A Primer on Insider Trading Laws and Defenses

Dmitriy Smirnov

May 1, 2024

Securities Law

Introduction

Insider trading is a term that often evokes images of financial scandal and corporate malfeasance. At its core, insider trading involves the buying or selling of a publicly-traded company’s stock by someone who has non-public, material information about that stock. While the concept may seem straightforward, the legal landscape surrounding insider trading is complex and nuanced. This guide aims to provide a foundational understanding of insider trading laws and defenses, essential for anyone involved in the financial markets.

What is Insider Trading?

Insider trading can be broadly categorized into legal and illegal activities. Legal insider trading occurs regularly when corporate insiders—officers, directors, and employees—buy or sell stock in their own companies in compliance with the law. These transactions must be reported to the Securities and Exchange Commission (SEC) to maintain transparency. Conversely, illegal insider trading involves trading based on material, non-public information, which can unfairly benefit the insider and undermine investor confidence in the fairness and integrity of the securities markets.

Key Laws Governing Insider Trading

The primary law governing insider trading in the United States is the Securities Exchange Act of 1934. Section 16(b) prohibits short-swing profits (profits realized in any period less than six months) by corporate insiders in their own corporation’s stock, except in very limited circumstance. It applies only to directors or officers of the corporation and those holding greater than 10% of the stock and is designed to prevent insider trading by those most likely to be privy to important corporate information. Rule 10b-5 prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. Additionally, the Insider Trading Sanctions Act of 1984¹ and the Insider Trading and Securities Fraud Enforcement Act of 1988² enhanced penalties and enforcement measures, emphasizing the government’s commitment to deterring insider trading.

Regulatory Bodies

The SEC is the principal regulatory body enforcing insider trading laws. It investigates and pursues civil violations of insider trading, often in parallel with the Department of Justice (DOJ), which prosecutes criminal violations of the federal securities laws. The SEC has broad authority to seek civil penalties, including disgorgement of profits and fines, while the DOJ can pursue criminal charges that may result in imprisonment.

Common Defenses in Insider Trading Cases

Defending against insider trading charges requires a thorough understanding of the law and the specific circumstances of the case. One common defense is the lack of materiality, arguing that the information in question was not significant enough to influence an investor’s decision. Another defense is that the accused did not possess insider knowledge at the time of the trade. Defendants may also argue that the information was already public or that there was no intent to defraud, which can be challenging to prove.

Consequences of Insider Trading

The consequences of illegal insider trading can be severe. Civil penalties often include substantial fines and disgorgement of profits, while criminal penalties can involve significant prison sentences. Beyond legal repercussions, individuals found guilty of insider trading may suffer irreparable damage to their professional reputations and careers, underscoring the importance of compliance and ethical behavior in the financial markets.

Crucial for Those in Securities Markets

Understanding insider trading laws and defenses is crucial for anyone participating in the securities markets. While the temptation to leverage non-public information can be strong, the legal and personal risks far outweigh potential gains. Staying informed and adhering to ethical standards helps protect individuals and maintains the integrity of the financial markets.

1. 
   The Act provides for penalties up to three times the profit gained or the loss avoided by the insider trading, providing a powerful deterrent to would-be violators. 15 U.S.C. § 78u-1.M
2. 
   Congress passed this Act to facilitate the SEC’s cooperation with foreign regulators. The Act expanded the SEC’s authority to assist foreign regulators by allowing it to use its subpoena power to compel testimony and the production of documents to obtain information requested by a foreign securities authority.