Insider Trading: Types, Consequences, & Avoidance

By May 5, 2021Overview

This article discusses the history of insider trading legislation, the main forms of insider trading with both hypothetical and historical examples, the main forms of punishment perpetrators can face, and the steps you can take to prevent insider trading from occurring within your company.

Disclaimer: This article is not intended to provide legal advice or counsel. See here for our full disclaimer.

History of Insider Trading Legislation

Insider trading wasn’t always illegal. Further, today’s general definition of insider trading—breaching a fiduciary duty or other relationship of trust by buying or selling a security on the basis of material and nonpublic information—is the product of many historic legislations and court rulings. Punishment for insider trading has likewise changed over the years.

The Securities and Exchange Act of 1934

In the wake of the Stock Market Crash of 1929 and the ensuing Great Depression, U.S. government officials wanted to protect the public from fraudulent market behavior. The first major step in combating such behavior came with Congress’s passing of The Securities and Exchange Act of 1934 (the “1934 Act” or the “Securities Exchange Act”). 1

Two key parts of this act include the regulation of fraudulent activity in the secondary markets and the creation of the Securities and Exchange Commission to enforce those regulations.

While these two aspects of the 1934 Act didn’t specifically mention insider trading at the time, the SEC would later interpret the 1934 Act in a way that also deemed insider trading illegal. This process began with the Cady, Roberts decision in 1961, when SEC Chairman William Cary ruled that trading on material nonpublic information was illegal based on the meaning of Section 10(b) of the 1934 Act. 2 Thus, the 1934 Act became the basis for establishing the illegality of insider trading while also creating the agency primarily tasked with detecting and enforcing insider trading. Other landmark legal cases such as Chiarella v. United States in 1981, Dirks v. SEC in 1983, United States v. O’Hagan in 1997, United States v. Newman in 2014, and Salman v. United States in 2016 have since narrowed the definition of insider trading in different scenarios, but the definition of insider trading still traces back to the 1934 Act.

Insider Trading Sanctions Act of 1984

Leading up to 1984, the SEC noticed that punishments for insider trading often were too small to prevent large instances of insider trading from occurring. One of the key responses to this problem was included in an amendment to the 1934 Act known as The Insider Trading Sanctions Act of 1984. This Act gave the SEC greater ability to prosecute those suspected of insider trading and to levy punishment against those found guilty. Specifically, the Act allowed the SEC to impose a civil penalty of up to three times the amount of profit made from the insider trading, and it increased the maximum criminal fine that could be imposed from $10,000 to $100,000.

Insider Trading Act of 1988

In a further effort to prevent both small and large instances of insider trading, the Insider Trading Act of 1988 included increases to the maximum civil penalty for insider trading to the greater of three times the amount of profit made OR $1 million. Likewise, it increased the maximum criminal fine and prison sentence. Current penalties today are even higher. These will be discussed later in the article.

Classic Insider Trading

What is Classic Insider Trading

The first type of insider trading discussed in this article is Classic Insider Trading. Thisis the type of insider trading that is most often reported in headline news articles. Classic insider trading is when people inside a company break their fiduciary duties and trade on material, nonpublic information.

Hypothetical Example of Classic Insider Trading

Leslie is a board member of Corporation ABC. As such, she is under a fiduciary duty to act in the best interest of the company’s shareholders. In a meeting, Leslie learns that the company will greatly exceed the public’s earnings expectation for the quarter, which will likely cause the company’s stock price to go up dramatically once the earnings are announced to the public. After the meeting, Leslie buys shares of the company’s stock in preparation for the earnings announcement, hoping to make a profit. This action is in direct violation of her fiduciary responsibility to act in the best interest of the shareholders.

What are “Tippers” and “Tippees”

In addition to our previous example, the law details many other ways people can get in trouble in a classic insider trading scenario. Let’s change the example with Leslie and instead assume that she doesn’t buy the company’s stock. Rather, she tells her brother, Michael, that ABC will exceed the public’s earnings expectations. Even though Michael is aware Leslie is breaking her fiduciary duty as a board member, he then goes and buys shares of ABC’s stock and agrees to give back to Leslie a little of the profit he expects to make.

In this altered scenario, both Leslie and Michael have committed classic insider trading. Even though Leslie didn’t trade on the information herself, she can get in trouble as a “tipper” because she broke her fiduciary responsibility by knowingly revealing material and confidential information and expected to benefit from doing so. In the same vein, Michael can be held liable as a “tippee” because he knowingly traded on confidential information that came from an insider breaking her fiduciary duty, and because he expected to benefit directly or indirectly from insider knowledge.

