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Explaining insider trading

Every eight years or so, it seems, the Congressional insider trading issue raises its head. This time round, the House has passed a bill banning insider trading by lawmakers, and there's talk the Senate may simply wave it through. That sounds like good news, except that -- like everything else up on Capitol Hill -- the term "insider trading" appears somewhat open to interpretation.

So what is insider trading?

The key to insider trading is what's called material non-public information. Insider trading takes place when a person in possession of material non-public information about a company buys or sells that company's stock. Imagine a chicken farm owned by a company called OrgEgg. Don't worry, it's a free-range organic farm, where the birds roam free over several acres. Because the birds are happy and well fed, they produce vast quantities of eggs and OrgEgg makes pots of money and its stock goes up, up, up.

There are certain things that everyone knows about the farm. They know how many hens there are, what they eat and on average how many eggs they lay. This is in the OrgEgg annual report, and thus it's all public information.
There are some things that only the company, the farmer and his hens know -- such as the gauge of his shotgun, the times of day that he feeds the hens, and the names of the dogs that guard the henhouse. None of this is in the OrgEgg report, so it's non-public information, but if someone found it out, it wouldn't be a big deal.

Finally there's the material non-public information. This is the stuff that the company wants to keep in-house and which someone could use to their advantage when buying or selling OrgEgg securities. For example, the fact that the farm is running out of grain and may have to switch to synthetic feed, which could affect both egg count and quality is material. The fact that more than 70 percent of the eggs are laid by a small group of hens, all of whom recently caught the flu, is material. The fact that the farm is expecting a delivery of a thousand new chickens is material.

It's legal to know this stuff -- after all, every hen in the house knows. It's also legal to uncover it. There are a bunch of foxes who are always hanging around the place asking questions, and we're pretty sure they know what's up.

What's not legal is when you use that information to make money. For example, Chicken Joe might decide to call a friend in the next farm over, send him a few hundred bucks via PayPal and get him to short OrgEgg's stock. When the news about the bird flu breaks, the stock crashes and Chicken Joe makes a bundle. That's illegal.

Likewise, one of those sly foxes might hear about that hen delivery and nip down to see his broker and buy a bunch of OrgEgg stock. When the news of the delivery breaks, and the stock inevitably jumps, old Foxy walks off with a packet.

So what's the big deal, you might ask. So what if someone with makes a trade based on information that she recognizes will affect the company's share price and that no one knows about yet?

Well, for one this it's unfair. Allowing people with inside information to trade on it leaves the rest of us at a disadvantage, and that's not cool. For another, it can encourage corruption. If people with insider knowledge are allowed to trade on it, then people with influence over events or a company's fortunes might be tempted to manipulate events so that they could profit from them. And that's REALLY not cool.

About the author

Paddy Hirsch is a Senior Editor at Marketplace and the creator and host of the Marketplace Whiteboard. Follow Paddy on Twitter @paddyhirsch and on facebook at www.facebook.com/paddyhirsch101

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