What is Insider Trading?

Insider trading occurs when a person uses material, nonpublic information about a company to buy or sell stock for personal profit. It is a breach of fiduciary duty for an insider to trade stock based on confidential information because it gives the insider an unfair advantage over other investors and allows them to trade with reduced risks.  

What rules govern insider trading?

The Securities and Exchange Commission ("SEC") regulates insider trading and is responsible for maintaining fair and orderly markets. The Securities Exchange Act of 1934 established the SEC and laid the groundwork for insider trading regulations. The rules and penalties for insider trading are made up of a variety of laws designed to ensure the integrity of the securities markets.

• Securities Exchange Act of 1934: Section 10(b) makes it unlawful for any person, directly or indirectly, to use misleading statements, manipulative devices, or omit essential information to buy or sell securities. Section 10b-5 targets insider trading by prohibiting the employment of any device, scheme, or article to defraud, making it unlawful for an individual to trade securities on material, nonpublic information.

• Section 16(b) of the Securities Exchange Act of 1934: Section 16(b), known as the short-swing profit rule, requires individuals who own 10% or more of a company's shares to report when they make trades in their company. If they buy and sell the company's stock within a six-month period, they must disgorge the profits to the company. This rule is designed to prevent insider trading even when knowledge of insider information cannot be proven by making it more difficult for insiders to use their insider information for personal gain.

• Insider Trading Sanctions Act of 1984: This federal legislation allows the SEC to charge people found guilty of illegal insider trading up to three times the amount of profit or loss, up to $100,000. The Insider Trading and Securities Fraud Enforcement Act of 1988 revised the original Act of 1984 increasing the maximum civil penalty to $1 million.

• 18 U.S.C. § 1348: As part of the Sarbanes-Oxley Act, this statute makes it a federal crime to engage in fraudulent schemes related to the buying or selling of securities.

• STOCK Act: The Stop Trading on Congressional Knowledge Act of 2012 addresses insider trading by members of Congress and makes it illegal for them to trade on material non-public information gained through their public roles.

Who is bound by the rules against insider trading?

Inside information belongs to the company and should not be used for improper, personal reasons. Therefore, trading on inside information is a fraud against the company and its shareholders.

            Who is an insider?

Pursuant to Rule 10b-5, an insider includes:

• Officers
• Directors
• 10% Stockholders
• Anyone who possess inside information because of their relationship with the company or with an officer, director or principal stockholder of the company

This last bullet point is intended to include any employee who obtains material non-public information and any person who has received a "tip" from an insider concerning information about the company that is material and nonpublic.  

            What is material information?

Material information refers to company information, whether positive or negative, which, if known, could reasonably be expected to affect the value of the company’s stock.

            What is nonpublic information?

Information is nonpublic if it has not been disclosed to the public generally and is not readily available through ordinary research or analysis. For information to be considered public, there should be some evidence that it has been widely disseminated and that the investing public has had time to absorb the information.

Examples of nonpublic inside information include:

• A material change in anticipated earnings
• Proposed public or private offerings or securities
• Loan defaults
• Pending or potential mergers, acquisitions, joint ventures, or sales of significant assets or other strategic plans
• Regulatory approvals, patent registrations or issuances, investigations, etc.
• A proposed offering or issuance of new securities
• Occurrence of or developments in major disputes, claims, or significant litigation
• A change in management
• New product announcements
• The gain or loss of significant customers, suppliers, or business partners

What are the elements of an insider trading claim?

The SEC, the company, or a shareholder in the company may pursue a claim for insider trading. A typical insider trading claim requires proof of these elements: 

• The defendant had access to “material” information;

• The information was “nonpublic”;

• The defendant purchased or sold the company’s security;

• The transaction was “based on” the inside information;

• There was a breach of the duty of trust or confidence; and

• The defendant acted with “scienter.”

What are the theories of insider trading?

• Classical Theory: The classical theory of insider trading applies to corporate leaders, such as officers, directors, and employees, who have access to company information by virtue of their position within the company. This theory is implicated when the corporate leaders trade securities of their own company while in possession of material, nonpublic information. When this type of trading occurs, there is a violation of the breach of duty of trust and confidence owed by the corporation's insiders to the company and its shareholders.

• Misappropriation Theory: The misappropriation theory of insider trading applies to corporate outsiders who obtain confidential information. This theory is implicated when the individuals trade on material, nonpublic information from the source of the information, not from their own company. When this type of insider trading occurs, there is a violation of breach of duty of trust and confidence owed to the source of the confidential information. Rule 10b5-2 identifies when a duty arises such that a breach would constitute misappropriation: (i) when a person has expressly agreed to maintain the confidential information; (ii) when the person sharing and the person receiving the information have a history of sharing confidences; and (iii) when family members share information.

What is the harm of insider trading?

Insider trading can damage market liquidity and efficiency by preventing prices from responding normally to new information and making it costly for investors to trade. This in turn reduces investor confidence in the marketplace. Insider trading can create a culture of corruption and self-dealing within the corporate structure and allows those in power to abuse their positions for personal gain. Insider trading can cause reputational damage that can lead to a loss of business.

Is all trading by insiders illegal?

