Insider Trading Laws

Access to information that is not available to the general public can provide an edge in trading securities. However, the law aims to level the playing field by barring “insiders” from taking advantage of this edge. Someone convicted of insider trading could face years in prison. Anyone under suspicion should be aware that discussing the situation directly with police or prosecutors could undermine a potential defense. Even if they believe that they are innocent, they should not talk to law enforcement until they have consulted an attorney.

What Is Insider Trading?

Insider trading may be charged when a corporate insider buys or sells a security based on non-public information, or when someone misappropriates confidential information to use in trading a security.

Elements of Insider Trading

The Securities Exchange Act of 1934 provides the main basis for insider trading prosecutions. 15 U.S. Code Section 78j, also known as Section 10 of the Act, prohibits using a “manipulative or deceptive device or contrivance” contrary to rules enacted by the Securities and Exchange Commission in connection with the purchase or sale of a security. This implicates Rule 10b-5, which defines “manipulative and deceptive devices.” A separate provision of the Securities Exchange Act requires a prosecutor to show that the defendant “willfully” violated the law.

In U.S. v. O’Hagan, the U.S. Supreme Court explained that a prosecutor has two ways to get a conviction for insider trading. The standard, “classical” theory of liability provides that a corporate insider commits securities fraud when they trade in the securities of the corporation based on material non-public information. This is considered a “deceptive device” under the Securities Exchange Act because it violates the relationship of trust between the insider and the shareholders of the corporation. Meanwhile, a newer “misappropriation” theory of liability provides that a violation occurs if a person misappropriates confidential information for the purpose of securities trading, breaching a duty owed to the source of the information.

SEC Rule 10b5-1 reaffirms these theories of liability. It explains that “manipulative and deceptive devices” under Rule 10b-5 include buying or selling a security on the basis of material non-public information in breach of a duty of trust or confidence owed to the company or its shareholders, or to another person who is the source of the information. This regulation further explains that trading “on the basis of” material non-public information involves buying or selling a security when the person making the transaction was aware of the information at the time.

Some defendants also might face charges under 18 U.S. Code Section 1348, part of the Sarbanes-Oxley Act. This prohibits knowingly executing (or attempting to execute) “a scheme or artifice” to defraud someone in connection with a security, or to obtain money or property in connection with the purchase or sale of a security through false or fraudulent pretenses, representations, or promises.

State laws may prohibit insider trading as well. For example, Pennsylvania has a statute addressing “inside information.” This prohibits an insider from purchasing or selling a security when they know material information about the company that would significantly affect the market price of the security and that is not generally available to the public, and the insider knows that the information is not intended to be publicly available. As with the federal Securities Exchange Act, a violation must be “willful” to warrant criminal penalties.

Example of Insider Trading

Paul is a director at ABC Group. He finds out from an internal email that the CEO is about to be indicted for fraud. Paul quickly sells his stock in the company before the indictment is announced.

On the other hand, consider a situation in which Peter is a director at XYZ Group. He finds out through an internal chat that the CEO is a fan of the football team that Peter supports. He gets excited by this discovery and buys more stock in the company. This is probably not insider trading because the CEO’s rooting allegiances would not influence most shareholders.

Offenses Related to Insider Trading

Some other offenses that could be charged in situations similar to those supporting insider trading charges include:

• Securities fraud: this can cover many types of deception beyond insider trading, such as pyramid schemes, Ponzi schemes, and creative accounting
• Embezzlement: another type of financial crime involving the misappropriation of money or property with which a person has been entrusted
• Wire fraud: often involves efforts to defraud by using phones or computers
• Perjury: could be charged if someone lies under oath about their actions as a corporate executive or director
• Bribery: could be charged if someone tries to pay off a government agent investigating allegations of insider trading

A prosecutor might charge multiple offenses if the evidence supports them and then negotiate with the defendant over dropping some charges in exchange for guilty pleas to others.

Defenses to Insider Trading

Since a prosecutor must prove that the information was both material and non-public, a defendant might challenge either of these elements. They might claim that the information was not important enough to affect the decision-making of an outside investor. Or they might claim that the information had been made public when they performed the transaction. In other cases, a defendant might argue that they did not have access to the inside knowledge at the time of the trade, even though others in the company may have been aware. Perhaps they were not included in an internal email or meeting disclosing the information.

Rule 10b5-1 sets out certain affirmative defenses that allow a person to show that their purchase or sale of a security was not “on the basis of” material non-public information. These generally involve a contract, instruction, or plan involving a purchase or sale of the security that the person had formed before becoming aware of the information. The contract, instruction, or plan must have contained certain specifications, and the purchase or sale must have fallen within the scope of the contract, instruction, or plan.

Penalties for Insider Trading

A criminal violation of the Securities Exchange Act may result in a fine of up to $5 million and imprisonment for up to 20 years. (A defendant will not be sentenced to imprisonment if they can prove that they did not know about the SEC rule or regulation that they violated, although this is unlikely in the context of insider trading.) A conviction under the securities fraud provision in the Sarbanes-Oxley Act carries up to 25 years of imprisonment, as well as a fine under Section 3571 that depends on the circumstances surrounding the offense.

Penalties under state laws may be less severe. For example, a violation of the Pennsylvania insider trading law generally carries a fine of up to $250,000 and up to seven years of imprisonment, although the maximum fine is $500,000 if the violation involved $250,000 or more.

Last reviewed September 2024