U.S. insider trading is relatively easy to commit but extremely difficult to prove. Here is a primer for fraud examiners explaining the problem, how to tell if a trade is illegal, and what can be done to detect and prevent this popular crime. 

A chemist is surprised at the swift progress of a new drug his pharmaceutical company is developing. Anticipating a successful market release of the drug, the chemist purchases several hundred shares of his company’s stock. One week later, the company issues a press release announcing the significant advancement of its drug. The value of the company’s stock increases by 30 percent in one day. The chemist sells his shares the following day for a gain of nearly $25,000. Does the profit sound too good to be true? It should, because it is illegal. The chemist purchased shares on the basis of material non-public information. Therefore, insider trading occurred.

Insider trading is relatively easy to commit but extremely difficult to prove, which makes it a popular form of white-collar crime. In a well-known ongoing case, Martha Stewart has pleaded not guilty to U.S. federal criminal charges of conspiracy, obstruction of justice, and securities fraud, all linked to the sale of her nearly 4,000 shares of ImClone Systems, Inc. stock. The sale took place on Dec. 27, 2001, the day before the company announced negative news about its cancer-fighting drug, which sent the value of its shares into a tailspin. Stewart has denied any wrongdoing. The former chief executive of ImClone, Sam Waksal, a friend of Stewart’s, pleaded guilty to criminal charges of insider trading for tipping off family members and trying to sell his own shares before the news was made public. He was sentenced to more than seven years in prison.

Many corporate insiders have access to non-public information that they easily can use for profitable but illegal trading. In fact, several insider trading studies show that insiders consistently earn higher returns than public investors. One survey even indicated that when executives and directors purchase shares of their own company’s stock, percentage returns during the first year tend to outperform the market by nearly 50 percent.¹

What is the Problem?

The basic argument against insider trading is that insiders should not be permitted to earn profits based on an informational advantage not held by the investing public. Furthermore, insider trading undermines public confidence in the securities markets. If investors fear that insiders will regularly reap profits based on unfair advantages, investors will not be as willing to invest. Lower numbers of investors will lead to a lower demand for securities, which in turn will lead to lower stock values and a deflated market.²

Who are Inside Traders?

Most individuals charged with insider trading are “direct insiders” such as a company’s directors, officers, managers, or staff. “Temporary insiders” such as external business consultants, lawyers, accountants, and investment bankers can also be charged with insider trading. In addition, “tippees” such as friends, relatives, and acquaintances of direct and temporary insiders can be charged with insider trading.³

When a direct or temporary insider provides inside information to a tippee, both the insider and the tippee may be subject to liability. However, the tippee is liable only if he or she knew that the person providing him or her with information intentionally breached a duty owed to the corporation in providing the tippee with information. Inadvertent or accidental disclosure of information to a tippee, leading to the purchase or sale of securities by the tippee, cannot trigger liability for either the insider or the tippee.⁴

How Can You Tell if a Trade is Illegal?

The primary dividing line between legal and illegal insider trading is the materiality of information. Most profits by insiders are lawfully made by trading on important but non-material inside information. Trading becomes illegal only when information held by the trader crosses the line from non-material to material.⁵ In this respect, materiality of information is the greatest indicator of whether a trade is illegal.

Detecting and Examining Insider Trading  

The Security and Exchange Commission (SEC) is the primary entity responsible for examining U.S. insider trading. In the years 2002, 2001, and 2000, the SEC formally filed 59, 57, and 40 insider trading cases, respectively. The number of defendants named in those cases was 144, 115, and 116, respectively.⁶

Examinations may be triggered in a variety of ways. They frequently arise from information developed internally through review of corporate filings submitted to the SEC. For example, all directors, officers, and owners of more than 10 percent of a public company’s stock must file a statement of changes in holdings within two days of any changes in holdings.⁷ If the report indicates suspicious trading activity in light of the dissemination of material information to the public, a formal examination may be brought.

Examinations also arise from tips provided by co-workers or acquaintances of individuals who engage in insider trading. To encourage tips, the SEC has established a Web site, www.sec.gov/complaint.shtml, for reporting suspected wrongdoing. The SEC even offers a “bounty” to informants of up to 10 percent of the fines collected from defendants found liable for insider trading. Information regarding the bounty program can be found at www.sec.gov/divisions/enforce/insider.htm.

