Comprehensive Guide to White-Collar Criminal Defense: Insider Trading

Introduction to Insider Trading

Insider trading is one of the most scrutinized offenses in the realm of white-collar crime, drawing intense regulatory and public attention. The SEC and FINRA both have computer systems designed to deter and detect instances of inside trading.

Put simply, insider trading is the buying or selling of securities, such as stocks or bonds, by individuals who have access to material, nonpublic information (MNPI) about the company. From the 30,000 level, this practice is considered illegal when the information used for trading provides an unfair advantage over other investors who do not have access to the same information.

Key elements of insider trading include:

1. Material Information: Information is material if it would reasonably affect an investor's decision to buy or sell the security. Examples include earnings reports, mergers, acquisitions, or significant corporate events.

2. Nonpublic Information: The information is not yet disclosed to the public, meaning it is not available through channels like press releases, financial reports, or other public filings.

3. Breach of Duty: Insider trading generally (but not always) involves a breach of fiduciary duty or other relationship of trust and confidence, such as when a corporate insider uses confidential information for personal gain or provides it to others.

4. Intent: The act is deliberate, with knowledge of the information's nonpublic nature and its potential impact on securities prices.

Statutes such as the Securities Exchange Act of 1934, particularly Section 10(b) and its accompanying Rule 10b-5, form the backbone of insider trading enforcement. These provisions prohibit deceptive practices in securities transactions. Other laws, such as the Sarbanes-Oxley Act and the Dodd-Frank, have bolstered enforcement capabilities by increasing penalties and providing whistleblower incentives. The interpretation and application of these laws have been shaped by landmark cases, including United States v. O’Hagan and Dirks v. SEC, which clarified key elements like the "personal benefit" test and the concept of misappropriation.

Insider trading is an extremely difficult concept to understand (even for experienced lawyers), as it requires not only trading based on “material” information that is “non-public” but it also requires the breach of a duty, referring to a breach of a fiduciary duty or one of trust and understanding these laws is critical for anyone facing insider trading allegations. Overhearing a CEO on the street talking about a company’s performance and then trading on that information is NOT illegal, while trading on that same information, when obtained from a company insider, IS illegal.

For individuals and corporations under scrutiny, navigating these complex legal frameworks requires an experienced defense team capable of dissecting the nuances of insider trading statutes and precedents.

The History of Insider Trading: From Early Concepts to Modern Regulation

Insider trading has a long and complex history intertwined with the development of modern financial markets.

1. The Birth of Regulation: 1929 Stock Market Crash

The Great Depression, triggered by the 1929 stock market crash, exposed widespread corporate fraud and market manipulation, including insider trading. This paved the way for federal intervention.

• Securities Act of 1933: Introduced disclosure requirements for publicly traded companies, aiming to level the playing field for investors.

• Securities Exchange Act of 1934: Established the Securities and Exchange Commission (SEC) and laid the groundwork for modern insider trading regulation.

Key Provisions of the ‘34 Act:

• Section 10(b): Prohibits manipulative or deceptive practices in securities trading.

• Rule 10b-5 (1942): Specifically targets fraudulent activities, including insider trading, by outlawing any act or practice that operates as a fraud or deceit upon any person in connection with securities transactions.

2. Judicial Interpretation: Landmark Cases of the 20th Century

Insider trading is not defined by statute. Rather, it has evolved over time as courts have gradually outlined what conduct is or is not illegal. Key cases helped clarify the legal principles underpinning enforcement.

• SEC v. Texas Gulf Sulphur Co. (1968):

  • Established the "disclose or abstain" rule, requiring insiders to either disclose material information or refrain from trading.

• Dirks v. SEC (1983):

  • Introduced the "personal benefit" test, determining that tipping material, nonpublic information constitutes insider trading only if the tipper gains a personal benefit.

• United States v. O’Hagan (1997):

  • Adopted the "misappropriation theory," extending insider trading liability to individuals who misappropriate confidential information for securities trading, even if they are not corporate insiders.

4. The Modern Era: Increasing Enforcement and Expanding Boundaries

By the late 20th and early 21st centuries, insider trading became one of the SEC's top enforcement priorities, and additional statutes were passed that provided rules and laws governing trading by insiders and others.

• Sarbanes-Oxley Act (2002):

  • Enacted in response to corporate scandals like Enron and WorldCom, it increased penalties for insider trading and required CEOs and CFOs to certify financial statements.

  • Notably, SOX introduced 18 USC 1348, which made illegal certain securities and commodities frauds, and which has increasingly been used to prosecute people for insider trading.

• Dodd-Frank Act (2010):

  • Bolstered whistleblower protections and incentivized reporting of insider trading through financial rewards.

