Why is insider trading illegal? The US makes it clear that insider trading falls into the category of security fraud. The SEC states that “it includes any person who uses or employs, directly or indirectly, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe…”

According to the US Securities and Exchange Commission, insider trading is also a violation of the anti-fraud provisions and of the Insider Trading and Fraud by those in Special Relationships sections of the Securities Exchange Act of 1934.

In order to understand why insider trading is illegal, it is first necessary to understand what insider information is. The law considers every investor to have a duty in equity, an “expectation interest”, that a company will disclose all material information that could affect the price of its stock. All material information is material that could “reasonably be expected to affect the value of the corporation’s stock or otherwise materially affect the market for its stock.”

Purchasing or selling of a security is not a crime. The law only becomes applicable when there is an action that defrauds another, such as an insider trading transaction. Any time there are material securities being transferred from one person to another there must be disclosure. The disclosures should be made public information to prevent insider trading.

Insider trading is not illegal if the source of the information is factual and publicly available. If the source of the information comes from a public document, then it is not a violation. The main issue that surrounds insider trading law is when a person who possesses privileged or material non-public information purchases or sells securities with knowledge that this action will affect an equity market in a specific direction – to his or her advantage.

There are a number of reasons Insider Trading is illegal in the United States. The first is out of the need to protect the shareholders and investors in a corporation. The corporation should be working on its own behalf, not to benefit individuals who have knowledge that may affect a stock’s value. This information is not the result of a mistake, or personal or private gain. The second reason why insider trading is illegal is that it actually affects the market. If a person knows the details of a broader market at this moment, he or she can influence it by selling or buying stock. Thus, this action can have negative effects on an entire economy in which the company in question and its shareholders are also part of.

There are laws against insider trading in the United States. Securities and Exchange Commission v. W.J. Howey Co., 328 U.S. 293, 301 (1946) declared that the definition of “security” is “a fungible, negotiable financial asset that is readily tradable in secondary markets” (such as a stock or bonds in the US). Securities and Exchange Commission v. Texas Gulf Sulphur Co., 401 F.2d 833, 849 (2nd Cir. 1968) said that “The common thread running through all these definitions is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”

In a 1933 case, SEC v. W.J. Howey Co. the Supreme Court of the United States defined a security to be any “investment contract …in which a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party,” who is known as the “purchaser of a security.”

As a matter of law, the SEC considers insider trading to be fraud. The SEC defines “fraud” as "an intentional misrepresentation of a material fact which is made with the intent to induce another party to act on it and thereby to deceive that party." The Supreme Court has held that it is the intent of the person making disclosures that matters – not the action, or consequences thereof.

Takeaway: The concept of insider trading laws is that if a person learns material information that affects the value of stock held by another person then they must disclose this information to ensure any subsequent transactions are not considered an illegal act. This is to protect the investors who are interested in making profit through proper investment decisions.