Your Questions About Insider Trading Answered

The Securities and Exchange Commission (SEC), which is a federal, civil law enforcement agency that is empowered to enforce the federal securities laws.  Its statutory mission is to protect investors, to ensure financial market integrity, and to encourage the facilitation of capital formation.  In particular, the SEC has jurisdiction over the stock exchanges, options markets, broker-dealers and investment advisors, among other market participants.

The Department of Justice (DOJ) also has the authority to investigate and criminally prosecute illegal insider trading.  At times, the SEC and DOJ will conduct parallel investigations into the same insider trading that may result in both a civil and criminal prosecution of an individual.

Insider trading occurs when one buys or sells securities while in possession of material, nonpublic information (MNPI), in violation of a duty of trust or confidence.  In many instances, insider trading investigations target corporate insiders (executives, directors, or employees), but can also include anyone who receives confidential information (known as a tippee) and uses it to gain an unfair market advantage in breach of a duty.

There are two recognized legal theories of insider trading: classical and misappropriation.

Classical insider trading takes place when a corporate insider trades in his company’s stock based upon MNPI or tips one, referred to as a tippee,  who then trades on the information in violation of the insider’s fiduciary duty.

The misappropriation theory is where one who is lawfully entrusted with MNPI, such as a lawyer, accountant, or consultant, misuses it for personal trading purposes in breach of a confidentiality and/or fiduciary obligation.  The misappropriation theory was originated in the Supreme Court case of United States v. O’Hagan, 521 U.S. 642 (1997), which involved an attorney who traded options in the target company that was being acquired by his client.

An SEC investigation can be initiated based upon: news reports that discuss potential illegal insider trading, whistleblower tips, alerts prompted from sophisticated market surveillance tools that identify highly irregular and/suspicious trading, referrals from other securities regulators (including the Financial Industry Regulatory Authority), as well as filings made by officers of publicly traded companies that disclose their purchases and sales of company stock.

Yes, the Division of Enforcement is responsible for the investigation and prosecution of violations of the federal securities laws, including insider trading.  Other cases usually involve various forms of securities fraud, including Ponzi Schemes, offering frauds, spoofing and other forms of market manipulation,  It also prosecutes securities registration violations.

Most SEC insider trading investigations begin as an informal inquiry where the SEC does not have subpoena power (which allows the SEC staff to compel the production of documents and sworn testimony from individuals suspected of engaging in insider trading).  In the informal inquiry stage, the SEC must seek the voluntary cooperation of non-licensed individuals to obtain information.  However, the SEC can readily obtain trading information and other data from stock exchanges and broker-dealers without subpoena power.

Yes.  While the scope of documents requested by a SEC Subpoena can be negotiated or objected to, one cannot simply ignore or disregard a validly issued subpoena.  One does so at his own peril.  In the event an individual does not timely and/or sufficiently comply, the SEC has the legal authority to file a subpoena enforcement action in federal district court that will seek to force the individual and/or company to respond.  In most all instances, the SEC will prevail in such a legal action as it has broad powers to enforce its subpoenas.  Moreover, by the SEC filing such a lawsuit, it takes an otherwise non-public investigation and effectively makes it public by virtue of the court filing thus exposing the targeted individual to adverse publicity even before the insider trading investigation has been concluded.  Not a wise strategic move.

Yes, an individual, but not a corporate entity, can invoke his/her Fifth Amendment Right in an insider trading investigation.  This includes asserting the privilege in response to document requests sought in the SEC Subpoena, as well as to questions asked during sworn testimony.  In fact, the Fifth Amendment is not just for the guilty, but is also designed to protect the innocent.  The United States Supreme Court in the case of Ohio v. Reiner, 532 U.S. 17, 21 (2001) held that “one of the Fifth Amendment’s basic functions is to protect innocent men [and women] who otherwise might by ensnared by ambiguous circumstances.”

While the SEC may take a negative inference from an assertion of the Fifth Amendment, it still requires evidence to prove that illegal insider trading occurred – in other words, the SEC cannot rely exclusively on this negative inference.  While the critical decision to invoke or not invoke the Fifth Amendment is a complex one, often involving the weighing of several evidentiary considerations, I have often utilized the Fifth Amendment as an effective strategic tool in successfully defending my clients in SEC insider trading investigations.

There is no definitive time period for an SEC insider trading investigation.  Depending upon the complexity, number of suspected instances of insider trading, and others who may be involved, such investigations can take several months or sometimes years.

Legal defenses to insider trading include, but are not limited to, arguing that the information was either not material and/or non-public, or that the trade was not made based upon MNPI but rather for a legitimate trading reason.

