Insider Trading, Investigation, MNPI, SEC, Securities Laws

How does the SEC Track Insider Trading?

Contrary to popular belief, insider trading is not always illegal. Legal insider trading is frequent occurrence by corporate insiders like C-level management, directors, and high-level executives. These insiders are legally permitted to buy and sell shares of the company so long as all transactions are properly registered with the SEC and filed accordingly. Legal insider trading happens pretty frequently – most common examples include a CEO or C-level management buying back shares of their company or when employees purchase stock of their employer. In the case of C-level management, often the buying/selling of the stock by these individuals may move the needle in terms of price just because these individuals hold large blocks of shares (C-level management typically earns stock options as part or all of their compensation).

The U.S. Securities and Exchange Commission (SEC) defines illegal insider trading as the buying and selling of a public company security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information (MNPI) about the security. Simply obtaining inside information is not illegal. Reporters and journalists, for example, use inside information to obtain earnings data before it is disclosed and used for a story. The act would be illegal if the reporter used that information to buy a specific company stock before an announcement.

Its important to pursue insider trading cases to protect individual investors, ensure that no one has an unfair advantage and to prevent any undermining of public confidence in the capital markets.

What does Material mean?

The definition of material information has not been precisely defined but has been explained in case law as any information specific to a company that would be considered important enough for an investor who is considering buying or selling the stock. This could be business developments, mergers/acquisitions, dividend share increases/decreases, winning or losing major contracts, positive or negative earning statements, strategic plans, impending or potential litigation, etc.

The SEC has brought hundreds of insider-trading cases over the years. Most common types of cases include:

  • Corporate insiders who traded the company’s securities after learning of significant, confidential developments;
  • Insiders’ friends and family, as well as other recipients of tips who traded securities after receiving such information;
  • Employees of service firms such as law, banking, brokerage, and printing companies who came across material nonpublic information on companies and traded on it; and
  • Government employees who obtained inside information because of their jobs.

How Easy is it to Track Insider Trading?

Insider trading doesn’t leave clear tracks outside of a radical increase in trading of a certain security before a public announcement of the event. In such instances, the common cause of this is that someone has received material, nonpublic information ahead of the announcement.

The SEC monitors insider trading in the following ways:

  • Market Surveillance – using sophisticated surveillance tools, the SEC detects irregularities in trading volumes and patterns especially around the time of earnings reports and key corporate developments. These irregularities are pretty evident. Someone trading on inside information is looking to make a lot of money, therefore putting in a large order to buy or sell. These anomalous trades are automatically flagged as being suspicious.
  • Tips – disgruntled traders and unhappy investors regularly complain and submit anonymous tips to the SEC highlighting suspicious trades. Tips can also come from whistleblowers can collect between 10-30% of the money collected from those who are charged with violating securities laws.
  • Media, Investigative Journalists, other SEC Divisions – insider trading leads can come from reporters, journalists, self-regulatory organizations (FINRA), other divisions within the SEC itself.

Investigation Phase

Once the SEC has gathered facts on a possible securities violation, the agency’s Division of Enforcement launches a private, full investigation. This stage entails interviewing witnesses, examining trading records, subpoenaing phone records and emails, using wiretaps, etc. The goal of this is to establish a chain of events to fit together the pieces of the evidence puzzle. Following the investigation, the Division of Enforcement presents their finding to the SEC for review which can authorize an administrative action or file a case in federal court.

  • In a civil action, the SEC files a complaint with a US District Court and seeks a sanction or injunction against the individual that prohibits any further acts that violate securities law, plus civil monetary penalties and disgorgement of illegal profits.
  • In an administrative action, the proceedings are heard by an administrative law judge who issues an initial decision that includes findings of fact and legal conclusions. Administrative sanctions include cease and desist orders, suspension or revocation of financial industry registrations, censures, civil monetary penalties, and disgorgement.

Bottom Line

Insider trading cases are vigorously pursued by the SEC and are punishable by hefty fines and lengthy incarceration. Maximum punishment for violating the U.S. securities laws as a result of insider trading includes:

  • Criminal penalties – the max. sentence for an insider trading violation is 20 years in federal penitentiary; $5 million criminal fine for individuals; and $25 million criminal fine for an entity/company.
  • Civil sanctions – disgorgement of profits gained or losses avoided subject to treble damages (basically liable for an amount up to 3X the profit gained or losses avoided); an individual could face a civil penalty not to exceed $1 million or 3X the profit gained or losses avoided as a result of the violation; and the violator is subject to being sued by a party adversely affected in the illegal trade.
  • Additional charges – individuals may also face prosecution for tax fraud, obstruction of justice, computer fraud, making false statements, disciplinary proceedings by a state licensing board and suspension/revocation of a license to practice in a professional field (e.g. CFA, MD, JD, securities licenses).

Share this:

Leave a Reply