Insider trading: The Consequences Of Corporate Fraud

Individuals who possess non-public and material information on a business can engage in insider trading. It is a crime to trade on non-public information, which gives those with it an unfair edge in the marketplace. It is difficult to distinguish between insider trading that’s legal from illegal, because the legality of the activity depends on both the source and nature of the information.

The securities markets are based on the idea that investors have an equal right to access information which may influence their decision to purchase or sell. The Securities and Exchange Commission in the United States enforces rules that maintain fairness and transparence. The SEC monitors transactions and conducts investigations in order to prevent and punish illegal insider trading. The SEC is required to report legal insider trades, including those made by executives of companies but in compliance with rules on insider trading.

Insider trading: Legal definition

Individuals with nonpublic and material information on a business can engage in insider trading by making transactions involving the securities of that company, such as stocks or bonds. To understand the legal landscape, it is important to be familiar with both the fundamental legislation and the subsequent regulatory clarifications.

Securities Exchange Act of 1934

Securities Exchange Act of 1939 is the main federal law that regulates the trading of stocks. This act includes violations of insider trading, such as the purchase or sale of securities on the basis of material information not made public or breach of a trust or confidence relationship.

Key provisions

• The Section 10b: prohibits fraud in the sale or purchase of securities
• Rule 10b-5 prohibits acts or omissions that result in deception or fraud in the securities transaction

Amendements to the Rules

Specific rules and amendments were introduced over time to clarify and enforce the principles laid down in the Securities Exchange Act of 1933:

• Rule 10b5-1 clarifies when insider trades are illegal, highlighting the importance that the trader be aware of nonpublic material information during the trading period.
• Rule 10b5-2 establishes the duty to trust or believe in certain circumstances. This is crucial when dealing with insider trading where there may not be a clear definition of relationships.

Amendments These rules were supplemented with amendments which provide guidance regarding corporate officers, directors, and beneficial owner’s stock transactions and reporting obligations. Sarbanes-Oxley Act of 2003, for example, tightened reporting deadlines and added new obligations to corporate governance.

There are different types of insider trading

The legality of insider trading and its context can help to categorize it.

Illegal Insider Trading Insider trading is illegal

Legal insider trading happens when corporate insiders–executives, employees, or shareholders with more than 10% ownership–buy or sell stock in their own companies and report these trades to the U.S. Securities and Exchange Commission (SEC).

Insider trading is illegal when it involves the trading of material, non-public information without a breach of fiduciary duties or any other trust relationship. The U.S. laws are strict in prosecuting this practice, which carries severe penalties.

The Theory of Misappropriation

This theory is applicable to those who have confidential information but are not insiders of a company. This theory states that it is illegal for these people to trade with confidential information when they violate a trust obligation owed by the company to which the information was provided, even though the shareholders of the trading firm are not directly affected.

Tipping Theory and Tipper/Tippee Method

In the context of insider trade, tipping is when a tipper or an insider with non-public information provides that information to another individual, called the tipee. The tipee trades on the basis of that information.

Tipper/Tippee Theory: The Tipper/Tippee Theory states that both tipper and tipee are liable if tipper breaches fiduciary duties by disclosing information, and tipee is aware or should be aware that tipping was wrong.

Insider Trading: Consequences and Illegal Insider Trading

Insider trading is illegal and can result in severe fines and even imprisonment. It also damages a company’s reputation and may lead to incarceration.

Civil Penalties

• Civil Fines Individuals can face fines up to 3 times their profit or loss from illegal insider trading.
• Restitution Courts have the power to order that illegal gains be repaid, along with interest accrued before the judgment, to anyone who has been harmed as a result of insider trading.

Criminal Penalties

• Prison: The penalties can be up to twenty years of federal prison.
• Monetary fines Individuals can face fines of up to $5,000,000, while entities may be subjected to fines much higher.

Reputational damage

• Impact on Individual Being involved with insider trade can seriously damage an individual’s reputation and career prospects.
• Impact on Corporate Image Companies that engage in insider dealing are subject to public scrutiny, which can affect their credibility.

Preventive measures and compliance

To mitigate the risks of insider trading, corporations must implement robust prevention measures.

Corporate Policies

Companies must have clear policies on insider trading. The policies must define insider trading, and how to handle material nonpublic data. They might, for example, state that all trades requiring preclearance should be reported within a certain timeframe to the compliance officer.

Compliance Programs

To enforce the insider trading policy, a comprehensive compliance program will be required. The program could include:

• Surveillance and Monitoring: Reviewing trades and communication for any unusual activities.
• Reporting System: Setting up anonymous channels to allow employees to report possible insider trading.

Compliance teams should perform risk-based assessments of any conduct which could indicate insider trading.

Employee Training

All employees should receive regular training to make sure they are familiar with corporate policy and insider trading rules. The sessions should include:

• Legal Consequences : Clarification of personal and corporate liability
• Policy Detail: Understand the specifics about what actions are allowed and prohibited.

The training aims at preventing insider trading, by empowering employees to make legal decisions.

Some notable insider trading cases

A number of important cases highlight the topic of insider trade. Martha Stewart, a domestic icon and Enron’s downfall are two of the cases that have been the subject of most media attention.

Martha Stewart Incident

Martha Stewart’s name is synonymous with American domesticity. She was thrown into legal trouble in 2001 after she sold ImClone Systems shares. Stewart saved $45,673 after her broker informed her that ImClone’s drug application would be rejected by the FDA. She was found guilty of conspiracy, obstruction, and false testimony to federal investigators.

Enron Scandal

Enron’s collapse, which was one of the biggest energy companies in America, had been precipitated by fraudulant financial practices. This included notorious insider trading cases. Jeffrey Skilling sold stock worth millions of dollars based on his insider information about the impending financial collapse of Enron, before the news became public. Skillings’ actions were not just an example of corporate fraud, but they also resulted in massive losses to Enron investors.

FAQs

What is the definition of insider trading under law?

Insider trading is defined by law as the act of buying or selling securities in violation of fiduciary duties or any other trust relationship, when in possession of non-public, material information.

What could be the legal implications of being found guilty of insider dealing?

Insider trading convictions can result in fines that may be higher than the gains or losses averted from illegal transactions, disgorgement (return of profits and losses) or imprisonment. Criminal securities fraud can result in up to 20-year prison sentences for those convicted.

How can the insider trader be identified and monitored?

The detection and monitoring of insider trading is possible through an analysis of the trading volume and pattern, and through investigations of those with material access to nonpublic information. Regulating organizations may also ask insiders to make regular disclosures. This can be helpful in monitoring the insider trading activity.

What is an insider trading violation?

A case of illegal insider trade involves either an insider, or someone related to one who has traded stocks or securities for a company based on nonpublic material information that they obtained from their position. This is a violation of the laws or company prohibitions.

How long is the average prison sentence for those convicted of insider trading?

Insider traders can face incarceration for a variety of reasons, including the seriousness of their offenses, how they were committed, whether the gain was positive or negative, etc. In the worst cases, sentences may range anywhere from several years up to 20 years.