At the conclusion of the SEC’s investigation, and based upon the evidence it has developed, the SEC can either: (1) drop the case and decline to bring an enforcement action, or (2) issue a Wells Notification, which is a formal notice that it intends to recommend civil prosecution.

Counsel has the opportunity to respond to a Wells Notification and attempt to persuade the SEC to not prosecute.  If not successful, one can seek to settle the case, or litigate it in federal court.  However, losing an insider trading case can lead to penalties up to three times the profit gain or loss avoided through the illegal insider trading.  See 15 U.S.C. § 78u-1.M.

The SEC will typically settle an insider trading case on a neither admit nor deny basis as to the allegations of wrongdoing, and for payment of the profit made or loss avoided (called disgorgement), plus prejudgment interest, in addition to a one-time civil penalty of the amount of profit (or loss avoided).  So, if you made $100,000 in profit from an illegal insider trade, the disgorgement would be $100,000 (with prejudgment interest calculated on this amount), in addition to a civil penalty of $100,000.  Also part of the standard terms is an injunction, which is a court order prohibiting one from violating the anti-fraud provisions of the securities laws in the future.

Yes, although the SEC does not have criminal authority and can only bring civil charges.  The SEC can, and at times does, refer its insider trading investigations to the Department of Justice, which criminally prosecutes these cases.   The DOJ can also independently launch, investigate and prosecute an insider trading investigation.

There are no hard and fast rules for when the SEC refers insider trading cases to the DOJ for criminal prosecution; however, those that are referred typically involve repeated instances of illegal insider trading, multiple parties (like an insider trading ring), sophisticated means and/or large dollar profits.

If you are contacted by the SEC, whether directly by phone without warning (known as an “ambush call”) or if you have received a subpoena, it is critical to immediately retain an experienced and knowledgeable insider trading lawyer.  Anything you say to the SEC, however seemingly innocent or even under the intention of being helpful under the belief (whether mistaken or not) that you did nothing wrong, can and will be used against you.  Don’t go at it alone, the stakes are simply too high.

David is a former SEC Prosecutor who investigated and prosecuted insider trading cases.  He thus knows how the SEC identifies, investigates and prosecutes insider trading.  Using this deep understanding, he effectively defends his clients with the objective of avoiding charges.  David is also an Adjunct Professor of Law at the University of Miami School of Law where he teaches a course on SEC investigations, including insider trading.  He has been recognized as an outstanding securities lawyer in his field by Chambers & Partners and Super Lawyers, has been widely quoted in the media, including the Wall Street Journal, interviewed on Bloomberg Television on SEC matters and has extensively written on insider trading.

Yes.  In some circumstances, a person may be liable for illegal insider trading even if they never personally bought or sold a security.

Federal prosecutors and the Enforcement Division Staff of the U.S. Securities and Exchange Commission (SEC) may pursue enforcement actions against individuals who disclose material, non-public information (MNPI) in breach of a duty and for a personal benefit to another who, in turns, trades on that MNPI knowing it sourced from a breach of fiduciary duty, even though the individual who conveyed the information did not trade.

Many people assume insider trading can take place only when someone profits from confidential information by purchasing or selling stock.  In truth, insider trading laws reach significantly beyond the person who executed the trade.

Understanding how insider trading liability works is critical for corporate executives, officers, directors, employees, consultants, attorneys, accountants, family members, and anyone who may receive confidential business information and trades upon it.

Federal insider trading laws are designed to protect and preserve the integrity of the financial markets.  As a result, insider trading liability may extend to individuals who improperly disclose confidential information to others, even if they never place a trade themselves.

For example, suppose a corporate employee learns that her company is about to be acquired.  Instead of purchasing stock, the employee shares that information with a friend who then buys shares before the public announcement.  Although the employee never traded, regulators may argue that the employee (a “tipper”) unlawfully “tipped” material, nonpublic information and therefore bears responsibility for the resulting trades (profits) by her friend (knows as a “tippee”).

This principle was recognized by the Supreme Court in Dirks v. SEC, 463 U.S. 646 (1983), which established the framework for determining when a person who discloses confidential information may be held liable for trading conducted by others.  The Court explained that liability may arise when an insider breaches a fiduciary duty by disclosing material nonpublic information for a personal benefit, and the recipient knows or should know that the disclosure was improper.

One of the most common ways a person can face insider trading allegations without trading is through a practice known as tipping.

A tipper is someone who provides material nonpublic information to another person (a tippee) in breach of a duty and for a personal benefit.