ImClone (2003): Historical Example of Classic Insider Trading, Including Tipper and Tippee

Shares of ImClone took a sharp dive when it was found out that the FDA rejected its new cancer drug. Even after such a fall in the share price, the family of CEO Samuel Waskal seemed to be unaffected. Additionally, after receiving advance notice of the rejection, Martha Stewart sold her holdings in the company’s stock when the shares were trading in the $50 range, and the stock subsequently fell to $10 in the following months. She was forced to resign as CEO of her company and Waskal was sentenced to more than seven years in prison and fined $4.3 million in 2003. 3

Misappropriation

What is Misappropriation

The legal ground for the crime of misappropriation emerged from one of the historic legal cases mentioned earlier in this article, United States v. O’Hagan in 1997. A lawyer named James Herman O’Hagan learned that the law firm he worked for would represent Grand Met in a takeover of Pillsbury. Before the tender offer was announced to the public, O’Hagan purchased what would be the largest amount of Pillsbury call options, which he later sold for $4.3 million.

At this point in time, a conviction of classic insider trading required the perpetrator breach a duty (fiduciary or similar) to the company traded on, but O’Hagan didn’t owe such a duty to Grand Met in this case. The Supreme Court, however, ruled that O’Hagan violated Section 10(b) nevertheless through misappropriation. The Harvard Law School Forum on Corporate Governance explains the key difference between classic insider trading and misappropriation in the following way:

In a “classical” insider trading case, the [essential condition] of the violation is wrongdoing by the source of the information in disclosing it for his or her personal benefit; in a misappropriation case, the essence of the violation is wrongdoing against the source of the information by betraying an agreement or understanding that the information would be kept confidential and not be used to trade. 4

Thus, misappropriation does include a breach of duty. But unlike classic insider trading, the broken duty is with the source of the information rather than with the company traded on.

Hypothetical Example of Misappropriation

Jordan is a lawyer for a large law firm that offers legal services during corporate takeovers. He learns through a coworker that another team in the law firm is preparing to offer services to Corporation ABC as it acquires Corporation XYZ, but the public does not yet know about the impending merger. Jordan, anticipating that XYZ’s stock price will rise significantly, buys shares of XYZ with the hope to make a profit. Jordan thinks that since his law firm is not offering services to XYZ (only ABC), he doesn’t have a duty to uphold toward XYZ, and he believes that he’s found a loophole he can legally exploit.

Jordan is correct in that he’s avoided committing classic insider trading, but he’s instead committing misappropriation.

United States v. Blaszczak (2019): Historical Example of Misappropriation

Blaszczak involved a scheme in which several employees of a government agency–the Centers for Medicare & Medicaid Services—obtained confidential information regarding planned changes to certain Medicare and Medicaid reimbursement rates and provided the information to a former colleague, who then tipped employees of a hedge fund that traded and profited based on the information.  The members of the alleged scheme were indicted for insider trading based on the misappropriation theory and were charged under Section 10(b) of the Exchange Act and the criminal wire fraud and securities fraud statutes of Title 18. 5

Short-Swing Trading

What is Short-Swing Trading

Short-Swing Trading is when company insiders who own more than 10 percent of the company trade the stock with the intention of making short-term profits at the expense of the company and its shareholders. However, determining if insiders are short-swing trading or simply reallocating their investments can be tricky. Congress responded to this problem by adopting a preventative procedure outlined in Section 16b of the 1934 Act. Known as the Short-Swing Profit Rule, it broadly removes the ability for insiders to make short-term profits on their company’s stock regardless of whether they are suspected of short-swing trading. Thus, the incentive to short-swing trade is removed altogether by the rule.

The Short-Swing Profit Rule specifically mandates that officers, directors, and shareholders who own more than 10% of the company must report to the SEC about the status and size of their holdings in the company, report any trades in the company’s stock to the SEC within two business days, and turn over to the company any profits they make from subsequent purchases or sales of the company’s stock within a six-month period. By removing the upfront incentive for insiders to short-swing trade, the rule prevents short-swing trading from occurring. This rule is still used today, and insiders of newly-public companies that own more than 10 percent of their company will need to be ready to adhere to this rule.

