Contrary to common belief, insider trading is not always illegal. Insider trading is legal when corporate insiders—such as a company's directors, officers, and employees—buy or sell shares in their company in accordance with securities laws and regulations. Such legal insider trading must be filed with the U.S. Securities and Exchange Commission (SEC) on certain forms within stipulated time periods.
The version of insider trading that makes the headlines, however, is the illegal trading made by someone who possesses material and nonpublic information. The SEC vigorously pursues such insider trading cases in order to ensure that the capital market is a level playing field where no one has an unfair advantage. Otherwise, rampant insider trading can erode public confidence in the market and impede its functioning. The SEC's successful cases against high-profile individuals like Martha Stewart and former McKinsey global head Rajat Gupta prove that no one is above the law if they undertake such illegal activity.
Illegal Insider Trading
The SEC defines illegal insider trading as "buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security." The SEC goes on to clarify that insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and trading by those who misappropriate such information.
What is material information anyway? While there is no precise definition, “material information” may be broadly defined as any information specific to a company that would be considered important enough by an investor who is thinking of buying or selling the stock. This could include a vast array of items, including financial results that differ from current expectations, business developments, security-related items such as an increase or decrease in dividend, share split, or buyback; acquisition or divestiture; winning or losing a major contract or customer. “Nonpublic information” refers to information that has not yet been released to the investing public.
Over the years, the SEC has brought insider-trading cases against hundreds of parties, including:
- Corporate insiders who traded the company's securities after learning of significant, confidential developments
- Insiders' friends and family, as well as other recipients of tips who traded securities after receiving such information
- Employees of service firms such as law, banking, brokerage, and printing companies who came across material nonpublic information on companies and traded on it
- Government employees who obtained inside information because of their jobs
In a September 1998 speech titled "Insider Trading—A U.S. Perspective" by Thomas Newkirk and Melissa Robertson of the SEC's Division of Enforcement, Newkirk, and Robertson pointed out that insider trading is a very difficult crime to prove. They noted that since direct evidence of insider trading is rare, the evidence is almost completely circumstantial.
The SEC tracks insider trading in a number of ways:
- Market surveillance activities: This is one of the most important ways of identifying insider trading. The SEC uses sophisticated tools to detect illegal insider trading, especially around the time of important events such as earnings reports and key corporate developments.
Such surveillance activity is helped by the fact that most insider trades are conducted with the intention of "hitting it out of the ballpark." That is to say, an insider who is indulging in illegal trading typically wants to rake in as much as possible, rather than settling for a small score. Such huge, anomalous trades are usually flagged as suspicious and may trigger an SEC investigation.
- Tips and complaints: Insider trading is also revealed through tips and complaints from sources such as unhappy investors or traders on the wrong side of a trade. In the above-mentioned speech, Newkirk and Robertson noted that the SEC regularly receives phone calls from "angry" option writers who may have written hundreds of out-of-the-money (OTM) contracts on a stock shortly before another company launches a tender offer for it. They added that several important insider-trading cases have commenced with such a call from an irate trader. This tendency to leverage up the inside information as much as possible is another vulnerability that makes it easier to detect insider trading.
The easiest way for someone to capitalize on inside information is through the use of OTM options since these deliver the most bang for the buck. Let's say you had $100,000 to invest in a nefarious trading scheme and were tipped about an imminent takeover offer for a biotech stock that is currently trading at $12. Your source, a high-level executive at the potential acquirer, tells you that the offer for the target will be $20 in cash. Now you could immediately buy 8,333 shares of the target company at $12, sell it at about $20 once the deal is announced, and pocket a cool profit of $66,664 for a 60% return. But since you want to maximize your gains, you buy 2,000 contracts of one-month calls on the target company with a strike price of $15 for $0.50 each (each contract costs $0.50 x 100 shares = $50). When the deal is announced, these calls will soar to $5 (i.e., $20— $15), making each contract worth $500, for a 10-fold gain. The 2,000 contracts would be worth a cool $1 million, and the gain on this trade would be $900,000.
The traders, who wrote the calls that you purchased at $0.50, did so unaware that you possessed inside information that could be used for your pecuniary benefit and to their detriment. Would it be any surprise if they complained about the suspicious nature of this trade, which has saddled them with a gigantic loss to the SEC?