Potential examples include:

• Sharing confidential earnings information with a relative
• Discussing a pending merger or acquisition with a friend
• Providing advance notice of a major corporate announcement
• Revealing confidential and significant regulatory developments
• Disclosing nonpublic financial results, typically quarterly or annual corporate earnings

If in the above examples the recipient trades on the information, both the tipper and the trader may become subjects of an SEC or Department of Justice investigation.

Yes.

The Supreme Court examined this issue in Salman v. United States.  In Salman, confidential information was shared among family members and ultimately used for securities trading.  The Court held that an insider who makes a gift of confidential information to a trading relative or close friend may satisfy the “personal benefit” requirement established in Dirks, even if the insider receives no direct financial payment.

The Salman decision underscores an important point that to many comes as a shock: a person does not necessarily need to profit personally to become the target of an insider trading investigation and ultimately convicted.  Simply providing valuable confidential information to a relative or close associate may be enough to trigger scrutiny from regulators and prosecutors.

As a result, insider trading investigations often focus not only on who traded, but also on who supplied the information that made the trade possible, and the nature of their relationship.

Many begin with unusual trading activity by family members, friends, business associates, or other individuals connected to someone with access to confidential information.

Regulators often examine:

• Phone records
• Text messages
• Emails
• Messaging applications
• Trading histories
• Financial relationships

Even casual conversations with family, often times at family events where the mood is light and guards are down, often become potential evidence in an insider trading investigation.

That depends on the specific facts.

Insider trading cases often focus on intent, knowledge, and expectations.  Prosecutors may attempt to prove that the person disclosing information knew, expected, or intended that the recipient would use the information for trading purposes.

In other cases, the Government may take the position that the provider of the MNPI did so in confidence fully expecting that the recipient of the information would not trade on it.  In that scenario, the Government my prosecute only the trader on the legal theory that he misappropriated the information for his own personal gain without either the knowledge, consent or expectation of the individual who shared it in confidence.  This legal concept was espoused in the case of U.S. v. O’Hagan, 521 U.S. 642 (1997).

Not every confidential fact creates insider trading liability.

The information generally must be both:

Material

Information is considered material if a reasonable investor would likely view it as important when making an investment decision to either buy, sell or hold a security.  The United States Supreme Court discussed what constitutes “materiality” for purposes of the federal securities laws in the case of Basic, Inc. v. Levinson, 485 U.S. 224.

Examples may include:

• Merger or acquisition discussions
• Earnings results
• Significant contracts
• FDA regulatory approvals or denials
• Major litigation developments
• Drug results
• Executive leadership changes

Nonpublic

The information must not yet be available to the investing public or have otherwise been disclosed.

Information that has already been broadly disclosed through legitimate public channels generally does not qualify as nonpublic information.

Individuals accused of insider trading, specifically “tipping”, may face serious consequences, including:

• SEC civil enforcement actions
• Criminal prosecutions
• Monetary penalties
• Disgorgement claims of the profits made by the tippee and any downstream tippees
• Injunctions
• Industry bars, and
• Imprisonment

The specific penalties depend on the alleged conduct and whether the matter proceeds as a civil (SEC) or criminal investigation/prosecution.

It depends.  While a typical SEC insider trading investigation may take around a year or so, its duration will often depend upon the extent of cooperation received, whether there are multiple traders, and whether certain individuals involved are offshore and beyond the SEC’s jurisdiction.

Insider trading investigations do not always begin with a clear admission or obvious trading pattern.  Rather, regulators often attempt to reconstruct relationships, communications, and circumstances surrounding a trade to prove, either circumstantially or through direct evidence, liability or guilt.

Questions frequently asked by the SEC during an investigation include:

• Who knew the information?
• When did they learn it?
• Who received the information?
• Why was it disclosed?
• By what method was it disclosed?
• Was there an expectation of benefit?
• What was the relationship between the provider of the MNPI and the recipient (family, close friends or transactional parties)?
• Was there a benefit provided and, if so, in what form?
• Did anyone trade as a result and, if so, did they profit and, if so, by how much?

Yes, as explained in detail above, in certain circumstances, prosecutors or regulators may allege that a person who provided confidential information bears responsibility for unlawful trading conducted by another individual.

Potentially, yes.  Criminal insider trading cases may involve allegations that confidential information was intentionally disclosed for personal benefit or other improper purposes.

The absence of direct financial profit does not automatically eliminate potential liability.  Authorities may examine whether any personal benefit, relationship benefit, or other advantage existed under the holdings of Dirks and Salman.

Yes. Text messages, emails, encrypted messaging applications, and social media communications are frequently examined during insider trading investigations.