Insider Trading in the United States

By Authored by Rachel Replogle, Esq. for the Association of Corporate Counsel

Overview

"Insider trading" is the act of purchasing or selling securities (most commonly shares of stock) on the basis of material nonpublic information.  Material nonpublic information is that which has not been released to the public and will likely have an impact on the corporation's stock price when released. Corporate insiders must allow the market reasonable time (generally six months) to absorb the information after publication before they can trade upon it. An insider can be a director, officer, or employee of the corporation, or anyone who, even temporarily, becomes a fiduciary of the corporation (e.g., attorneys, accountants, consultants, brokers).

Prohibitions on insider trading in financial markets are put in place to protect investors' confidence in the integrity of securities markets and the value of their investments. Without such restrictions, investors and businesses would be disadvantaged by those with "inside" information, and disincentives to market investment would arise.

While the term is frequently used to refer to the practice in which an insider trades on material nonpublic information obtained during the performance of the his or her duties at that corporation, any trading done while "aware" of inside information about the corporation is illegal. Thus, friends, family members, brokers, government employees, and anyone else who misappropriates inside information can be subject to insider trading liability, in addition to the insider who tipped them off.

Federal Laws

Federal law governs insider trading in the United States. Congress has passed numerous pieces of legislation affecting insider trading, however the following are most relevant:

  • The Securities Act of 1933 ("'33 Act") required companies engaging in the public sale of securities to provide investors with financial and other significant information concerning that sale. It also penned a general prohibition on deceit, misrepresentation, and other fraud in connection to the sale of securities to the public.
  • Soon after, Congress passed The Securities and Exchange Act of 1934  ("'34 Act") which established the SEC and formed the basis for financial market regulation in the United States.  In contrast to the '33 Act, the '34 Act was concerned with regulating the secondary market, where securities are bought and sold. 
  • The Sarbanes-Oxley Act of 2002 ("SOX") was enacted in the wake of numerous high-profile corporate and accounting scandals. Although the vast majority of SOX mandates relate to other wide-ranging corporate issues, its provisions did require accelerated deadlines for insider ownership report filings.

Legal Insider Trading

Not all trading by insiders is illegal; if it is done without taking advantage of material, non-public information and is properly reported to the SEC, traders will likely not incur insider trading liability. Transactions made upon knowledge of nonpublic "outside" information (e.g., pending market-wide, industry or competitor developments) are not prohibited by current insider trading regulations.

In addition, transactions by insiders made under specified circumstances, such as pursuant to an existing trading plan or contract, are also protected by law, provided they were made in good faith (see "Affirmative Defense" below).

Reporting Requirements

Directors, officers, principal stockholders, and any other beneficial owners of more than 10% of any class of a company's security are subject to the Section 16 of the '34 Act (see below). To be in compliance, insiders must report their trades to the SEC on Forms 3, 4 and 5:

  • Form 3 – the initial filing required for all securities. First-time registrants must file a Form 3 no later than the effective date of the registration statements. Subsequently, Form 3s must be filed within 10 days of becoming a director, officer, or beneficial owner.
  • Form 4 – must be filed with the SEC within two business days of a change in ownership (with exceptions).
  • Form 5 – used to report deferred reporting-eligible transactions and transactions that should have been previously reported on a Form 4. Form 5s must be filed no later than 45 days after the end of the company's fiscal year.

These forms require detailed information, including the title of the securities, amounts owned, ownership form (direct versus indirect), and the nature of indirect beneficial ownership. As of 2003, all insiders must submit these forms electronically through the SEC's EDGAR system.

Illegal Insider Trading

Because trading on the basis of material, non-public information can adversely affect securities markets, and decrease the firm's value, those engaging in illegal insider trading should be held accountable. The prevailing rationale behind this is that insiders are agents of the corporation, owe duties to their principals (the shareholders), and breach those duties in an instance of insider trading.

The key component of insider trading is the misuse of information, not the job title or even how the information was discovered. Aside from those insiders directly employed by the company, individuals indirectly involved with the corporation such as temporary insiders and tippees (one who receives material nonpublic information about the company from an insider) can also be subject to insider trading liability.

