Using insider information to make investment decisions on the stock market is illegal and can lead to serious financial penalties.
This type of investment fraud is commonly referred to as insider trading.
In this article, we will cover the definition of insider trading, how it is detected and prosecuted when insider trading is illegal, and the potential penalties that a person may face if convicted.
For example, if a company insider tells his or her friend about an upcoming merger that has not been made public, both the company insider and the friend could be held liable for insider trading if the friend buys the stock.
IMPORTANT: The definition of an “insider” for insider trading purposes is far broader than most people realize. While it includes corporate officers and directors, it also covers employees at lower levels, friends and family members, and other persons who have access to nonpublic information.
Who is an “insider”?
An “insider” is anyone who is an officer, director, 10% stockholder or has access to inside information as a result of his or her relationship with the Company or an officer, director, or principal stockholder of the Company.
According to SEC Rule 10b-5, the definition of an “insider” goes considerably beyond these key company personnel. In fact, this rule also covers ANY employee who has access to confidential information as part of his or her job duties. In addition, if ANY person outside of the company has received a “tip” from an “insider” about the material, nonpublic information, that person would also be considered an “insider” under this rule.
Lastly, Rule 10b-5 also covers any family members or close friends of an “insider.” For example, if the CEO of a company tells his son about an upcoming merger, and the son then buys stock in the company before the merger is public knowledge, both the CEO and his son would be considered “insiders” under this rule.
Who can be charged with insider trading?
An individual is liable for insider trading when they have acted on privileged knowledge or confidential information that is not available to the general public to attempt to make a quick/easy profit.
This may include using information about:
- Upcoming mergers or acquisitions;
- Unreleased financial reports;
- New product releases;
- Changes in company leadership;
- and any other information that could give an individual an unfair advantage in the marketplace.
Identifying insider threats might be simple at times: CEOs, executives, and directors are immediately exposed to important information before it’s made public.
However, lower-level employees may also have access to this type of information, which means that anyone from an entry-level analyst to a janitor could be susceptible to committing insider trading.
Note: If you are under investigation or have been charged with insider trading, it is important to seek legal counsel immediately. An experienced SEC defense attorney can help you understand the charges against you and build a strong defense.
How is insider trading detected?
Both companies and regulators try to prevent insider trading to ensure the integrity of a fair marketplace. Despite what you may have read before, not all insider trading is illegal.
Directors, workers, and management of a corporation may buy or sell the company’s stock with special knowledge as long as they notify the Securities and Exchange Commission (SEC) about those transactions; these trades are then made public.
Unfortunately, not all insider trading is this transparent.
Illegal insider trading happens when people use confidential information to make profits in the stock market. The SEC investigates and prosecutes these cases as they are a form of securities fraud.
Here are a few of the ways that the SEC detects insider trading:
Monitoring Trading Activity
The government tracks stocks that are being bought and sold to look for patterns that may be indicative of insider trading. The SEC monitors trading activity, especially around the time when significant events happen, such as a major announcement or earnings release.
This practice of surveillance can lead to the discovery of large, irregular trades around the time of these events. The SEC may then investigate the people behind those trades to see if they had access to nonpublic information.
Complaints From The Public
The SEC also relies on tips from the public to help detect insider trading. When the SEC receives a large number of complaints from investors who lose substantial sums of money around the same time, it can be an indication that insider trading has taken place.
Since the insider trader has special knowledge, they can leverage investment tactics like options trading on the company’s stock to make a lot of money in a short period. When this occurs, it can lead to other investors losing money and filing complaints with the SEC.
The SEC’s Office of the Whistleblower was created in 2011 to reward people who come forward with information about securities law violations, including insider trading.
The SEC gets tips from whistleblowers who come forward with information about potential violations. Whistleblowers can be current or former employees, lawyers, accountants, or anyone else with knowledge of insider trading.
Whistleblowers have incentives to come forward, as they may be eligible for a portion of the money recovered by the SEC. The maximum award is 30% of the amount recovered, and it can be higher if the SEC takes action based on the information provided.
Which regulatory agencies are involved in investigating insider trading?
The SEC is the primary federal regulator that investigates and prosecutes cases of insider trading. The agency has a division, called the Division of Enforcement, which is responsible for bringing enforcement actions against individuals and companies who violate securities laws.
The Department of Justice (DOJ) also plays a role in investigating and prosecuting insider trading cases. The DOJ can bring criminal charges against individuals who engage in insider trading.
In addition to government agencies, FINRA (Financial Industry Regulatory Authority) is a private organization that regulates the securities industry. FINRA can bring disciplinary actions against broker-dealers and individual brokers who engage in insider trading.
In order for federal prosecutors to establish a case for insider trading, they must be able to prove four key elements:
- In connection with the purchase or sale of a security, there has been a breach of a fiduciary duty or an instance of “trust and confidence” has been violated.
- The use of “material” and/or nonpublic information has been used to inform the decision to buy or sell of a security.
- The knowledge and/or reckless use of the insider information while trading in securities.
- There has been personal benefits (profits or prevented losses) due to the trading of securities.
IMPORTANT: If you are under investigation or have been charged with insider trading, it is important to seek legal counsel immediately. You will want to hire an SEC attorney who has handled these sorts of issues in the past.
Nonpublic information is defined as information that could significantly impact the price of a stock but is not known to the general public.
Of course, having access to such information might sway an investor’s decision to purchase or sell the security, providing them with a competitive advantage over the general public that does not have this knowledge.
IMPORTANT: The consequences of illegal insider trading can be severe. Individuals who engage in illegal insider trading can be fined and/or imprisoned. In addition, the SEC can bar individuals from serving as an officer or director of a public company.
According to the SEC’s Insider Trading Policy:
“Insiders are subject to insider trading laws that affect the sale and purchase of the Company’s stock. In conducting the business of the Company, Insiders may from time to time obtain material nonpublic information regarding the Company or other companies. Insiders may be sued civilly either by the Securities and Exchange Commission (“SEC”) or by private litigants if they trade in securities while in possession of material nonpublic information concerning the issuer of the securities. They may also be charged with a criminal violation. In recent years, the SEC and United States Attorneys have aggressively investigated and prosecuted persons who engaged in insider trading or tipped others.”
What are the penalties for insider trading?
Penalties for insider trading can be severe. Individuals who engage in illegal insider trading can be fined and/or imprisoned. In addition, the SEC can bar individuals from serving as an officer or director of a public company.
According to the SEC, a conviction for insider trading can result in:
- Fines of up to $5 million
- Imprisonment of up to 20 years
- Being banned from serving as an officer or director of a public company
- Disgorgement of all ill-gotten gains plus interest
Have you been charged with insider trading?
If you have been charged or are under investigation for insider trading, it is important to seek the advice of an experienced SEC defense attorney.
The SEC has limitless resources and will aggressively pursue those it believes have violated the law, independent of whether the government can actually prove its case.
An experienced attorney can help you navigate the SEC’s investigation and, if necessary, defend you in court.
If you are under investigation for insider trading or have been charged with a securities crime, contact the Law Offices of Robert Wayne Pearce, P.A., today.
Attorney Pearce began his legal career at the United States Securities and Exchange Commission (“SEC”) as an enforcement attorney more than 40 years ago. His SEC defense law practice clients have included public companies and their officers and directors, broker-dealers, investment advisors, and individuals being investigated in connection with their personal securities transactions.