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Trading a public company’s stock using material non-public information is illegal and subject to harsh penalties under federal law.
HOW TO AVOID A CRIMINAL INSIDER TRADING CASE
INTRODUCTION
Insider trading carries negative connotations even though it is not always wrong or illegal.
For this reason, anyone involved in trading public company securities — professionally or personally — must understand the differences between legal and illegal insider trading to avoid a criminal investigation.
WHAT IS INSIDER TRADING?
Simply put, an insider is someone who has either (a) access to valuable non-public information about a company or (b) ownership of more than 10% of a company’s equity, including directors and high-level executives.
Formally, the US Securities & Exchange Commission (SEC) defines an insider as a “director, senior officer, or any person or entity of a company that beneficially owns more than 10% of a company’s voting shares.”
In addition, for criminal legal purposes, insiders also include people with access to material non-public information about a company.
LEGAL INSIDER TRADING
Insider trading happens in the stock market all the time. Insider trading is legal as long as it conforms to the rules set forth by the SEC.
Legal insider trading often happens when a CEO buys back company shares or employees purchase stock in their own company. As long as the transactions are disclosed and registered with the SEC, insiders can trade in their companies’ shares. However, the federal government closely scrutinizes insider trading because it has significant potential to influence share prices in the open market.
The Securities Exchange Act of 1934 requires legal disclosure of company insiders’ stock transactions. Directors and significant owners of stock must disclose their stakes, transactions, and change of ownership. And their companies have to promptly report their insider transactions electronically to the SEC, which they must also disclose on the company website.
WHEN IS INSIDER TRADING ILLEGAL?
Illegal insider trading involves buying or selling a public company’s stock based on non-public material information about that stock. The SEC defines illegal insider trading as: “The buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, based on material, non-public information about the security.”
Material information is any information that could substantially impact an investor’s decision to buy or sell the security. Non-public information is information that is not legally available to the public.
The illegal use of non-public material information for profit is the crux of the criminal conduct. Anyone’s transactions are subject to the SEC’s review: company officers and executives, their friends and relatives, or anyone else, as long as the information is unknown to the public. Significantly, illegal insider trading includes tipping others about any material non-public information.
For example, if the Chief Financial Officer of a public company inadvertently discloses quarterly earnings at the deli, even the clerk who takes this information and trades on it could get wrapped up in a criminal insider trading investigation. Or, what if someone learns about non-public material information from a family member and shares it with another? Anyone who uses the information to profit in the stock market can become a target of a government investigation.
The SEC closely monitors insider trading. The SEC can monitor illegal insider trading by looking at the trading volumes of any particular stock. Volumes commonly increase after material news goes public. However, if trading volumes rise dramatically without any public news to support such trading patterns, the SEC can flag those transactions for further scrutiny. The SEC then investigates to determine the persons involved in the unusual trading and whether or not material non-public information played a role.
The SEC takes its role to maintain a fair marketplace for all very seriously, believing that anyone trading based access to inside information would have an unfair advantage over investors lacking the same information.
*Pro-Tip: Anyone who comes across material non-public inside information would be wise to avoid trading on it. Remember to consult with legal counsel regarding any criminal investigation or court case.
In addition to criminal penalties, the Insider Trading Sanctions Act of 1984 allows the SEC to seek civil penalties for insider trading.
*Pro-Tip: Remember to consult with legal counsel regarding any court case or government investigation.
NOTABLE EXAMPLES OF INSIDER TRADING CASES
Martha Stewart 2003
In 2003, the SEC charged business mogul Martha Stewart with securities fraud—including insider trading—for her part in the 2001 ImClone case.
Stewart sold thousands of shares of ImClone Systems based on information received from Peter Bacanovic, her broker at Merrill Lynch. Bacanovi’s tip came after ImClone Systems CEO, Samuel Waksal, sold all his company shares, which was not public information.
At the time, ImClone was waiting on the Food and Drug Administration (FDA) to decide on ImClone’s cancer treatment. But soon after Waksal’s insider sales, the FDA rejected ImClone’s drug application. The FDA’s action caused ImClone’s shares to fall more than 15% in one day. By selling her shares ahead of the market, Martha Stewart saved about $45,673. But it cost her a criminal charge, trial, imprisonment, and penalties.
Amazon 2015
Former Amazon financial analyst Brett Kennedy faced insider trading charges for providing non-public information on Amazon’s 2015 first-quarter earnings to a friend in exchange for $10,000. Quarterly earnings are always material information that could influence a person’s decision to trade in a company’s stock.
*Pro-Tip: Insider information is any fact that can be of financial advantage if acted upon before it is generally known to shareholders. Any information that could influence an investor’s decision to buy or sell a company’s stock is material.
Mylan 2021
Nasdaq news recently revealed that a former information technology executive at Mylan pleaded guilty to insider trading for using tips received from the drugmaker’s Chief Information Officer. Dayakar Mallu used the tips to trade in Mylan stock, generating $4.27 million of illegal profit. Mallu pleaded guilty to conspiracy to commit securities fraud (and other unrelated tax charges).
The government’s investigation found that between October 2017 and July 2019, Mallu traded Mylan stock based on material non-public information about the company’s financial results, the status of FDA drug approvals, and information about upcoming mergers.
The plea agreement indicates that Mallu faces 57 to 71 months in prison under the federal sentencing guidelines at sentencing. Mallu also agreed to forfeit $4.27 million and make restitution to the Internal Revenue Service. Finally, the SEC filed related civil charges.
The consequences of illegal insider trading can be quite devastating personally and professionally. Prison Professors, an Earning Freedom company, regularly works alongside our client’s legal counsel to help craft sentencing mitigation plans in advance of the sentencing hearing.
CONCLUSION
Company insiders are legally permitted to buy and sell shares, but insiders must register the transactions with the SEC. The SEC monitors insider trading activity and flags potentially illegal trading by looking at trading volumes increasing before significant corporate events. The SEC protects the market’s integrity, which it considers compromised when people have the unfair advantage of trading based on inside information.
In the end, the best way to avoid an insider trading investigation is to understand the rules of the road and err on the side of caution. In some unfortunate cases, even casual conversations about a piece of company information can result in an SEC investigation or prosecution. And even for innocent parties, these investigations are time-consuming and costly.
*Pro-Tip: Remember to consult with counsel regarding any aspect of a criminal or civil court case or investigation.
Prison Professors, an Earning Freedom company, helps clients locate and vet legal counsel experienced in insider trading investigations and court cases. We work alongside defense counsel to craft successful strategies for sentencing mitigation and other matters.
