 when the FDA’s ruling was made public. She later lied to the SEC and criminal investigators about the trades and ultimately served five months in federal prison.

Former Amazon (AMZN) employee

The SEC charged former Amazon financial analyst Brett Kennedy and his college roommate with insider trading in 2017. The charges alleged that Kennedy had accessed Amazon’s first quarter 2015 earnings report early and sold the information to Maziar Rezakhani, his college roommate, for $10,000. Rezakhani made more than $116,000 in illegal profits from trading on the information and shared some of those profits with his advisor Sam Sadeghi, the SEC alleged. Kennedy was sentenced to six months in prison and fined $2,500.

Dean Foods

In 2016, the SEC charged famed Las Vegas sports gambler Billy Walters with insider trading, alleging that he made $40 million in illegal profits after former Dean Foods board member Thomas Davis, who owed Walters money, tipped him off to information about the company over a five-year period.

Walters shared the material nonpublic information with pro golfer Phil Mickelson, who used the information to make nearly $1 million in illegal profits, which he used to pay a debt to Walters. Mickelson was not charged but was named as a relief defendant for the purpose of recovering profits made off Walters’ illegal scheme.

Walters was sentenced to five years in prison, while Davis was sentenced to two years.

Bottom line

If you’re involved in the financial markets, it’s important to have a solid understanding of insider trading laws. If you’re unsure of whether information is material or nonpublic, it’s a good idea to consult with a financial expert or attorney before acting on it. Anything that’s close to the insider trading line should likely be avoided.