In addition, the NYSE, AMEX, and NASDAQ exchanges maintain sophisticated computer systems that identify suspicious trading activity that can be reported to the SEC.

For example, one AMEX system collects data identifying the buyer, seller, price, and time of day of each trade. The system monitors trading activity to determine whether it falls within the historical pattern of price and volume movement for the particular security. If unusual trading activity occurs just prior to a company’s release of material information to the public, an investigation may take place to determine whether the traders were aware of non-public information at the time of the trade. If the traders were in possession of non-public information, liability might result.⁸

In one case, an AMEX computer program identified suspicious purchases of a high number of seemingly worthless options. The next day, the company from which the stock options were purchased publicly announced that it was the target of a tender offer. The tender offer price was nearly $30 higher per share than the price called for by the options. Therefore, the value of the stock options increased, and the buyer of the stock options realized a $427,000 increase in the value of his stock options. After a preliminary investigation, AMEX officials learned that the buyer was the son of a director of the company that was the target of the tender offer. The buyer ultimately agreed to return all profits from the transaction.⁹

The NYSE even administers a computer system that maintains information on more than one million individuals who are likely to have access to inside information. Through public records, the system identifies people who work for publicly traded companies or who might otherwise have access to inside information. When unusual trading occurs just prior to the public dissemination of information by a company, the NYSE system attempts to identify personal relationships among insiders within the company and buyers or sellers of the company’s stock. Connections such as similar addresses and even common college class membership have triggered investigations in the past.¹⁰

Proving Insider Trading

Each of the following elements must be proven to find a defendant guilty of insider trading: 1) possession of material non-public information, 2) causation between the material non-public information and the investor’s decision to buy or sell securities, and 3) intent to deceive.¹¹

“Possession” of information is often difficult to prove. Memoranda, e-mails, or other tangible documents are frequently needed to prove that the defendant actually possessed the underlying information. Alternatively, possession may be proven with evidence that the defendant attended meetings at which non-public information was discussed, or held conversations with other individuals regarding the non-public information.¹² To circumstantially prove that conversations took place, particularly between a tipper and tippee, investigators may subpoena telephone records near the date of the trading event. Further-more, expense records or receipts may be obtained indicating that a suspected tipper and tippee attended an event together.

“Material” information is broadly defined under the securities laws as information having a “substantial likelihood that a reasonable investor would attach importance (to it) in determining whether to purchase the security.”¹³ Examples of material information include, but are not limited to, information regarding mergers or acquisitions, actual or projected earnings, litigation developments, reorganizations, dispositions of existing operations, bankruptcies, changes in key management personnel, reductions in orders from major customers, and new products or services.¹⁴

“Non-public” information is information that has not been disseminated to investors in the marketplace. Examples of methods of dissemination that normally suffice include, but are not limited to, distribution through a press release, SEC filing (Form 10K, 10Q, 8-K, annual report, etc.), newswire, newspaper, magazine, or analyst’s report.¹⁵

Sufficient time must also be allowed for information to permeate throughout the market. Generally, courts hold that insiders must refrain from trading for at least 24 hours after information has been disseminated to the public. This will allow the market to fully absorb the information. However, a waiting period of up to one week may also be appropriate, depending on the circumstances. The length of time required by courts generally depends on the method of dissemination and the number of avenues selected for dissemination.¹⁶

“Causation” between material non-public information and a defendant’s decision to buy or sell securities may be proven in different ways, depending on whether the charges are civil or criminal in nature. In civil cases, causation is shown simply by proving that the trader was “aware of the material non-public information when the person made the purchase or sale.”¹⁷ Mere possession of material non-public information creates a presumption that the information caused the insider’s decision to buy or sell the securities. The rationale of the presumption is that “material information cannot lay idle in the human brain.”¹⁸ To rebut this presumption, the insider must offer evidence that the decision to buy or sell securities was independent of the possession of material non-public information.¹⁹

In criminal cases, causation is more difficult to prove. Causation is not presumed from mere possession of material non-public information. Rather, it must be proven that the defendant actually used the material non-public information in making the decision to buy or sell securities. Actual use may be proven by evidence that the defendant told a third party that he or she made the trade because he or she believed the upcoming dissemination of information to the public would affect the stock price.²⁰ Actual use also may be proven by producing written records or letters in which the defendant revealed that the subject was motivated to trade securities because of possessing material non-public information. Furthermore, actual use may be proven at least in part from circumstantial evidence.

