Material Insider Information - Definition
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Table of ContentsWhat is Material Insider Information?What Qualifies as Material Insider Information?How Material Insider Information WorksExamples of Insider InformationHow do you Prevent the Communication of Insider Information?The Legality of Trading in Material Insider InformationExampleMaterial Insider Information versus Insider TradingAcademic Research on Material Insider Information
What is Material Insider Information?
Material insider information refers to a company's information that is not yet out to the public and is likely to affect the price value of the company's shares once it is out. In finance, information becomes material if it is able to affect the security's market value once it is released. Another term for insider information is the material non-public information.
What Qualifies as Material Insider Information?
Generally, when there is sharing of certain company's information to the public, it affects how investors make decisions. For instance, investors decision to buy or sell shares of a given company will highly depend on the information the company releases. The information may generally affect a companys price value of securities in the stock market.
How Material Insider Information Works
Lets assume that ABC company was not able to achieve its profit target for the quarter because it missed out its target per share by three cents. However, ABC company is not issuing a press release on this quarters financial information performance until after two days. In this case, the company has material insider information (non-public information). It is material insider information because it is likely to affect the investors' decisions when it comes to buying and selling of the companys shares once released.
Examples of Insider Information
Some of the material insider information, include and not limited to the following:
- Bankruptcy filings
- Change in the companys board of directors, public accounting firm, or corporate officers
- Information regarding a companys activities such as stock repurchase plans, change in dividends, stock splits, auction, a take-over bid, consolidation, private placement, or public offering, etc
- Changes in the fiscal year of the company
- Financial statements revision
- The pending change in rates
- Anticipated earnings that are inconsistent with expectations
- Pending sale or purchase of an asset, or significant orders
- Information developments in an ongoing legal dispute involving a firm
How do you Prevent the Communication of Insider Information?
Most investment companies, as well as financial institutions, have what we call firewalls. In business finance, a firewall refers to a legal barrier that prevents inside information sharing and the performance of financial transactions. The firewalls prevent the sharing of non-public information from one department to the other within a firm or institution. Meaning that any non-public information should remain within the walls of that particular department. In other words, firewalls are used to prevent interdepartmental communication. They can also be used to review the trading activity of employees. Apart from firewalls, firms and institutions may come up with lists of stocks that are not open to the employees and their families (restricted lists). Meaning that they are not allowed to trade in them. It is a good measure, especially where a company believes that its employees have access to insider information. Additionally, firms can also use code names when discussing transactions whose release is pending.
The Legality of Trading in Material Insider Information
Note that it is illegal for an insider information holder to use the information to his or her own benefit when trading stock. It is also against the law for him or her to share it with a family member or friend. It is even worse when the information is given out to help a person benefit during stock trading. The holder may be an insider like a director, officer, or employee. Illegal insider trading takes place when a person uses the information for the publicly-traded company to his or her own benefit. It may also occur when an entity involved in the trading stock access the information before a firm releases it to the public. An example of an entity is a stockbroker.
Lets assume that a marketing director of Company XYX happens to hear a discussion between the chief finance officer (CFO) and the Chief executive officer (CEO). A week before the release of the companys earnings, the CFO notifies the CEO that the company was not able to meet the initial revenue target. The company lost money in that particular quarter. Remember, this is already material insider information that the two have in their possession pending release to the public. Now the CEO uses this information to inform her cousin, who happens to hold shares in the company to sell her shares immediately. The cousin then sells her shares the following day ahead of the company earnings release. The action becomes illegal because the selling of the shares was as a result of sharing the insider information. Access to this information before its public release gave this particular investor an advantage over the other investors. On the other hand, even after receiving the tip earlier, the cousin sells her shares after the initial public release of the earnings, then the procedure is not illegal. In other words, using the insider information before it is released, is what makes the process illegal. However, any transaction done after a public release becomes legal. Note that insiders are not the only people who can face the law for engaging in illegal stock trading. Any other person who intentionally uses the material insider information to commit a crime qualifies for prosecution. Punishment for such offense may include:
- Loss of professional licenses
Material Insider Information versus Insider Trading
Generally, it is illegal to trade on material insider information. First, it takes away the confidence of the public in the financial markets as it leads to an unfair trading advantage. So, before you can determine whether or not something is material insider information, it is important to find out first if the source of information is reliable. However, nothing is cast on stone as there are also exceptions when it comes to trading on material insider information. For instance, sharing of insider information is allowed provided that those individuals adhere to the regulations set by the Security and Exchange Commission. For example, insiders can use the information if they are able to:
- Adhere to the set trading limit
- Publicly disclose their trade
It is also important to note that if an insider discloses the analysts information, it does not necessarily mean that the information is public.
Academic Research on Material Insider Information