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The Business Ethics of Insider Trading

written by: John Garger•edited by: Ronda Bowen•updated: 12/30/2010

Insider trading and business ethics are two subjects that are often discussed both in news media and business school classrooms. Learn the definition of insider trading and how it relates to material information, business ethics, and financial and criminal penalties.

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    In the wake of the Enron scandal, insider trading was once again brought to the front pages of business newspapers and magazines. The grey areas that surround insider trading help confound the public’s understanding of the definition of insider trading and the business ethics issues associated with it. This article briefly discusses a definition of insider trading and explores the business ethics, the concept of material information, and the financial and criminal penalties associated with insider trading.

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    Insider Trading Definition

    picture Insider trading is said to occur when an individual with special knowledge of a corporation uses this knowledge to buy and/or sell securities such as stocks and bonds to make a profit. This special knowledge is known as material information and includes any pertinent knowledge about a company that is not known to the general public.

    Suppose, for example, that a company is about to announce that its quarterly earnings were much higher than that which was forecasted in the previous quarter. An individual on the inside of the company, say a manager or vice present, who quickly buys up stock in the corporation knowing that the pending announcement will drive up the price of the company’s stock, is said to have engaged in insider trading. The underestimated quarterly sales is said to be material information not known to the general public.

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    Material Information and Business Ethics

    One of the problems of discussing business ethics in insider trading has to do with the definition of material information. Although material information is defined by whether it is known or not known by the general public, a question of who may possess this knowledge often creates a grey area from a business ethics point of view.

    For example, not all insider trading is perpetrated by people inside an organization. The term “insider" is a misnomer because you need not be inside the company to possess material information. If the vice president of the large corporation were to tell you about the underestimated quarterly sales, for example, you are said to possess material information. Using this information to profit from the public’s ignorance of the information would make you an inside trader even though you are in no way associated with the organization.

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    SEC Financial and Criminal Penalties for Insider Trading

    The Securities and Exchange Commission (SEC) has the power to seek legal action against individuals suspected of insider trading. Individuals convicted of insider trading may not only have to give back the profit they amassed through using the material information, they may, at the recommendation of the SEC, be forced to pay a penalty of up to three times the profit they made through insider trading.

    There is also the possibility of criminal charges. These criminal penalties carry with them jail time and further fines based on the principle of defrauding stockholders. This fraud may be categorized as a felony depending on the severity and consequences of the insider trading.

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    Insider Trading and Business Ethics

    The focus of business ethics when it comes to insider trading has to do with the idea of a level playing field. Generally, it is believed that securities markets work best when everyone is privy to the same information. Insider trading creates too much asymmetrical information allowing a few to profit at the expense of others. Consequently, trading becomes too risky and far fewer trades would take place as a result. By creating and maintaining a level playing field, investors have the confidence that their wealth will not be pulled out from under them because of unforeseen, asymmetrical information and insider trading.