After the 1929 stock market crash, Americans’ faith in the economy crashed with it. In response to this and in an attempt to find a solution during the Great Depression, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. Focusing more on the SEA of 1934, it created the Securities and Exchange Commission (SEC). The law had two main objectives: (1) forcing companies to properly inform the public about their businesses and securities and (2) ensuring that those who sold and traded securities put the interests of the investors before their own interests.[1] These were trying years for the American economy and people and Congress hoped that the new laws would stabilize markets and protect investors in a future economic crash. President Franklin Delano Roosevelt appointed Joseph P. Kennedy to be the SEC’s first Chairman all in an attempt to boost American morale.

Insider Trading and the SEC

With the Securities Exchange Act of 1934, the newly created SEC was given authority over all aspects of the securities industry. Among other things, the SEC has the power to regulate brokerage firms, transfer agents, and clearing agencies and securities self-regulatory organizations (SROs) in the country. SROs encompass the many securities exchanges including, but not limited, the New York Stock Exchange and the NASDAQ Stock Market.[2] The act discusses corporate reporting, proxy solicitations, tender offers, insider trading, and the registration of exchanges, associations, and others. One of the most important aspects of the Securities Exchange Act is the information regarding insider trading.

The SEC observes two versions of insider trading – legal and illegal – but most people only associate insider trading with being illegal. The SEC defines insider trading to be legal when “corporate insiders – officers, directors, and employees – buy and sell stock in their own companies.”[3] These insiders must report all of their trades to the SEC when they trade their personal securities. Illegal insider trading is defined 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.”[4]

The Securities Exchange Act of 1934 explains in detail the civil penalties for insider trading. The penalties can be enacted if someone violates the rules by “purchasing or selling a security or security-based swap agreement while in possession of material, non-public information” or by “communicating such information in connection with, a transaction on or through the facilities of a national securities exchange or form or through a broker or dealer, and which is not part of a public offering of securities.”[5] The Commission may bring an accused individual to a district court for them to pay a civil penalty. One form of penalty is monetary payment – the amount is based on the individual’s involvement – if the individual was directly making the transaction, the penalty fine may not be greater than three times the profit gained or loss avoided as a result of the illegal transactions. If the individual directly or indirectly controlled the person making the trade or if the person was instrumental to the passing of information, the fines and penalties vary.

Enforcement 

Today, the United States is leading in its prohibition and regulation on insider trading. However, not everyone feels the same. According to a 2002 study at Indiana University, 87 of the 103 countries studied have insider-trading laws but the state has prosecuted cases in only 38 of those countries.[6] While the United States has the strictest laws, many people are now wondering if it is time to let go of these laws. Some economists believe that insider trading should be legal and defend it by considering it healthy for the economy.

The effectiveness of the SEC is due to its enforcement authority. Insider trading is one of the most common infractions against the securities laws and results in individuals and companies having civil enforcement actions against them. The Commission is comprised of a multiple divisions, one being the Division of Enforcement. This division helps the Commission by “recommending the commencement of investigation of securities law violations, by recommending that the Commission bring civil actions in federal court or as administrative proceedings before an administrative law judge, and by prosecuting these cases on behalf of the Commission.”[7] The SEC is considered a part of a federal government therefore infractions are technically handled and enforced by the federal government. The Division of Enforcement plays a major role in the investigative process to bring insider traders to light and to justice. Insider trading violations are one of the Commission’s biggest priorities as they pose a large threat to the SEC’s mission of maintaining a trustworthy market environment by undermining investors’ confidence in the fairness and integrity of American securities markets.

In this technological age, the Division of Enforcement can use new data analytics tools to spot patterns of suspicious activity. They are also notified of possible violations from tips and complaints from investors. Once they have their suspicions they can recommend opening an investigation of possible securities violations and can either recommend that the Commission bring civil actions in federal court or in front of administrative law judges. Once an investigation is opened, it is conducted privately. The fact-finding process includes informal inquiry, witness interviews, examination of brokerage records, and review of trading data, among other things.[8] Once collected and organized, the Division of Enforcement shows the information to the Commission who then either authorizes SEC staff to either file a case with a federal court or to bring about administrative action. However, most parties accused choose to settle with the Commission as opposed to going to trial. The Commission, through the Division of Enforcement, has filed insider trading cases and complaints against a variety of entities and individuals such as financial professionals, attorneys, hedge fund managers and corporate insiders. Since insider trading involves the passing of sensitive information, often times the charges are against groups, or high-ranking employees or employees with considerable access to said information and are therefore wealthier individuals.