Likewise, a controlling person—someone who directly or indirectly supervises other employees—may also be liable for insider trading. If a controlling person knew (or should have known) that an employee under his or her supervision was likely to engage in insider trading and failed to prevent it, the controlling person could also face substantial penalties.

Most operative in SEC insider trading enforcement efforts are the broad antifraud provisions of federal securities law, primarily Section 10(b) of the Exchange Act and Rule 10b-5. These provisions are violated when a corporate insider who has material nonpublic information trades in the securities of his corporation based on that information. Section 10(b) proscribes the use of "any manipulative or deceptive device" in connection with the purchase or sale of securities in contravention of rules prescribed by the SEC. Note that this section prohibits any deceptive device, not simply deception by the purchaser or seller. Therefore, an insider who "tips" others to purchase or sell based on that information is also in violation and thus subject to insider trading liability.

Pursuant to 10(b) rulemaking authority, the SEC adopted rule 10b-5 which prohibits, generally, fraud and deception in connection with the purchase or sale of any security. Rules 10b5-1 and 10b5-2 were later added to resolve unsettled issues among the judiciary over the definition of insider trading.

Rule 10b5-1 provides that a person must only be "aware" of the material nonpublic information at the time of the purchase or sale (rejecting the former "use" standard). In other words, an employee could be liable for making a trade, while in possession of inside information, even when he or she would have purchased or sold the securities without that information. The rule also allows for certain exceptions when it is clear that the transaction was not affected by the aforementioned awareness, and was made pursuant to a pre-established trading plan or contract (see Affirmative Defense below).

In order to encourage 10b5-1 compliance, many corporations implement "blackout" periods during which corporate insiders are prohibited from trading in the company's securities. For example, employees may only trade in the company's securities beginning on the third business day following the company's widespread public release of material information.

Rule 10b5-2 concerns the "misappropriation theory," which holds that a person engages in insider trading when he or she misappropriates (steals) confidential information for securities trading purposes. This rule commonly applies when an insider "tips off" family members or friends, thus breaching the insider's fiduciary duties to the corporation. Liability can arise for both the tippee and the insider under Rule 10b5-2 and the U.S. Supreme Court's decision in Dirks v. SEC, 463 U.S. 646 (1983).

Affirmative Defense

Rule 10b5-1(c) provides an affirmative defense against insider trading liability if the individual or entity can establish three factors:

  • First, that before becoming aware of the information, he or she has entered into a binding contract to purchase or sell the security, provided instruction to another person to execute the trade, or adopted a written plan for trading securities.
  • Second, with respect to the first factor, the trader either: (1) expressly specified the amount, price, and date; (2) provided a written formula or algorithm, or computer program for determining amounts, prices, and dates of purchase or sale; or (3) did not permit the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales, provided that any other person who did exercise such influence was not aware of the material nonpublic information when doing so.
  • Third, that the purchase or sale that occurred "was pursuant to" the prior contract, instruction, or plan.  A purchase or sale does not meet this requirement if, among other things, the person who entered into the contract, instruction, or plan altered or deviated from it, or if he or she entered into or altered a corresponding hedging transaction or position with respect to those securities.

Under this section, one who puts a plan in place to buy or sell securities (for example, in anticipation of retirement) at X number of shares every month for the next 3 years would be protected and allowed to continue the plan even if that person later came upon material nonpublic information that would tend to affect a decision to buy or sell securities. If the plan was in put place before the person became aware of the information, all applicable forms have been filed with the SEC, and the person makes no effort to change the course of the plan, there is no reason to subject that person to insider trading liability.

Penalties

Those prosecuted for insider trading face potential disgorgement of profits and fines up to three times the amount gained or the loss avoided by the illegal trades.  Individuals convicted of a willful violation may be imprisoned for up to 20 years and fined up $5 million. Insider trading by high-level employees can also subject their companies to fines of up to $25 million, and expose the company, its officers and directors to shareholder lawsuits.


CONCLUSION

Despite its negative association, insider trading can be, and frequently is, done legally in the U.S. So long as the reporting requirements set forth in the '34 Act are adhered to, insider traders are free to trade their securities according to their pre-established plans without fear of an enforcement action. The water only turns murky when a trade is made on the basis of material, non-public information. The penalties of such trading can bankrupt even a wealthy man and land him in jail, so traders beware!


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