The Insider Trading and Securities Fraud Enforcement Act of 1988

Bilal Mirza

The University of California, Berkeley

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

          Americans are investing in the stock market more than they ever have in history. The American people account for more than twice as much money in the market place than commercial banks. [1] The large sum of investment in the securities market all stems from investor confidence and laws have been enacted to maintain it. There have been many rules and regulations set in place to battle the fraudulent activity that occurs in the market. The most common of these is insider trading. Insider trading entails the act of buying or selling of a security by an individual or a firm whom has access to information that has not been made to the public.[2] This deems as a large issue because those in possession of insider knowledge will have an unfair advantage. To counter this a series of laws were enacted and Insider Trading and Securities Fraud Enforcement Act of 1988, which was passed to seek civil and criminal penalties against persons who participated in illegal insider trading.

           Prior the Great Crash of 1929, there was little regulation in the securities market and after nearly half of the market was wiped away, Congress proceeded to enforce new preventative laws. It wasn’t until the mid 1900s where the government made attempts at regulating insider trading. The Insider Trading and Securities Fraud Enforcement Act of 1988 was passed on November 19th, 1988 when President Reagan signed it. The intent of the act was “to improve the procedures and remedies for the prevention of insider trading…”[3] The law itself is an amended version of the Securities Exchange Act of 1934. This law was enacted in 1934 to govern the secondary trading of securities (stocks, bonds, and debentures) in the US.[4] The act also established one of the key players in regulating the stock market, the Securities of Exchange Commission (SEC), at an attempt to restore investor confidence in the marketplace by providing more consistent information and clearer rules.

There are several methods of implementing and tracking insider trading. The bulk of data retrieved on insider trading comes from informants, self-regulatory organizations (SROs) and the SEC’s market trading monitoring. When the SEC suspects someone of insider trading they will work with the broker to identify the account holder and request any and all information including knowledge of insider information, reasons for trade, monthly account statements, blue sheets and any relevant information that the SEC could use to build a case.[5] With sufficient evidence the SEC can begin the prosecution and take it to congress if necessary.

The market forgoes numerous changes and to account for these changes new laws are created and augmented. The Insider Trading and Securities Fraud Enforcement Act of 1988 was established to supplement The Securities Act of 1934 and to specify and expand the penalties for insider trading. The law broadens the provisions of the law passed in 1934. The extended provisions include: further liability to “controlling persons” who do not take the proper measures to prevent any incident of insider trading. [6] The “controlling persons” must follow the guidelines designed to keep an individual or a firm from insider trading. The penalties at a civil level for insider trading can come at a cost of up to 3 times the amount of gain or loss realized or up to $1,000.000 for an individual and up to $2,500,000 for an entity.[7] Furthermore, a criminal prosecution comes with a max jail sentence of an additional 5 years from the 1934 act to a 10-year maximum sentence. [8] The act also calls for a bounty provision to those who come forward about insider trader information that authorizes the SEC to incentivize payments of up to 10% of the civil penalty.[9] The law clarifies that no action can be taken 5 years after the incident.

The ongoing debate of the regulations set on insider trading come down to whether it is moral (fair) from the proponent and if it is economically efficient from the opponents’ side. [10] The Securities of Exchange Commission enforces the regulation of insider trading and deems it to be a high priority. The ongoing debate argues whether or not the SEC should focus their attention to those employees and directors whom are part of the corporation in which the shares are traded or to assume that the board has the morals and ethics to enforce these rules within their company. The issue here is that the majority of insider trading stems from executives of companies and financial institution’s that make their money solely from the market place. The opponents of this act are, are stock traders, fund managers, executives, board members and often times the employees of the companies themselves. The main argument for permitting insider trading is to maintain efficiency in the market place; however, the unethical outcomes for those with the insider knowledge out ways any argument for permitting insider trading.

Insider trading rules are continuously augmented to keep up with the new technological advancements. Some of the largest scandals in the history of the US economy have risen from insider trading. Those affected by insider trading are often times the average investor who put their hard earned money in the market place from sheer belief and confidence in the system. A quote from the chairman of the SEC in 1988 stated, “Trading based on privileged access to information can demoralize investors and destabilize investment. It has utterly no place in any fair-minded, law-abiding economy.” [11] This statement sheds light on the severity and level of priority the SEC puts on insider trading, however are these enacted laws attacking this problem of insider trading as a whole and if not, who are the ones benefiting and who are the ones facing the repercussions?

The financial markets have continued hitting historical levels and the SEC is putting high priority on enforcing regulations on insider trading. FINRA (Financial Industry Regulatory Authority) mandates firms to establish written supervisory procedures that are designed to detect and prevent the misuse of inside information by persons within a corporation according to Section 15(f) of the Exchange Act. In section 204A of the Insider Trading and Securities Fraud Enforcement Act of 1988, it states that “Every investment adviser subject to section 204A of this title shall establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment, to prevent the misuse in violation of this, or the rules or regulations thereunder, of material, nonpublic information by such investment adviser or any person associated with such Investment adviser.” [12] The SEC advises that if an individual is uncertain as to whether or not it is legal to trade a companies security, to do the following report to the Chief Accounting officer, refrain from placing any trades until further notice and to not communicate any information inside or outside of the company.[13] The Insider Trading and Securities Fraud Enforcement Act (1988) also implemented incentives for informants, holds companies responsible for employees, and allows contemporaneous traders to recover losses. Additionally, the SEC enforces that insiders of a company must refrain from buying or selling of a companies shares on the open market without following with the companies’ pre-clearance process. Lastly, any insider with knowledge that has not been made public must follow the procedures set in place and must wait until the information has been made public before placing any trades on the open market. Failing to follow these procedures will result in a loss of employment and could be potentially taken to court.