5. Recent Developments: Adapting to a Changing Market

In recent years, insider trading regulation has evolved as trading has evolved. As examples:

• Rule 10b5-1 Amendments (2022):

  • Introduced stricter requirements for trading plans to prevent abuses by corporate insiders.

• Shadow Trading Cases, such as SEC v. Panuat:

  • The SEC has expanded its focus to unconventional forms of insider trading, such as trading securities of one company based on nonpublic information about another.

Statutes Governing Insider Trading

Federal prosecutors enforce the nation’s securities laws on a criminal level, and use both the 1934 Act and the recently passed 18 USC 1348 to do so. The SEC is an agency that prosecutes people by suing them in court (civil law), and, in the context of insider trading, can only use the 1934 Act. 18 USC 1348 is a criminal statute only. Below is a detailed overview of these two statutes:

1. Securities Exchange Act of 1934 - Section 10(b) and Rule 10b-5

The Securities Exchange Act of 1934 is the primary statute that governs securities trading and regulates fraudulent activities, including insider trading.

• Section 10(b):
  Section 10(b) of the Securities Exchange Act makes it unlawful for any person, directly or indirectly, to use any manipulative or deceptive device in connection with the purchase or sale of any security. This section is the broad provision under which many insider trading cases are prosecuted.

  • Text of 10(b):

    "It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails or of any facility of any national securities exchange, to use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe..."

• Rule 10b-5 (adopted by the SEC in 1942 under Section 10(b)):
  Rule 10b-5 specifically targets insider trading by prohibiting the employment of any device, scheme, or artifice to defraud, making it unlawful for an individual to trade securities based on material, nonpublic information. It is the key rule that has been used in numerous insider trading enforcement actions.

  • Text of Rule 10b-5:

    "It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails or of any facility of any national securities exchange, to use or employ any device, scheme, or artifice to defraud, or to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security."

As explained, this statute can be used by both criminal and civil prosecutors.

2. 18 U.S.C. § 1348 – Securities Fraud

18 U.S.C. § 1348 is a key provision that criminalizes securities fraud, including insider trading, as part of the Sarbanes-Oxley Act. This statute makes it a federal crime to engage in fraudulent schemes related to the buying or selling of securities and has recently been used in multiple insider trading prosecutions.

Text of 18 U.S.C. § 1348:

• "Whoever knowingly executes, or attempts to execute, a scheme or artifice—(1) to defraud any person in connection with any security of an issuer with intent to deceive or defraud; or (2) to obtain by means of false or fraudulent representations or promises, any money or property from any person in connection with the purchase or sale of a security—shall be fined under this title or imprisoned not more than 25 years, or both."

  • Key Elements:

    • Fraudulent Scheme: The statute prohibits schemes intended to deceive or defraud in connection with the purchase or sale of securities.

    • Intent to Defraud: The individual must have intent to deceive or defraud someone, which is often a critical element in proving securities fraud.

    • Penalties: The penalties under 18 U.S.C. § 1348 are severe, including criminal fines and up to 25 years in prison.

      This statute is particularly powerful in cases where insider trading involves fraudulent behavior or deceptive conduct beyond simple misuse of confidential information.

Supreme Court Decisions Governing Insider Trading

As explained, Supreme Court decisions have been instrumental in defining the boundaries and principles of insider trading law. Below is an expanded overview of the most influential federal cases on insider trading:

1. SEC v. Texas Gulf Sulphur Co. (2d. Circuit 1968)

Background:
This seminal case marked the first significant interpretation of insider trading under the Securities Exchange Act of 1934. Executives of Texas Gulf Sulphur Co. traded stock based on material, nonpublic information about a major mineral discovery before it was disclosed to the public.

Ruling:
The Second Circuit established the "disclose or abstain" rule. Insiders who possess material, nonpublic information must either disclose it before trading or abstain from trading altogether.

Impact:
This decision emphasized the importance of fair disclosure in financial markets and became the foundation for modern insider trading enforcement.

2. Dirks v. SEC (1983)

Background:
In this case, Ronald Dirks, a financial analyst, received material, nonpublic information from an insider whistleblower and shared it with clients who traded on the information. The SEC sought to hold Dirks liable for insider trading under the tipper-tippee liability framework.

Ruling:
The Supreme Court ruled in favor of Dirks, holding that tippee liability arises only when the tipper (the insider who disclosed the information) receives a personal benefit from providing the tip. If the tipper acts altruistically, without personal gain, the tippee is not liable.

Impact:
The personal benefit test became a crucial element in determining tipper-tippee liability. This case provided clarity for analysts and professionals who rely on information provided by insiders.

3. United States v. O’Hagan (1997)

Background:
James O’Hagan, a partner at a law firm, traded shares of Pillsbury Company based on confidential information about a pending acquisition. Although O’Hagan was not an insider of the company, he used the information for personal gain.