Effectiveness

Every year, the SEC announces its enforcement results for its past fiscal year. On October 11, 2016, the results for the 2016 fiscal year were announced. Two of the most significant enforcement actions include charges for insider trading and beneficial ownership against Leon G. Cooperman and his firm Omega Advisors and charges for insider trading against William “Billy” Walter and his source, Thomas C. Davis, a former Dean Foods Company board member. Overall there were 78 major insider-trading cases, many of which involved elaborate insider trading rings. Other insider trading cases included charges against a former Goldman Sachs employee; a former senior employee at Puma Biotechnology Inc.; and two hedge fund managers and their source, a former U.S. Food and Drug Administration employee. Of the five US District Court jury or bench trials that were won with favorable jury verdicts, two were based on insider trading. Nan Huang was found guilty of illegal insider trading with information he obtained while working as a data analyst for Capital One. Daryl Payton and Benjamin Durant, former stockbrokers, were found guilty of insider trading by acting right before an acquisition of SPSS Inc. by IBM Corporation worth $1.2 billion.[9]

A high profile famous case includes Martha Stewart’s 2004 conviction. She was indicted on charges of conspiracy, obstruction of justice and securities fraud in a personal stock trade from 2001. The trade involved the sale of almost 4000 shares of IMClone Systems. Steward pleaded not guilty tried to conceal the fact that she made the sale only after learning that her friend Sumel D. Waksal, the founder of the company, was selling his personal stocks.[10] However, in her case, the charges were focused more on the fact that she attempted to cover up the true circumstances and less on the trade itself. As a result, while her case was well known, it didn’t change much in terms of precedence.

Salman v. U.S.

Currently the Supreme Court is facing a case, Salman v. U.S., that could change the way all insider-trading cases are processed in the future. Bassam Salman was originally convicted of insider trading with confidential information he received from an extended family member’s brother who worked at Citigroup. The decision reached by the Supreme Court will be monumental and set precedent for future cases since Congress has never specifically defined the details of insider trading as a crime and the Supreme Court has not taken a case related to insider trading in over two decades.[11] In the past, insider trading rules and crimes have been defined and investigated just by the SEC alone.

While Salman himself isn’t a high-profile individual, the details of this case will affect other insider trading cases involving high-profile individuals such as those of Raj Rajaratnam, Galleon Group cofounder, and Rajat Gupta, former Goldman Sachs director. Both Rajaratnam and Gupta have appealed their convictions due to similar reasons to Salman’s. Salman did not trade through his personal accounts but used the accounts of Karim Bayyouk, his brother-in-law. His trades resulted in his account reaching $2.1 million at which point he was found guilty of conspiracy to commit securities fraud and insider trading in 2011. He proceeded to appeal to the U.S. Court of Appeals for the Ninth Circuit who decided that there was in fact sufficient evidence that Salman was consciously trading on insider information due to the close family relationship in play. However the question that remains that the Supreme Court faces is “Is evidence of a close family relationship sufficient to sustain a conviction fro insider trading, or must there be evidence that the individuals knew there would be financial gain through the exchange of information?”[12] The court is expected to reach a decision in the coming year as the decision will set precedent for many future insider-trading investigations conducted by the Securities Commission’s Division of Enforcement.

Conclusion

While the textbook definition of insider trading seems cut and clear, in real life, it isn’t always the case for two reasons – the ambiguity of the definition and difficulty in tracking it. There is a fine line between what is and isn’t legal when it comes to insider trading. There is no clear definition on how much or how far in advance information must be transferred for it to really be insider trading. The other difficulty lies with actually catching and proving insider trading. Most insider trading cases are investigated on the basis of abnormal trading patterns and profits or on the basis of tips. However, often times insider trading is left undetected since the passing of information is done through word-of-mouth making it hard to prove. Fortunately since insider trading laws and court decisions rely heavily on precedent, each case helps refine the definition and methods. The Galleon case was a hallmark in setting precedent for its methods of gathering information with the usage of bugged conversations, wiretaps and inside informants to bring down one of the country’s wealthiest people[13]. Similarly Salman v. United States will change how these cases are perceived in the future by deciding whether having a family member in possession of valuable information is a sign of intent to commit securities fraud. If the Supreme Court maintains that Salman is indeed guilty of insider trading from information he received from a relative, similar cases in the future will have less ambiguity when it comes to reaching a verdict.

With more well-defined circumstances, future cases will have precedent making it easier for the Division of Enforcement within the Securities and Exchange Commission to investigate and enforce securities regulations therefore fulfilling their mission for the securities market. Maintaining and further defining insider trading laws and regulations allows the SEC to keep the market fair for all Americans. While the Securities Exchange act of 1934 in theory would prevent all illegal insider trading, in reality, the law is too ambiguous to work that way. However, as the state prosecutes more cases, more precedent is set and the rules surrounding insider trading are clarified. While controversial, insider trading should remain illegal to keep the playing field fair.

 

[1] What We Do – Creation of the SEC Sec.gov

[2] Fast Answers – The Laws That Govern the Securities Industry Sec.gov

[3] Fast Facts – Insider Trading Sec.gov

[4] Fast Facts – Insider Trading Sec.gov

[5] Securities Exchange Act of 1934 Sec. 21A

[6] The World Price of Insider Trading (University of Indiana)

[7] What We Do – Organization of the SEC Sec.gov

[8] What We Do – Organization of the SEC (Sec.gov)

[9] SEC Announces Enforcement Results for FY 2016 (Sec.gov)

[10] Prosecuting Martha Stewart (NYTimes.com)

[11] The Supreme Court is Weighing in (Businessinsider.com)

[12] Salman v. United States (Oyez.org)

[13] Insider Trading is Hard to Define, Prove and Prevent (knowledge.wharton.upenn.edu)

 

Works Cited:

 

 

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