Hypothetical Example of Short-Swing Trading

than 10% of the company. In January, she buys 100 shares at $10 per share. In February, she reviews her personal portfolio and performs a routine rebalance of her holdings. In this process, she sells the same 100 shares in February for $20 per share, thereby making a $1,000 profit. Morgan bought and sold the shares within a six-month period, so Morgan must return the $1,000 to the company under the short-swing profit rule. However, while Morgan must return the short-term profits on EFG’s stock, she is not in legal trouble. Rather, the profit return is a product of the Short-Swing Profit Rule that requires returning of funds without respect or inquiry into the insider’s motives, malicious or not.

Delendo Corporation (1940): Historical Example of Short-Swing Trading

Seskis and Kaplan (defendants) were directors, officers, and 12 percent shareholders of Delendo Corporation (Delendo) (defendant). Delendo had been negotiating to sell its assets to another corporation, but had to stop due to outstanding tax liabilities. After the tax claims were settled, Delendo finalized the sale and dissolved the company on July 16, 1940. Between December 1939 and May 1940, Seskis bought over 15,000 shares and sold nearly 16,000 shares. During that time Kaplan bought nearly 23,000 shares and sold over 21,000 shares. Some of the transactions were conducted on the Curb Exchange and others were private. For all but about 2,000 shares, different certificates were received for the purchases than the ones given for the sales. Shareholders Smolowe and Levy (plaintiffs) sued the defendants in district court under Securities and Exchange Act of 1934 (SEA), 15 U.S.C. § 16(b). The court concluded that Delendo was entitled to the profits from the transactions and set the award by calculating the highest profits. Seskis was ordered to pay $9,733.80, and Kaplan was ordered to pay $9,161.05. 6

Punishment

In each of the insider trading scenarios mentioned above, those convicted as a lone perpetrator, a tipper, or a tippee can face the following penalties from the SEC:

  • Disgorgement: giving up illegally obtained profits
  • Civil Penalty: 1-3 times the amount of gain or loss avoidance
  • Bar From Future Violations: would put defendant in line for further violations such as contempt of a court order if violations were to continue
  • Officer/ Director Bar: can no longer serve as an officer or director of a U.S. publicly traded company

Additionally, the SEC often works with the Federal Bureau of Investigation (FBI) to impose criminal punishments, which can include the following:

  • Prison Sentence: maximum of 20 years in a federal penitentiary
  • Fine: maximum for individuals is $5,000,000 and the maximum for “non-natural” persons is $25,000,000 7

Individuals and companies can also face class action lawsuits from the public, which can bring additional fines and penalties.

Further, material reputational damage can come upon individuals and companies. 8

How to Prevent Insider Trading in Your Company

The following steps can help prevent insider trading from occurring within your company:

  • Educate employees, directors, board members, and others about insider trading and the duties they are bound to (fiduciary or otherwise)
  • Form a legal team in house that can address concerns as they arise
  • Develop systems in house to prevent insider trading
  • Proactively provide reminder messages and materials when big company events arise (merger, dividend cut, and so forth)
  • Cultivate a culture of ethical behavior

Conclusion

Insider trading has many forms, and based on the historical evolution of those forms, insider trading will likely continue to evolve and surface in tomorrow’s business world. However, educating your company on the common ways insider trading scenarios occur can prove to be the most effective tool in preventing the tangible and intangible damages that come from insider trading.


Resources Consulted


Footnotes

  1. The 1934 Act was preceded by the 1933 Act which requires the registration of securities and the disclosure of full and fair information. See this page at www.investor.gov for more information.
  2. An overview can be seen on this Cornell Law School page.
  3. This excerpt is from this Investopedia article.
  4. This excerpt is taken from this Harvard Law page.
  5. This excerpt is from this New York University School of Law page.
  6. This excerpt is from this Quimbee page.
  7. Such as an entity whose securities are publicly traded. For more information, see the following Wallin and Klarich page.
  8. However, the frequency of those that face severe legal punishments connected to short-swing trading is relatively low due to the broad and preventive nature of the Short-Swing Profit Rule, as discussed.
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Author Josh Shipp

Josh is a proud native of Houston, Texas. He aspires to become a compassionate and effective finance leader. When he's not researching emerging companies or watching the markets, Josh loves to lift weights and watch his favorite Houston and BYU sports teams. He also loves to eat food, run, and hike. He plans to join Goldman Sachs in Salt Lake City after graduation.

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