What is the risk of insider trading for private companies and their shareholders?

The risk of insider trading for a shareholder of a private company is completely different from that for the shareholder of a public company. This is due to the fact that private companies do not report to the public.

Public companies by their nature periodically report information to the general investing public. This means that as a shareholder you have access to the same amount of information as anyone else of the investing public, whether they own shares or not. In such a situation, the risk of insider trading arises if, as a shareholder or otherwise, you possess so called ‘material non-public information’. Nonpublic information is information that is not available to members of the general investing public. Such information is a rare commodity in the context of public companies, and is usually obtained via conspiracies involving company insiders. The findings of the Gupta trial provides a good example of such a conspiracy.

If you own shares in a public company, bar exceptional circumstances where you have obtained nonpublic information, the risk of insider trading when selling your shares is low.

Private companies on the other hand do not disclose much to the general investing public. In fact, they almost never disclose anything to the public. The few people aside from senior executives with access to company information are the institutional shareholders such as VCs, who have access to information by way of privately negotiated information rights. Also employees in general will have had access to varying levels of corporate information.

This creates a particular set of problems for a shareholders wishing to sell shares: as a shareholder there is a good chance that you have had access to information that the general investing public will not have had access to, either because of your information rights, or because of your employment at the company. This means the risk of committing a de facto ‘insider trade’ when selling your shares to someone from the general investing public is much higher for shareholders of private companies than it is for shareholders of public companies. In the context of a private company, you might possess nonpublic information simply because you worked at the company.

While it seems that many in the tech industry think that insider trading does not apply to private company stock, this is a mistake that could cost dearly. If you wonder whether the SEC really is looking into insider trading at private companies, here is the proof that they do.

So what can private companies do to reduce the risk of insider trading for their shareholders who wish to sell shares? The answer seems to be that the company should make information available to the buyer of the shares, in order to reduce the risk of insider trading for the seller. Ideally this should be the same information to which the selling shareholder has had access.

To quote from The Facebook Effect: Secondary Markets and Insider Trading in Today’s Startup EnvironmentOnly the startup firm itself can effectively make available to counter-parties the kind of information that would ensure that a sale or purchase does not run afoul of the prohibition on insider trading. It is therefore prudent for the company itself to set the terms under which its employees, consultants, and advisors can trade in its securities.

So ideally shareholders of private companies should only attempt to sell shares to buyers who have had access to the same level of information as the seller themselves, which can practically only be achieved by having the company cooperate with the transaction.

So what do companies need to do to prevent their shareholders from selling outside of this scope? The companies could adopt an Insider Trading (IT) policy.

The above quoted article provides some cues as to what such a policy should entail:

  • Prepared by outside securities counsel, an IT Policy should make clear to all company employees that trading by insiders may in certain circumstances be illegal under federal securities laws
  • The IT Policy should establish a general principle that no employee should trade or cause someone else to trade the company’s securities while in possession of material nonpublic information.
  • The IT Policy itself should help educate rank and file employees, who are very likely not to have any familiarity with securities law, by providing clear examples of what material information means.
  • Examples of material information are financial information such as revenues, operating margins, or net income; risk factors such as potential environmental liabilities; and background information on key executives.

The article concludes that “although the founders of, and investors in, early-stage companies may chafe at the restrictions that an IT Policy places on liquidity, it is important that their counsel remind them of the far more catastrophic risk of facing liability for insider trading. “

Further discussion on the topic can be found on Quora.

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1 comment
  1. “What is the risk of insider trading for private companies and
    their shareholders? | OpenShares’ blog” tmcent was a remarkable article. If merely there were far more web blogs like this specific one in the world-wide-web. Anyhow, thanks for your personal precious time, Adrienne

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