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 Insider Trading FAQ Part 1 

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Michael Santos

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INSIDER TRADING: FREQUENTLY ASKED QUESTIONS

Using material non-public information to trade is illegal and subject to harsh penalties under federal law.

INSIDER TRADING FAQs

This 2-part blog answers key questions people frequently ask about insider trading and the role of the Securities and Exchange Commission (SEC) in insider trading. 

Also, questions are rising about the SEC’s role in regulating cryptocurrency and whether existing insider trading laws apply to cryptocurrency.

INTRODUCTION

More people than ever have access to the financial markets and engage in trading various financial instruments. Naturally, they have myriad questions about the crime of insider trading, knowing that insider trading jail time is a real potential consequence. 

In our experience, many people accused of insider trading did not even realize the illegality of their conduct. That’s because they trade after a conversation with another person without realizing that the person was sharing confidential information. While the lack of knowledge that the information was non-public and confidential might work as a defense, people still end up facing criminal charges.

Sometimes people trade stocks based on information they overheard and then wonder if it is illegal insider trading if you overhear

We will tackle all of these frequently asked questions in this 2-Part series. 

An insider trading charge can happen to anyone active in the stock market and acting on information or advice from others. Insider trading is illegal when trading a company’s stock based on material, non-public information. Prison or jail time for insider trading is likely under federal law. 

WHO IS AN INSIDER?

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 SEC defines an insider for insider trading 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.

WHAT ARE THE TWO (2) TYPES OF INSIDER TRADING?

There are two types of insider trading. One is legal, and the other is illegal. 

Legal insider trading is when insiders trade the company’s securities (stock, bonds, etc.) and report the trades to the authorities such as the SEC under applicable regulations. Acceptable 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, for example, 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 stock owners must disclose their stakes, transactions, and change of ownership. And companies have to promptly report their insider transactions electronically to the SEC, which they must also disclose on the company website. 

How do people check insider trading by company insiders? People check insider trading by company insiders on Edgar. Companies must report all insider trading to the SEC, and such reporting appears on the SEC Edgar database. 

The SEC’s Edgar database allows free public access to all filings related to insider buying and selling stock shares. Several financial information websites offer databases that are easier to use than Edgar to track insider buying. Canadian transactions are available on a government website and on other financial websites.

WHEN IS INSIDER TRADING ILLEGAL?

Insider trading is illegal when it involves buying or selling a public company’s stock based on material non-public 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. Quarterly earnings, for example, are always material information that could influence a person’s decision to trade in a company’s stock.

Non-public information is information that is not legally available to the public. Non-public information is sometimes called “insider information” because insider information, by definition, is not generally known. Insider information is any fact that can be of financial advantage to an insider if acted upon before it is generally known to shareholders and the public. 

The illegal use of material non-public information for profit is the crux of the criminal conduct in insider trading. And 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. The person providing the tip can face charges. 

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 material non-public 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.

IIS IT INSIDER TRADING IF YOU OVERHEAR?

It would not be illegal insider trading merely to trade on the information a person overhears, especially information in a public setting. For example, people may overhear information about a company standing in line at Starbucks. If the material non-public information is overheard in a private setting and then used to make trades, the legal risk might be quite different.  

It is not illegal per se to trade on tips that a person hears or overhears. Illegal insider trading takes into account the facts and circumstances of each case. 

Another example is when a company receptionist overhears members of the board of directors talking outside of a conference room. The board of directors agrees at the meeting to buy another company and pay a premium over the current share price. 

If the receptionist buys shares in the target company based on that information, they could face charges of illegal insider trading. The board members had private discussions and did not publicly discuss buying the target company. Moreover, the government might take the view that the employee has a duty under the circumstances to keep information overheard at work confidential. 

It bears noting that some people have overcome insider trading charges based on information they overheard by showing that they had no duty to ignore information they overheard in a public place. 

*Pro-Tip: Anyone who comes across material non-public inside information in any setting should exercise caution about trading on it and must understand the risks. Remember to consult with legal counsel regarding any criminal investigation or court case.

WHO GOT IN TROUBLE FOR INSIDER TRADING?

Some very prominent people have committed insider trading and got in trouble for it, including business mogul Martha Stewart in 2003. Securities industry mogul Ivan Boesky is at the heart of one of the most notorious insider trading scandals of all time. 