Circumstantial evidence is applicable when, for example, an insider who has never invested in the past invests an unusually large sum of money shortly after acquiring material non-public information. Such trading activity creates an inference that the defendant may have used the information in making his or her decision to trade the securities.²¹

“Intent to deceive,” also referred to as “scienter,” is generally the most difficult element of insider trading to prove. Intent to deceive may be proven by evidence that a defendant communicated his or her unlawful intentions to a third party. Also, similar to causation, intent to deceive may be proven at least in part from circumstantial evidence. Circumstantial evidence of intent to deceive includes, but is not limited to, uncharacteristically large trading patterns just before a company’s dissemination of material information to the public, or evidence that the defendant executed trades under a name different than his or her own.²²

Burden of Proof

In civil cases, the elements of insider trading must be proven by a “preponderance of the evidence.” In criminal cases, the elements must be proven “beyond a reasonable doubt.” The latter standard is much more difficult to meet than the former. Thus, in general, cases are brought in a criminal context only if authorities have obtained substantial proof or if the cases involve relatively high-dollar amounts so that it is justified for the government to expend significant resources in gathering further proof.²³

Liability for Insider Trading

Civil penalties for insider trading include disgorgement (i.e. repayment) of profits gained or losses avoided, plus a fine of up to three times the amount of the profit gained or loss avoided.²⁴ Profits gained and losses avoided are measured by the difference between the market price of a company’s securities on the date of the defendant’s purchase or sale of the securities and the market price of the company’s securities “a reasonable period after public dissemination of the non-public information.”²⁵ A reasonable period has been held to be as little as one day to as many as eight days.²⁶

Disgorged profits are remitted either to investors who have been harmed by the insider trading, or to the U.S. Treasury. As a practical matter, it is extremely difficult to determine which investors were harmed by insider trading, and the extent of the investors’ losses. Therefore, disgorged funds are usually paid to the U.S. Treasury.²⁷

Although civil fines may equal up to three times the amount of the profit gained or loss avoided, civil fines are most often assessed at the same amount of the disgorgement.²⁸ Similar to disgorged profits, civil fines are paid to the U.S. Treasury.²⁹

Criminal penalties for insider trading include a fine of up to $5 million, a sentence of imprisonment of up to 20 years, or both.³⁰ Criminal monetary fines are usually low, particularly when the SEC has already ordered a civil fine, or when a sentence of imprisonment has been imposed. Courts also are willing to impose lower fines when the fine will place a significant financial burden on the defendant and his or her dependents.³¹

Under the U.S. Sentencing Guidelines, the term of imprisonment for insider trading is calculated based on the amount of profits gained or losses avoided. The sentence is increased as profits gained or losses avoided are increased. For example, for a defendant with no criminal history, the following sentencing ranges are applicable:

These sentencing ranges represent base sentences. Under the guidelines, there are a number of specific factors within a case’s context that may lead to an increase or decrease in a base sentence.

If the low end of the sentencing range is less than 12 months, under the guidelines judges may order that the sentence be served by a combination of imprisonment, supervised release, and/or probation. However, if the sentence imposed is greater than 12 months, a term equal to at least the low end of the sentencing range must be served by actual incarceration. Thus, defendants in cases involving high-dollar profits gained or losses avoided can expect to serve at least some part of their sentence in prison.³³ Defendants may earn a reduction in their sentence of up to 15 percent for good behavior while in prison.³⁴

Preventing Insider Trading

To help prevent insider trading, companies may establish a code of conduct informing employees of the risks and consequences of insider trading. Codes of conduct tend to be most effective when employees are required to sign a statement (perhaps annually or every few years) verifying that they read the policy, understand it, and agree to abide by it.

