Ok, this post is going to be a bit off the usual startup/VC path.  Insider trading is not typically associated with stock in a private company (like a startup) simply because there is no public market on which to trade the stock.  Fraud rules embodied in state and federal statutes certainly apply to both public and private companies, but it is really difficult to insider trade in a private company.  In fact it is practically impossible.  It is not impossible to commit securities fraud with private company stock. Insider trading is just one type of fraud, and there are plenty of other types of fraud that can snag private company transactions.

Keeping the concept simple, “insider trading” is buying or selling stock while in knowing possession of material non-public information about the company whose stock is being traded.  “Material” means that a reasonable person would want to take the information into account with respect to the transaction.  “Non-public” means that it is not known by the public/public markets.  And “knowing” means that the person trading knew (or should have known) that the information is not public.  A classic example would be when a CEO of Company X tells his/her spouse about upcoming good news that has not been publicly released (like a positive earnings report) and then the spouse goes and purchases a bunch of stock in Company X.  That is insider trading.  The CEO owes a duty to Company X’s shareholders and that duty is transferred to his/her spouse (via arcane case law rules involving “tippers” and “tippees”).  Another example would be when the CEO tips off his buddy at Hedge Fund YY and the buddy uses the information to trade (buy or sell) to make a profit or avert a loss for the hedge fund.  However, if a taxi cab driver hears the CEO chatting in the back seat about the good earnings release and then buys some stock in Company X prior to the release being made public, then the taxi cab driver is not insider trading in the legal sense because he does not owe any duties to the Company X shareholders.  Kind of nuts actually.  Insider trading laws and court interpretations are complex.

I just read a short piece in The Week magazine (one of my favorite magazines – the other is Smithsonian) in which the author argued that insider trading should be legal because there really is no victim and the government should go after the truly damaging securities fraud crooks (like Madoff).  The Week only provides short summaries; here is a link to the full article.

To me, this is 100% bogus.  There certainly is a victim (the person on the other side of the transaction) and since when should small time crimesters not be sought out?

In my view, the simplest and most efficient route would be to make knowingly trading on material non-public information illegal.  No caveats for duties to shareholders.  No caveats for tippers and tippees.  No caveats for all the other case law theories on the topic (and there are many of them).  My rule would capture the taxi cab driver. It would capture anyone who “knows” the information is non-public.  A jury would decide whether or not the information is “material”.  Juries are supposed to interpret subjective matters.

My bottom line on this issue is that stock trading on material non-public information is immoral and should be illegal.  Simplification of the body of law would be a step in the right direction.