Martha Stewart

Stewart got in trouble for insider trading after she sold four thousand ImClone shares one day before that firm’s stock price tanked. Although Stewart’s insider trading charges got dismissed, she served time in prison for obstruction of justice and lying to investigators.

Stewart’s case presents an example of insider trading, what it is and why it is illegal. As noted below, insider trading is illegal because it provides the person trading with an unfair advantage over other people who participate in the financial markets. 

Stewart sold thousands of shares of ImClone Systems based on information received from her broker at Merrill Lynch. Her broker tipped Stewart that ImClone Systems CEO, Samuel Waksal, sold all his company shares, which was suspicious. Waksal’s sale of all his ImClone shares was not known to the public at the time. 

That is a classic example of insider trading. The reason why ImClone Systems CEO sold all of his company shares? Because he learned that the Food and Drug Administration (FDA) would reject ImClone’s proposal for a novel cancer treatment. ImClone’s CEO sold all his shares based on material non-public information, a classic example of insider trading,  and later received a sentence of seven years in prison as a penalty for insider trading.

Stewart and Waksal committed insider trading by selling their shares ahead of the market when they had material information that would affect the stock price once it became public. They traded with an unfair advantage. As such, both Steward and Waksal got in trouble for insider trading.

Ivan Boesky

Another classic example of insider trading is Ivan Boesky. Boesky got in trouble for insider trading after his scheme to pay for material non-public information was discovered in the 1980s. 

The Boesky case involved other people working at large US investment banks, who provided Boesky with tips about upcoming corporate takeovers. During an SEC investigation, the SEC discovered that Boesky, who had his own stock brokerage company, made his investment decisions based on material non-public information received from corporate insiders.

For example, Boesky had been paying employees of investment banking firms involved in mergers and acquisitions for information to help him decide what to buy. Boesky profited from nearly every major merger and acquisitions deal in the 1980s. Boesky’s penalty for insider trading included a prison sentence was three years.

Following the Boesky insider trading scandal, Congress passed the Insider Trading Act of 1988, which increased the penalties for insider trading. 

*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. Quarterly earnings are always material information that could influence a person’s decision to trade in a company’s stock.

WHAT IS THE PENALTY FOR INSIDER TRADING?

The penalty for insider trading can be civil, criminal, or both. 

People facing sentencing and punishment for insider trading can learn strategies to mitigate their prison sentence and obtain a better outcome. 

Prison Professors, an Earning Freedom company, helps clients craft a sentencing mitigation plan when they face a sentencing hearing. 

The consequences of illegal insider trading can be quite devastating personally and professionally. People should invest the time and effort to put together a sentence mitigation plan. 

Click here for videos from Justin Paperny regarding sentencing mitigation: Prepare For Shorter Prison Sentence.

As to the criminal penalties for insider trading, the maximum sentence for an insider trading violation is 20 years in federal prison. The maximum criminal fine for individuals is $5 million, and the maximum fine for a company is $25 million.

In general, people want to know what is the minimum sentence for insider trading.  There is no mandatory minimum for insider trading. The minimum sentence for insider trading is up to the discretion of the federal sentencing judge. Although the sentencing guidelines may suggest that a particular defendant receive a prison or jail sentence for insider trading, with a maximum prison of up to 20 years, the sentencing judge has the discretion to depart downward and sentence a defendant to probation. 

In addition to criminal penalties, the Insider Trading Sanctions Act of 1984 allows the SEC to seek civil penalties for insider trading. 

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

There are two types of insider trading, legal and illegal. 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 illegal kind, one breaches the company’s trust by trading based on the inside information while others remain ignorant. In legal cases, an insider buys or sells securities of their corporation based on the inside information.

In the end, the best way to avoid an insider trading investigation is to err on the side of caution. In some cases, even casual conversations about 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.

Prison Professors, an Earning Freedom company, works alongside (not in place of) civil and criminal defense counsel to help clients proactively navigate through investigations and prosecutions. Our team also helps clients prepare mitigation and compliance strategies.

If you have any questions or are uncertain about any of the issues discussed in this post, schedule a call with our risk mitigation team to receive additional guidance.

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