The code of conduct should be sufficiently short and straightforward for employees to read and understand it. Some common contents of insider trading codes of conduct include: 1) examples of situations, or types of insider information, that employees are likely to encounter in their jobs (examples may be provided based on the type of industry and business environment in which the company operates); 2) a statement that the organization prohibits trading when one is in possession of material non-public information; 3) a statement that the organization prohibits tipping outsiders about non-public information; 4) brief definitions of the terms “material,” “non-public,” and “tipping”; 5) a summary of the sanctions for insider trading; and 6) the name of a person to whom all questions of interpretation should be addressed.

Many companies also impose restrictions on employee trading. For example, some companies limit purchases and sales of securities by employees to a designated period of time following the public dissemination of annual or quarterly financial information, periodic press releases, or other public announcements. Generally, such a period begins at least two business days after the public dissemination of information and ends approximately 10 days thereafter.³⁵

Insider trading liability is not reserved just for high-level corporate executives. Low-level employees, temporary insiders, and tippees have increasingly been charged with insider trading. Furthermore, traditionally large insider trading schemes have been joined in recent years by smaller versions that are more difficult to detect.

Fines and criminal sanctions for insider trading have increased in recent years, and insider trading has become a greater priority to authorities. However, due to the complexity of insider trading law and the significant government resources needed to investigate and litigate insider trading, only a relatively low number of insider trading cases are actually litigated.

Investors with access to material non-public information might, intentionally or unintentionally, engage in insider trading. Insider trading laws are complicated and can be a trap for the unwary. To address insider trading at its source, one final proposition is warranted: Those who possess material non-public information must ensure that they do not use that information as a basis for their investment decisions. Otherwise, civil or criminal liability for insider trading could result.

Jon Lambiras, CFE, CPA, is a third-year law student at Pepperdine University in Malibu, Calif.

