Who is an insider, anyway?

December 1, 2010: 12:09 PM ET

Potentially hundreds of people may be privy to a major corporate merger before the deal is consummated. How do you know when you might be considered an insider?

As federal investigations into dozens of financial firms move forward, a spotlight is shining on the gray area of the legalities of insider trading. Probes are focused on a wide swath of the financial market -- from research firms and banks like Goldman Sachs (GS) to relatively under-regulated hedge funds such as SAC Capital to mutual funds like Janus (JNS) -- over issues as arguably wide and vague around the sharing of proprietary information.

The SEC defines illegal insider trading generally as the buying or selling of stocks and other securities while in possession of "material, nonpublic information" about the security. Such information would give one party an unfair advantage over other market players.

But who exactly is an "insider?" And generally when does illegal insider trading arise? The questions aren't easy to answer, especially as the Internet age has flooded even mid-to-lower-level corporate employees with potentially sensitive information about deals poised to move markets. And as Eleanor Bloxham, CEO of the board advisory firm, The Value Alliance and Corporate Governance Alliance, pointed on Fortune.com this week, providing inside information "is like spreading a virus" -- you can catch it almost anywhere and many would probably want to do without it.

Here's a look at potential insiders and scenarios that might typically raise a red flag for illegal insider trading.

Mid-to-lower-level employees

Insider-trading prosecutions often go after high-level executives, bankers and lawyers who help put together big business deals. But even lower-level employees from office secretaries to public relations executives have been named defendants in insider trading cases. And it's easy to see how, as even the office secretary could get copied on e-mails of a potential merger or acquisition deal.

Many corporations have a "quiet period" before and after quarterly earnings are reported during which employees cannot trade in their employers' shares. But those policies don't always act as a deterrent. Even the most unlikely suspects, such as railroad yard workers, who seem very far removed from high-level business negotiations, have been accused of insider trading.

In September, the SEC accused two employees who worked in the railyard of Florida East Coast Industries and their relatives of profiting from a trade on inside information about the takeover of the company. The mechanical engineer and trainman both worked in the Bowden Rail Yard in Jacksonville, Fla., and it appears they had a hunch that some kind of big business deal was up after noticing that "there were an unusual number of daytime tours" with "people dressed in business attire," according the SEC. The two men and their family members bought thousands of dollars of call options on the company's shares (Florida East Coast Railway was a wholly-owned subsidiary of Florida East Coast Industries). In May 2007, when Fortress Investment Group (FIG) acquired Florida East Coast Industries, the men and their families profited more than $1 million. As employees, they were subject to a code of conduct that prohibited them from trading in FECI stock if they knew about significant non-public information about the company, according to the SEC.

Corporate executives

If there's such a thing as a typical insider, this is it. No one has more intimate information about pending deals of their own companies than high-level executives and board members. They help put virtually all big deals together with the help of attorneys, bankers and consultants and they get regular briefings over how projects are doing, from its time line to its costs. But leaking non-public material information outside could land executives behind bars.

This was the case in 2003 case when former ImClone Systems (IMCL) CEO Sam Waskal, who dreamed of developing a blockbuster cancer drug, got sidetracked by a 7-year prison sentence. The scientist and businessman admitted selling his stock of ImClone based on advance word that the FDA was going to reject the company's application for approval of a cancer drug. This is related to the case that landed business magnet Martha Stewart behind bars in 2004 for lying to investigators.

Even former executives can be considered insiders, no matter how long they've been away from the company. They typically have vast networks of former colleagues with intimate knowledge of insider company information.

Traders

A trader isn't typically a traditional insider but rather more of a tip-ee. As the Financial Times points out, it's pretty routine for traders and investors to hit up their contacts at public companies for information about sales and earnings. Where it becomes a legal issue is when trades are made on very specific information about a pending deal. Such was the FBI's focus in 2009 surrounding New York City hedge fund Galleon in which an Intel (INTC) employee told the hedge fund's founder, Raj Rajaratnam, about details of pending deals. The employee pleaded guilty earlier this year.

Lawyers, bankers and consultants

This is another group of obvious insiders. Putting together a leveraged buyout or some other large-scale deal takes a team of experts. From the lawyer who drafts and helps negotiate the terms of a deal to the banker who analyzes its value to the consultant who offers industry insight, at some point these individuals hear and see intimate details of a deal.

Ordinarily insider trading takes place when the confidential information shared is material – that is, relevant enough to give certain groups a significant advantage over others. But while many legal experts use that as a rule of thumb, it's almost anyone's guess what is significant enough to put some at a bigger advantage than others.

As federal investigators reel in insider trading on Wall Street, the practice looks to be something hard to enforce.

Also on Fortune.com:

Now we're talking turkey: Insider trading arrests begin

Insider trading probe touches Janus

How expert networks came to dominate Wall street

Join the Conversation
About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

Email | @ninhaitseng | RSS

Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.