Consequences of Insider Trading: Penalties and Punishment

Introduction

The Securities and Exchange Commission (SEC) was formed by the American government in 1934.

According to its charter, the SEC is responsible for conducting market surveillance in an effort to prevent unfair business activities like fraud, market manipulation, and misrepresentation.

Insider trading is a form of market abuse and is prohibited by the SEC. Directors, officers, and significant owners of corporations frequently have access to early inside information that may impact the stock’s market value in the future. Insider trading may be permitted or prohibited.

When Is Insider Trading Illegal?

Corporate officers, directors, and other “insiders” may trade stocks of their own firm provided that all relevant information is disclosed and reported to the SEC. However, insider trading is illegal if you buy or sell security while in possession of material information that is not generally available and in violation of a fiduciary obligation, which is a relationship of trust and confidence.

A breach of insider trading may also occur if the person who received the information trades securities. For instance, whenever a company executive (the “tipper”) and his spouse (the “tippee”) exchange secret information, and it results in an inside transaction, both of them are in violation of American securities laws.

Additionally, insider trading occurs when a person takes knowledge from their job and uses it to trade stocks in either the business’s stock or the stock of a rival company.

The US Department of Justice is the only agency that has the authority to charge you for alleged criminal violations of US securities laws, despite the fact that the SEC may seek civil remedies against someone it is looking into for suspected illegal insider trading.

SEC Rule 10(b) 5-1

The United States Supreme Court’s decision in United States v. O’Hagan, 521 US 642 led to SEC Rule 10(b)5-1, which defines insider trading.

The usage of manipulative and deceptive devices in conjunction with the purchase or sale of securities is prohibited by Rule 10(b) 5-1 of the Securities and Exchange Commission (SEC). This includes the use of material nonpublic information about a security or issuer when trading, which is commonly referred to as market abuse or insider trading. These activities are considered to be a breach of duty to the issuer or shareholders of the company and can lead to severe consequences for the offender.

Legal action for illegal insider trading

The Securities Exchange Act of 1934’s Section 10(b), 15 USC Section 78j relating to manipulative activities, SEC Rule 10b-5, 17 CFR Section 240.10b-5, and other federal laws all forbid insider trading.

You either bought or sold security:

Normally, this factor is uncontested because monthly account records may attest to whether security was traded or not.

You had private, material information:

According to the SEC, illegal insider trading has taken place whether or not you employed nonpublic information when making your trading choice. It only takes possession of the information for this to be the case.

There was no public knowledge of the information:

Information is considered “material,” according to the US Supreme Court if there is a high possibility that a prudent investor would value it highly when making investment decisions.

The knowledge was crucial:

This aspect is typically not in question. However, if the information came from rumors or was covertly leaked information about or by the corporation itself, there may be grounds for argument in your favor or against whether it was public knowledge.

Protections Against a Charge of Illegal Insider Trading

You carried out a valid inside trade:

If the insider can show that the trades made on their behalf were carried out in accordance with an existing agreement or a legally enforceable plan for trading in the future, they have an affirmative defense against illegal insider trading.

You relied on non-material information:

In the case of unlawful insider trading, only the omission or misuse of material information may be used against you. You have a defense to the insider trading allegations if your lawyer can persuade a jury that you depended on information that was unlikely to have an impact on an investor’s choice to buy or sell a share.

The information you depended upon was widely known:

An affirmative defense to illegal insider trading is the existence of publicly accessible information influencing the sale or acquisition of security. Your lawyer might be able to claim that even though the information you relied on wasn’t widely known, it was nonetheless publicly shared prior to your trade.

Your motivation was pure:

To prove that a person committed securities fraud, a US prosecution must demonstrate that there was a “purposeful” or guilty intent to break the law on securities.

You were unaware of any illicit trade:

If someone overhears a private conversation you had about inside information and acts on the “tip,” you might not be held accountable for insider trading.

Sentences and Penalties for Insider Trading

The federal regulatory organization can launch a civil action against you for injunctive relief and monetary damages if it accuses you of engaging in securities fraud while trading on inside knowledge. Even though no one enjoys being sued, it is better than having the Department of Justice investigate potential criminal activities that might have violated American securities laws.

Market abuse is a major concern for the SEC and other regulatory bodies. The severity of the punishment depends on the specific facts of the case, but in general, civil and criminal sentences may include financial penalties, jail time, and/or probation. 

For instance, Martha Stewart was convicted in March 2004 of conspiring, impeding the course of justice, and lying to federal authorities. After selling her Imclone shares after learning in advance and in confidence that the federal Food and Drug Administration would make a bad decision that would lower the value of Imclone stock, the media icon was sentenced to five months in federal jail.

In a separate lawsuit that was ultimately resolved, the SEC also sued Stewart. Stewart consented to pay a $137,019 civil penalty as well as $58,062 in forfeiture (including interest from losses she avoided).

The maximum penalty you can receive if you are discovered to have violated US securities laws as a result of insider trading is as follows:

Criminal Penalties

A federal prison sentence of 20 years is the maximum punishment for an insider trading offense. Criminal penalties can be as much as $25,000,000 for “non-natural” people (such as an organization whose securities are sold publicly) and $5,000,000 for “natural” people.

Civil Sanctions

You could face an injunction and be required to forfeit (surrender) any profits made or losses saved if you break insider trading rules. “Treble damages” refers to the possibility of being held accountable for a sum up to three times the profit made or loss averted as a result of the insider trading breach. This is the legal term for the civil penalty for a violator.

A civil penalty of up to $1,000,000 or three times the profit made or loss prevented as a result of the violation is applied to natural persons or entities controlling insider traders. The person or organization in control must have been aware that the controlled party was likely to commit the actions that would constitute an insider trading violation or must have acted recklessly in failing to act accordingly.

Additionally, a party that is negatively impacted by illicit trade may bring a lawsuit against the offender and/or the controlling party. The SEC may offer rewards to people who give information that results in the enforcement of the civil penalty as a means of encouragement.

Other Consequences Of Illegal Insider Trading

Insider trading is a complicated area of federal law, and you may frequently face connected criminal accusations. For instance, you might be charged with any of the following:

• Fraud in banks
• Fraud via wire and mail;
• Internet fraud
• Financial fraud
• Tax evasion
• Making erroneous claims;
• Injustice obstruction;
• Extortion; 
• Money-laundering.

You can experience non-punitive collateral effects that have an effect on your career. For instance, Martha Stewart consented to a five-year prohibition from holding the positions of director, CEO, CFO, or any other officer with responsibility for preparing, auditing, or publishing financial statements of any public firm, in addition to civil and criminal fines.

Any professional license you now hold is likely to suffer if you violate insider trading laws. A state licensing board may initiate disciplinary action against you, which might lead to the revocation or suspension of your professional license.

Conclusion

The consequences of insider trading can be severe. Market abuse is a serious offense and it is important for investors to understand the potential penalties and punishments for engaging in such activity. The penalty depends on the individual circumstances of the case.

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