There are certain times in which insiders can legally trade their company's stock:

• When trading is based on public information: After a corporate announcement, insiders can trade based on this now-public information.

• Through pre-established trading plans: In 2000, the SEC introduced Rule 10b5-1, which allows insiders to set up prearranged trading plans. These plans must be established when the insider doesn't have material nonpublic information. The plan must either: (1)  expressly specify the amount, price, and date of trades; (2) provide a written formula, algorithm, or computer program for determining amounts, prices, and dates; or (3) give all discretion regarding the power to execute securities transactions to an independent body or person.

• When the "insider" has filed SEC Form 4: An insider must provide this document to the SEC within two business days of the relevant transactions to report changes in their ownership of the company's securities. This includes transactions such as purchases, sales, or exercises of stock options.

What are the penalties for illegal insider trading? 

Individuals can be prosecuted civilly by the SEC or criminally by the Department of Justice. Importantly, the SEC can bring charges for insider trading even if the individual did not make any money from the trade.

• Criminal penalties can include imprisonment of up to 20 years and/or monetary fines of up to $5 million for individuals and $25 million for entities. Sentencing considers various factors, including "the profits made or losses avoided as a result of the insider trading, whether a position of 'special trust' was abused, and whether the defendant cooperated with the government (as well as the degree of any such cooperation)." The Mandatory Victims Restitution Act of 1996 (MVRA), provides another ground for criminal remedies as it mandates restitution for securities fraud victims and other victims of fraud or deceit.

• Civil: Civil remedies available against perpetrators of insider trading include disgorgement of profits gained or loss avoided by the insider trading, monetary penalties of up to three times the illicit windfall, suspension or bar from being (or being associated with) a broker-dealer or investment adviser, injunctive relief to prevent existing and future securities law violations, freezing assets, and punitive damages in certain circumstances.

Hypothetical examples of insider trading:

• A board member of a pharmaceutical company learns a new drug is going to be approved by the FDA. He buys shares of the company before the news is made public and sells them after the stock price goes up. Conversely, a board member learns the FDA is about to deny a new drug application, which will likely cause the company's stock to tank, so he sells his ownership in the company before that happens. 

• A CFO learns that his company is about to announce lower-than-expected earnings. The CFO then sells his shares of the company's stock before the news is made public making a profit before the stock sinks.

• The CEO of a company tells her daughter that the company is about to announce higher than expected earnings. The daughter purchases shares just before the announcement, after which the stock increases 25%.

• An attorney spends a weekend at her parents' house working on a merger deal for her client. Her father discovers the merger target through documents left on a coffee table and trades on the information. He reaps a great financial benefit when the deal is announced.

Examples of Famous Insider Trading Scandals:

• MarthaStewart: In 2021, Martha Stewart sold approximately 4,000 shares of ImClone stock just days before the FDA announced it would not approve ImClone's new cancer drug, Erbitux. The stock dropped 16% when the news was announced; Stewart's advance sale earned her $250,000. Stewart claimed that the sale was a pre-existing order, but it was discovered that her broker, who was also the broker for ImClone's CEO, tipped Stewart off that ImClone's CEO has placed orders to sell his and his daughter's shares in advance of the FDA's rejection of Erbitux. The SEC charged Stewart with obstruction of justice and securities fraud. She was convicted of insider trading and sentenced to a minimum of five years in prison, of which she served five months, and a $30,000 fine. 

• R. Foster Winans: Winans was a columnist at the Wall Street Journal. In his column, "Heard on the Street," Winans would profile a certain stock, which would increase or decrease in value based on his opinion. Winans arranged a deal with a group of stockbrokers – he provided them with the contents of the column in advance of publication, and they would purchase positions before the column was published. The brokers shared their profits with Winans in return for the information. Though Winans' column contained personal opinions, the SEC convicted Winans based on the claim that the information belonged to the Wall Street Journal, and not to Winans. Winans was found guilty of 59 counts of securities fraud and served nine months in Federal prison.

• Raj Rajaratnam and the Galleon Group: Rajaratnam founded the Galleon Group hedge fund. Between 2003 – 2009, Rajaratnam manipulated an insider trading scheme using tips from corporate insiders to trade stocks, which profited him $60 million. In 2011, Rajaratnam was convicted and sentenced to 11 years in prison, was fined $10 million, and ordered to forfeit $53.8 million. The SEC imposed an additional $92.8 million penalty. Rajat Gupta was also involved in this scandal. The SEC charged Gupta with illegally tipping off Rajaratnam while serving on the boards of Goldman Sachs and Proctor & Gamble.

• Stephen A. Cohen: Steven A. Cohen founded hedge fund SAC Capital Advisors. The SEC brought an insider trading case against some people working for SAC Capital who had generated big profits by skirting the rules surrounding non-public information. One specific case involved a pair of employees who made illegal profits by using leaked knowledge about clinical trials. Cohen avoided jail time because it was determined that he did not encourage the practice but had failed to conduct appropriate supervision. Nevertheless, the case resulted in almost $2 billion in fines and a two-year ban preventing Cohen from managing outside money.

If you suspect that the insiders of the companies you are invested in are acting on illegally obtained inside information, we can help.