1. Jon Newberry, “Buying With the Big Boys: Tips on Tracking Insider Stock Purchases, Which Signal Big Gains Ahead,” 85 A.B.A. J. 84, 84 (1999).
2. Ralph C. Ferrara et al., Ferrara on Insider Trading & The Wall § 1.01 (2003).
3. 69A AM. JUR. 2D Securities Regulation – Federal §§ 1525, 1530 (2003).
4. Dirks v. SEC, 463 U.S. 646, 662 (1983); SEC v. Switzer, 590 F. Supp. 756, 766 (D.C. Okla. 1984).
5. Jesse M. Fried, Reducing the Profitability of Corporate Insider Trading Through Pretrading Disclosure, 71 S. CAL. L. REV. 303, 311 (1998).
6. Sec. and Exch. Comm’n, Annual Report (years 2002, 2001, and 2000), tbl. 1, available at www.sec.gov/about.shtml (last visited May 6, 2003).
7. 15 U.S.C. § 78p(a) (2003).
8. Ferrera et al., supra note 2, § 5.02(1), (2)(b).
9. Ibid.; SEC v. Reed, No. 81-7984, 1981 WL 315226, at *1 (S.D.N.Y. Dec. 23, 1981) (Litig. Release No. 9537).
10. Ferrara et al., supra note 2, § 5.02(2)(c).
11. Ferrara et al., supra note 2, § 2.01(1), (4), (5)(a); Michael R. Klein, “Trading on Inside Information: Problems of Defining, Detecting, Prosecuting, and Defending Insider Trading Cases,” in Civil Liability for Insider Trading 671, 686-91 (PLI Litig. & Admin. Practice Course Handbook Series, No. H4-4956, Nov. 1984), available at WL 270PLI/Lit 671.
12. Thomas C. Newkirk & Melissa A. Robertson, Sec. and Exch. Comm’n, Insider Trading – A U.S. Perspective, sec. 5 (Sept. 19, 1988), at www.sec.gov/news/speech/speecharchive/1998/spch221.htm (last visited May 6, 2003).
13. 17 C.F.R. § 230.405 (2003).
14. SEC v. Katz, No. 11185, 1986 WL 9962, at *1 (S.D.N.Y. Aug. 7, 1986) (merger); United States v. Cusimano, 123 F.3d 83, 87 (2d Cir. 1997) (acquisition); Feldman v. Hanley, 59 F.R.D. 299, 301 (S.D.N.Y. 1973) (actual earnings); Robert C. Rosen, “An Accountant’s Guide to the SEC’s New Insider Trading Regulations,” CPA Journal Online (Feb. 1993) (projected earnings), at www.nysscpa.org/cpajournal/old/13808667.htm (last visited May 6, 2003); Harvey L. Pitt et al., “Law Firm Policies Regarding Insider Trading and Confidentiality,” 47 BUS. LAW. 235, 243 (1991) (litigation developments, reorganizations, dispositions of existing operations, reductions in orders from major customers, and new products or services); Exchange Act Release No. 43,154, 73 SEC Docket (CCH) at 11 (Aug. 15, 2001) (bankruptcies, changes in key management personnel, and developments regarding suppliers).
15. United States v. Cusimano, 123 F.3d 83, 89 n.6 (2d Cir. 1997) (press release, SEC filing, newspaper, magazine, and analyst’s report); Ferrara et al., supra note 2, ß 2.01(2) (newswire).
16. Ferrara et al., supra note 2, § 2.01(2); Eric Landau & Shawn Harpen, “Insider Trading: Making Sure Your Corporate Policy Performs,” in Corporate Compliance 657, 668 (PLI Corp. Law and Practice Course Handbook Series, No. B0-01A2, July 2002), available at WL 1317 PLI/Corp 657.
17. 17 C.F.R. 240.10b5-1(b) (2003).
18. United States v. Teicher, 987 F.2d 112, 120 (2d Cir.), cert. denied 510 U.S. 976 (1993).
19. Ferrera et al., supra note 2, § 2.01(5)(c).
20. United States v. Smith, 155 F.3d 1051, 1067, 1069 (9th Cir. 1998).
21. Smith, 155 F.3d at 1069.
22. SEC v. Willis, 777 F. Supp. 1165, 1173 (S.D.N.Y. 1991)); In re Splash Tech. Holding, Inc. Securities Litig., No. C 99-00109 SBA, 2000 WL 1727405, at *11 (N.D. Cal. Sept. 29, 2000); Ferrera et al., supra note 2, § 2.01(4) nn.40-42.
23. Harold S. Bloomenthal & Samuel Wolff, 3C Sec. & Fed. Corp. Law § 19:53 n.4 (2002), available at WL SECFEDCORP 19:4; Erica Clements, The Seventh Amendment Right to Jury Trial in Civil Penalties Actions: A Post-Tull Examination of the Insider Trading Sanctions Act of 1984, 43 U. MIAMI L. REV. 361, 378 n.88 (1988); 69A AM. JUR. 2D, supra note 3, § 1740.
24. SEC v. Lipson, 278 F.3d 656, 663 (7th Cir. 2002) (disgorgement); 15 U.S.C. § 78u-1(a)(2) (2003) (fine).
25. 15 U.S.C. § 78u-1(f) (2003).
26. Lipson, 278 F.3d at 663-64 (one day); SEC v. Chapnick, No. 90-6793, 1994 WL 113040, at *2-3 (S.D. Fla. Feb. 11, 1994) (eight days).
27. Rory C. Flynn, SEC Distribution Plans in Insider Trading Cases, 48 BUS. LAW. 107, 121 (Nov. 1992).
28. 2-9 Fed. Sec. Exch. Act of 1934 § 9.02(3)(d)(ii) (Matthew Bender & Co. ed., 2002).
29. 15 U.S.C. § 78u-1(d)(1) (2003).
30. 15 U.S.C. § 78ff(a) (2003).
31. United States Sentencing Guidelines Manual § 5E1.2(d)(1)-(5) (2003) (noting factors courts may consider in determining criminal fines).
32. Ibid. § 2B1.4 (Base Offense Level); Ibid. § 2B1.1 (Loss Table); Ibid. ch. 5, pt. A (Sentencing Table).
33. Ibid. § 5C1.1(b)-(d), (f); Ibid. ch. 5, pt. A (Sentencing Table).
34. Ibid. pt. A, sect. 3 (Introduction to the Guidelines).
35. Bass, Berry & Sims PLC, “Corporate and Securities: Insider Trading Compliance Policies for Public Companies and Law Firms,” secs. C, D(2)(a), available at www.bassberry.com/resources/corp/012496/4.html (last visited May 6, 2003); Steven Chasin, Insider v. Issuer: Resolving and Preventing Insider Trading Compliance Policy Disputes, 50 UCLA L. REV. 859,
    861-63 (2003).