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Why is Insider Trading Illegal?

The U.S. economy depends on the stability and integrity of the financial markets. When market participants engage in securities fraud, such as insider trading, the potential for ill gotten gains, investor losses and damage to the financial system is significant. This is why most, but not all, insider trading is illegal. 

What is insider trading?

According to the U.S. Securities and Exchange Commission (SEC), the federal agency tasked with policing the securities markets, insider trading involves the “buying or selling of a security, in breach of a fiduciary duty or other relationship of trust or confidence, on the basis of material, nonpublic information.” 

In particular, insider trading is prohibited by Section 10(b) of the Securities Exchange Act of 1934, as well as SEC Rule 10(b)5-1. This type of white collar crime occurs when an individual engages in a securities transaction based on information that is not available to the general public and violates his or her duty to keep that information confidential in order to make a profit. 

Further, an insider is one with a relationship to a business, such as an officer or director, who has access to nonpublic information about a corporation. These individuals, or insiders have a fiduciary relationship with their companies and shareholders. This means that they (1) have an obligation to put the interests of those to whom they owe a fiduciary duty first and (2) cannot attempt to profit from inside information. 

While this seems straightforward, legal insider trading can and does occur. At times, it is legal for insiders to buy and sell shares of the corporation, such as when a CEO buys back shares; however, these transactions must be registered with the SEC. On the other hand, a conviction for illegal insider trading can result in civil and criminal penalties. 

When is insider trading illegal?

Insider trading involves the illegal use of material nonpublic information (MNPI) for profit in breach of a fiduciary duty. Insider trading may also involve “tipping” which occurs when an individual outside of a company (a “tippee”) uses information obtained from an insider (the “tipper”) for profit. 

The tipper is said to have breached his or her fiduciary duty by intentionally disclosing MNPI, while the tippee knowingly and unlawfully used that information to buy or sell securities. The key factor in insider trading is the illegal use of information that is not publicly known to make a profit by anyone — corporate executives, investors, friends, and relatives.

How is insider trading investigated?

The SEC investigates illegal insider trading by reviewing trading volumes of any particular stock to determine if there was unusual trading activity. Examples of illegal insider traders who may be in the SEC’s crosshairs include:

  • Officers, directors, and employees of a corporation who trade the company’s stock  after learning of material confidential information
  • Business associates, family members, or friends (“tippees”) of insiders who buy or sell securities after receiving information not publicly available
  • Employees of service providers (e.g.  law firms, banks, broker-dealers, printing companies) who use information they obtained while providing services to a corporate client to buy or sell its stock 
  • Individuals who use confidential information obtained from employers, family, friends, and others to engage in insider trading 

It is noteworthy that SEC collaborates with other federal agencies on insider trading cases, including the Department of Justice (DOJ) and the Federal Bureau of Investigation (FBI). 

What are the penalties for insider trading?

The SEC has the authority to seek a court order requiring those who violate insider trading laws to return the profits, which is referred to as “disgorgement.” In addition the SEC can seek a penalty of up to three times the amount of the ill gotten gains. Moreover, the DOJ may also pursue a criminal case: a conviction for insider trading is punishable by up to 20 years in prison. Finally, an insider may also face a lifetime ban from the securities industry.

The Bottom Line

In sum, insider trading is illegal because it gives the insider an unfair advantage over others in the market (investors), which can have an impact on the value of a company’s stock and potentially disrupt the financial markets. If you are under investigation for or have been charged with insider trading, it is crucial to consult an experienced white collar crimes attorney. 

Your criminal defense lawyer can explain all your rights and choose the best of the defense. Depending on the circumstances, it may be possible to prove that you did not knowingly possess confidential information or that the information itself was not material. Although the federal government has an unfair advantage over defendants in insider trading cases, a skilled defense attorney can protect your freedom, your reputation and your future.

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