Ruling:
The Supreme Court adopted the misappropriation theory, which holds that a person commits fraud in connection with a securities transaction when they misappropriate confidential information for trading purposes, violating a duty of trust and confidence owed to the source of the information.

Impact:
This ruling expanded the scope of insider trading liability beyond corporate insiders, encompassing anyone who improperly uses confidential information for personal gain. It remains one of the most cited cases in insider trading law.

4. Salman v. United States (2016)

Background:
Bassam Salman traded on confidential information received from a friend, who in turn received the information from his brother, an insider. Salman argued that because the insider received no tangible benefit, he should not be held liable under the Dirks personal benefit test.

Ruling:
The Supreme Court upheld Salman’s conviction, reaffirming that a personal benefit can be inferred when an insider provides confidential information as a gift to a relative or close friend. The Court clarified that the benefit need not be tangible; the relationship itself suffices.

Impact:
This case reinforced the idea that gifting information to a close associate for trading purposes violates insider trading laws, even in the absence of monetary compensation.

Key Takeaways from Supreme Court and Second Circuit Jurisprudence

1. Broadening the Scope: Cases like O’Hagan expanded insider trading liability beyond corporate insiders to include those who misuse confidential information.

2. Defining Personal Benefit: Dirks and Salman clarified the tipper-tippee relationship and established that even intangible benefits can trigger liability.

3. Emphasizing Fairness: From Texas Gulf Sulphur to Liu, the Court has consistently reinforced the principle that fairness and transparency are paramount in financial markets.

These rulings (and others) collectively form the backbone of insider trading law in the United States.

Notable Recent Insider Trading Prosecutions

Insider trading continues to be heavily prosecuted by both the DOJ and the SEC. Typically, when a market moving event occurs, such as a merger or earnings release, FINRA will scrutinize any unusual activity leading up to the event. From there, FINRA will pass leads on to the SEC who will investigate the matter further. Significant cases, including where the SEC believes that a person willfully violated the securities laws, will then be taken to federal criminal prosecutors and prosecuted criminally. Set forth below are a number of notable prosecutions:

1. Ivan Boesky: The Face of 1980s Insider Trading

Case Summary:
Ivan Boesky, a prominent stock trader, became synonymous with insider trading during the 1980s. Boesky built his fortune by trading on nonpublic information provided by investment bankers and corporate insiders. His illegal activities were uncovered during a larger investigation into Wall Street misconduct.

Outcome:
In 1986, Boesky was fined $100 million, sentenced to three years in prison, and banned from securities trading. His cooperation with prosecutors also led to the downfall of other major figures, including Michael Milken, the "junk bond king."

2. Raj Rajaratnam: The Largest Insider Trading Case in History

Case Summary:
Raj Rajaratnam, founder of the hedge fund Galleon Group, orchestrated a sophisticated insider trading scheme involving a network of corporate insiders and Wall Street professionals. He used nonpublic information to earn millions in illegal profits over several years.

Outcome:
In 2011, Rajaratnam was convicted on 14 counts of securities fraud and conspiracy, resulting in an 11-year prison sentence and $156.6 million in fines and forfeitures. The case relied heavily on wiretap evidence, a rare tactic in white-collar prosecutions.

Impact:
This case set a precedent for using wiretaps to uncover insider trading schemes.. It also signaled a shift toward pursuing insider trading cases at hedge funds and other investment firms.

3. Sam Waksal: The ImClone Scandal

Case Summary:
Dr. Sam Waksal, the founder of ImClone Systems, was the central figure in the scandal that also implicated Martha Stewart. Waksal was tipped off that the FDA would reject ImClone's cancer drug application and attempted to sell his shares before the news became public.

Outcome:
Waksal was sentenced to over seven years in prison and fined $4.3 million. His actions also resulted in the SEC bringing insider trading charges against others involved.

Impact:
The ImClone scandal emphasized the importance of corporate leaders maintaining ethical standards, as their actions set the tone for their organizations.

4. Mathew Martoma: A Large Individual Payout

Case Summary:
As a portfolio manager at SAC Capital Advisors, Mathew Martoma obtained nonpublic information from a doctor involved in clinical trials for an Alzheimer's drug. Using this information, SAC avoided $276 million in losses and earned profits by trading before the trial results were announced.

Outcome:
In 2014, Martoma was convicted of securities fraud and sentenced to nine years in prison. SAC Capital also pleaded guilty to insider trading charges, paying a record $1.8 billion in penalties.

Impact:
This case remains one of the largest insider trading cases by monetary value. It demonstrated that firms and individuals alike could face severe consequences, including record-breaking financial penalties.

For expert legal advice, contact attorneys at Dynamis LLP or email whitecollar@dynamisllp.com, today. We’re here to guide you through every step of your defense.