INDEPTH: CRIME
Insider trading – What's the problem?
CBC News Online | Dec. 21, 2005

When people talk about insider trading, it's usually the illegal variety they're talking about. Illegal insider trading is one of those crimes that drive small investors to distraction The average retail investor never hears about a coming merger or acquisition before it's publicly announced. They never know of a big new contract or a sudden earnings shortfall before it's splashed all over the business pages.

All stock markets operate on the premise that they're transparent – that all market participants learn about material events at about the same time. Under this arrangement, no one is supposed to get an unfair advantage.

That's the theory. Unfortunately, some corporate insiders have used their knowledge of non-public key corporate events to profit from developments that only a privileged few are party to. When that happens, the integrity of the market is compromised.

Market surveillance teams have identified many suspected instances of insider trading. But enforcement actions in Canada have been rare.

What is insider trading?

Not all insider trading is illegal. Company executives frequently buy and sell stock in their own firms. Stock options and grants are a popular way to compensate senior officers in a company. The thinking in many company boardrooms is that there is no better way to ensure that the firm prospers and the stock price rises than to give the people who run it a financial stake in how they perform. Many companies also require their senior officers to own stock in the company equal to as much as six times their annual salary.

As long as they report their trades to regulators within 10 days of the trade (and they're not acting on information that has not been publicly disclosed), there's no problem. It's when they act on non-public information that the trade can become illegal.

Trading on privileged information isn't the only offence. Giving someone else an advance "heads up" on material news is also against the law. "Tipping", as it's called, is prohibited under provincial securities laws and the Criminal Code. The person who acts on the illegal tip can also be charged.

Illegal insider trading is not a "victimless" crime. If you'd bought shares in a company hours before bad news was released, would you think it was just bad luck if you later found out that insiders had been using their privileged knowledge to busily unload their shares? If this happens often enough, the market gets a reputation as an unlevel playing field and investors stay away.

Who is considered an insider?

Anyone who has privileged access to material information about a company (in other words, information that could affect a stock price) because of some special relationship to the company is considered an insider. This could include major shareholders, corporate executives, accountants, lawyers, bankers, analysts, secretaries and printers.

Anyone who acts on an illegal tip from an insider (like a spouse or friend) is also guilty of an offence.

What are the penalties?

Most cases of insider trading and tipping are prosecuted by provincial securities commissions. Penalties vary slightly from province to province. Typically, those found guilty of insider trading under provincial securities legislation can be fined up to $1 million, forced to give up their profits, jailed for up to two years, and can be banned from trading in securities.

In March 2004, Bill C-13 was given Royal Assent. This created the first specific Criminal Code offences of improper insider trading and tipping. It also made it a crime to threaten or retaliate against employees who blow the whistle on such activity.

This Criminal Code amendment was meant to apply to the "most egregious cases" of illegal insider trading. Conviction carries a maximum of 10 years in prison for each offence. Tipping carries a maximum term of five years.

How is illegal insider trading detected?

Most illegal insider trading cases are detected through market surveillance systems. Regulators use sophisticated computer programs to find changes in volume and price that are outside "normal" patterns.

Trading in stock markets is monitored, as is trading in derivatives markets, where options and futures contracts are traded.

Some people try to hide their trades by keeping them small, or by using "nominee" accounts held in another name (either in Canada or offshore). Of 289 insider trading cases opened in Canada in 2001 and 2002, 15 used offshore accounts.

In a 2003 task force report on insider trading, the Canadian Securities Administrators said only a few insider trading investigations began because of a complaint or tip. It noted that in the United States, public and industry tips are a major source of potential cases, perhaps because insider trading has a higher profile in the U.S.

How do I find insider trading data?

Studies of legal insider trades have tended to show that when company executives buy the stock of the company where they work, that company tends to outperform the market over the next 12 months. Insiders may sell shares for a variety of reasons (they want to diversify their holdings, they want to buy a bigger house, they're getting divorced). But they usually buy for just one reason – they think the price of their company's stock is going to rise.

In Canada, insider trades have to be reported to the System for Electronic Disclosure for Insiders (SEDI) within 10 days of the trade. Shareholder advocates would like to see instant, real-time disclosure of those trades. But in the meantime, the current SEDI database is searchable by company or insider at its website: www.sedi.ca

If you're looking for insider trading information on U.S.-listed stocks, you can carry out an online search of the SEC's EDGAR database.

EDGAR isn't the easiest site to navigate, but there is an online tutorial.