Successful stock trading requires access to information — preferably publicly available information. However, some investors attempt to get a jump on the market by using insider knowledge to make buying, selling and holding decisions. Federal and state laws prohibit trading by anyone with material nonpublic information about a stock’s underlying company. And it’s illegal for holders of material nonpublic information to share it with others who then use the tips to trade.

Insider trading policies aren’t required of public companies. However, having a policy can reduce your company’s risk and help insiders understand what actions might constitute a violation of securities law.

5 elements

A good insider trading policy typically answers the following questions:

1. Why does the policy exist and whom does it cover? Your policy should define insider trading, describe the laws prohibiting it (including sanctions and penalties for violating them), and specify who’s covered by insider laws and regulations. Most policies define covered individuals as directors, officers, employees and third parties such as consultants, agents and advisors. Policies also usually apply to family members of those who are covered.

2. What constitutes material nonpublic information? For information to be considered material, it simply needs to be something a reasonable investor would consider important when deciding whether to buy, sell or hold an investment. Nonpublic information is exactly what it sounds like: information that hasn’t been released to the general public.

To help individuals understand the terms, some companies provide examples. A company might, for instance, be in the process of vetting an acquisition target. It may have determined that it will miss earnings estimates this quarter. Or it may be planning a stock buyback or stock split. Such information has the power to move markets if it becomes generally known.

3. What’s required of covered individuals? In clear and compelling terms, the policy should detail how individuals can comply. They can’t, for instance, place trades or instruct others to do so if they possess material nonpublic information that would provide them with an unfair advantage. However, employees generally are allowed to invest in their employer’s stock as long as they don’t use material nonpublic information.

4. Do special rules apply to company leaders? To set the appropriate tone at the top and pinpoint those with the greatest access to sensitive information, some companies place additional trading restrictions on directors, officers and executives. For example, your policy might prohibit trading in your company’s securities at a certain point prior to the release of financial results or if it’s involved in a merger or lawsuit.

5. What are the exceptions? Your company may identify individuals in senior roles who must obtain prior approval (usually from your general counsel) before buying, selling or gifting your company’s securities. Failure to complete a transaction within the period of time specified would require them to resubmit their request. If they’re allowed to trade, corporate insiders (directors, officers and those with more than a 10% stake in the company) must report their transactions to the SEC within two business days.

Penalties and surveillance

Given the complexity of securities law and the impact on those covered, creating or updating an insider trading policy usually requires input from legal counsel, financial advisors and HR representatives. But it’s worth the effort because penalties for insider trading are steep. They can include imprisonment for up to 20 years, criminal fines of up to $5 million and civil penalties of up to three times the gain made or loss avoided. You also need to consider how news of insider trading can affect everything from sales to public relations to employee morale.

Although insider trading isn’t easy to prove, the SEC uses surveillance tools to ferret out unusual trading activity around corporate events, and then follows up with in-depth investigations. The SEC also relies on tips and complaints from whistleblowers within companies, market participants such as traders, and even other government agencies.

Consequential allegation

Any illegal activity within your organization can put its financial security and reputation at risk. But insider trading is one of the more consequential allegations that can be made against a company and its leaders. A robust insider trading policy can protect your company and discourage individuals from crossing the line.

(This is Blog Post #1278)