Tips about insider trading may also come from whistleblowers who can collect between 10% and 30% of the money collected from those who break securities laws. However, because insider trading is typically done on a one-off basis by a single insider who may either trade directly or tip someone else, whistleblowers seem to be more successful in unearthing widespread fraud rather than isolated insider trading abuses.
- Sources such as other SEC Divisions, self-regulatory organizations, and the media: Insider trading leads may also come from other SEC units such as the Division of Trading and Markets, as well as self-regulatory organizations like the Financial Industry Regulatory Authority (FINRA). Media reports are another source of leads for potential violations of securities laws.
Investigations by the SEC
Once the SEC has the basic facts on a possible securities violation, its Division of Enforcement launches a full investigation that is conducted privately. The SEC develops a case by interviewing witnesses, examining trading records and data, subpoenaing phone records, etc. In recent years, the SEC has employed a bigger arsenal of tools and techniques to combat insider trading. In the landmark Galleon Group case, for instance, it used wiretaps for the first time to implicate a number of people in a wide-ranging insider-trading ring.
As the evidence in an insider trading case is largely circumstantial, SEC staff has to establish a chain of events and fit together pieces of evidence, much like a jigsaw puzzle. A case brought by the SEC against a consulting executive and his friend in September 2011 illustrates this point. The executive passed on confidential information he had learned about the impending takeovers of two biotechnology companies to his friend, who bought a large number of call options on these companies. The insider trading generated illicit profits of $2.6 million, and the executive received cash from his friend in exchange for the tips. The SEC alleged that the two communicated about the potential takeovers during in-person meetings and on the phone. Some of these meetings were tracked through the two perpetrators' use of MetroCards at New York subway stations and large cash withdrawals from ATMs and banks made by the executive's friend before their meetings.
Following an insider trading investigation, the staff presents their findings to the SEC for review, which can authorize staff to bring an administrative action or file a case in federal court. In a civil action, the SEC files a complaint with a U.S. District Court and seeks a sanction or injunction against the individual that prohibits any further acts that violate securities law, plus civil monetary penalties and disgorgement of illegal profits. In an administrative action, the proceedings are heard by an administrative law judge who issues an initial decision that includes findings of fact and legal conclusions. Administrative sanctions include cease and desist orders, suspension or revocation of financial industry registrations, censures, civil monetary penalties, and disgorgement.
Examples of Insider Trading
While the 1980s was the decade of massive insider trading scandals by the likes of Ivan Boesky, Dennis Levine, and Michael Milken, two of the biggest insider trading cases in this Millennium include:
- SAC Capital—In November 2013, SAC Capital, founded by Steve Cohen (one of the 150 wealthiest people in the world), agreed to a record $1.8 billion fine for insider trading. The SEC alleged that insider trading was widespread at SAC Capital, and involved stocks of more than 20 public companies from 1999 to 2010. As many as eight traders or analysts who worked for SAC have either been convicted or have pleaded guilty to charges of insider trading. This includes Matthew Martoma, a portfolio manager who worked for an affiliate of SAC. Martoma was sentenced to nine years in prison after a federal jury found him guilty of trading on material, nonpublic information concerning an Alzheimer's drug that was being developed by Elan Corporation and Wyeth. In July 2008, Martoma's insider trading enabled the SAC affiliate to reap $82 million in profits and $194 million in avoided losses, for a total of over $276 million in illicit gains. Martoma received a $9.3 million bonus at the end of 2008, which was he was required to pay back when he was convicted.
- Raj Rajaratnam and the Galleon Group—In 2011, billionaire hedge fund manager Rajaratnam was sentenced to 11 years in prison for insider trading, the longest jail term imposed in such a case. Founder and manager of the Galleon hedge fund, Rajaratnam also paid a penalty of $92.8 million for widespread insider trading. The SEC alleged that Rajaratnam orchestrated a wide-ranging insider trading ring of 29 individuals and entities that included hedge fund advisers, corporate insiders (which included former McKinsey CEO and Goldman Sachs board member Rajat Gupta and Anil Kumar, a McKinsey director), and other Wall Street professionals. Rajaratnam was involved in insider trading of more than 15 publicly traded companies for more than $90 million in losses avoided or illegal profits made.
The Bottom Line
Insider trading in the U.S. is a crime that is punishable by monetary penalties and incarceration, with a maximum prison sentence for an insider trading violation of 20 years and a maximum criminal fine for individuals of $5 million. Although US penalties for insider trading are among the stiffest in the world, the number of cases filed by the SEC in recent years shows that the practice may be impossible to stamp out entirely.