The majority of development in insider trading has been an outcome of court decisions. The Insider Trading and Securities Fraud Enforcement Act was passed in 1988 and since then two prominent court decisions have affected the implementation of the statute. In 2000, the United States Securities and Exchange Commission (SEC) enacted Rule 240.10b51, which clarified the definition of insider trading. The case between the United States Supreme Court and James O’Hagan was a factor in enacting this rule. Mr. O’Hagan was a partner at the Dorsey and Whitney law firm, which was considering the takeover of Pillsbury Company. Despite being a part of the firm, Mr. O’Hagan was not directly involved with the takeover but had obtained information of the possible takeover. With this information he profited approximately $4.3 million from this information. O’Hagan’s argument was that “neither he or his firm owed a fiduciary duty to Pillsbury, hence he did not commit fraud”.[14] The court did not buy his argument and followed through with his conviction. From this, the Supreme Court implemented the “misappropriation theory” that then made it so that persons of a firm could not misappropriate or use confidential information for their own personal gain. Furthermore, another example of a court decision that influenced the law was the case of Dirks v. SEC. The case of Dirks v. SEC addressed the issue of “tipping” to friends about insider information. As stated in an article by Cornell Law school, “In Dirks, the Court held that a prosecutor could charge tip recipients with insider trading liability if the recipient had reason to believe that the information disclosure violated another’s fiduciary duty and if the recipient personally gained from acting upon the information.”[15] From this court decision, tippees could then also be charged with insider trading. There have been a couple court decisions regarding insider trading, from analyzing these court cases we can form a hypothesis on whether or not the courts can be selective or bias.

Bias and selectivity in the enforcement of insider trading are both significant and prevalent. The opportunity for bias or selectivity to occur happens in the enforcement process. Specifically the potential for this occurs in the investigation of a case. Opportunities for selectivity tends to stem from “gaps, ambiguities, and imprecision in the substantive regulatory framework”.[16] The bias in the US insider trading regulation system stems from the unclear and imprecise legal standards. One of the most famous insider trading cases is the charge of insider trading against Martha Stewart. The argument for bias in this case was that she is a woman, Democrat and that she is a well-known public figure (and wealthy). With these factors in mind, the conviction that lead to a 5-month jail sentence deems to be extremely light compared to her male counterparts that faced similar charges. The bias in this case raises questions of the due diligence of the SEC, DOJ and the courts in assessing her case. The apparent bias and selectivity in insider trading regulations does not always occur however, the integrity of the US securities market is something that raises concerns.

The goal of the SEC is to ensure a fair and honest market that will maintain investor confidence. However, the effectiveness of these insider-trading regulations still allow for insiders to trade based on non-public information and reap in large monetary gains. Empirical evidence from a vast number of studies done shows that the correlation of an increase in securities purchased and sold by insiders before good and bad news is evident.[17] The reasoning behind this is the difficulty to prove whether or not an insider had obtained valuable information that lead to their activity in the market. When looking into further market regulating reforms, this deems as a key area in which the SEC and the DOJ need to assess. The several laws that have been implemented to battle securities fraud and insider trading have unfortunately not been achieved. These laws are helpful in the prevention of certain large corporations from committing insider trading but do not tackle the issue as a whole.

In order for the SEC and DOJ to grasp a better hold of regulating the securities market, further laws and statutes need to be implemented to boost investor confidence and to instill fairness and honesty in the market place. A solution suggested by a group of professors from Arizona State University stated, “one possible solution would be the imposition of disclosure requirement on corporate insiders (including their legal, accounting, and investment banking advisors) that requires immediate disclosure of all value relevant information as soon as it is known by the company”.[18] This would make it so that the insiders, the average investor and anyone participating in the markets would have access to perfect information, making it a more fair system. An additional idea for reform could be the implementation of penalties against corporations if any of their insiders were found guilty of insider trading. One final solution, that is very unlikely but is a possibility would be to eliminate the ability of insiders to trade their company’s securities. Each of these ideas is feasible but the question is, will this disrupt the efficiency in the market place?

 

 

 

 

 

 

 

Works Cited

 

 

89-5 Insider Trading and Securities Fraud Enforcement Act of 1988. (1988). Retrieved       September 23, 2016, from http://finra.complinet.com/en/display/display_main.html?rbid=2403

 

Bettis, J. C., Duncan, W. A., & Harmon, W. K. (2011). The Effectiveness of Insider Trading Regulations. Retrieved November 4, 2016, from Clute Institute, http://www.cluteinstitute.com/ojs/index.php/JABR/article/viewFile/5652/5733]

 

Hemingway, J. M. (2003). Save Martha Stewart? Observations About Equal Justice in U.S. Insider Trading Regulation. Retrieved November 04, 2016, from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=489005

 

 

Insider Trading. np. n.d. Retrieved November 04, 2016, from https://en.wikipedia.org/wiki/Insider_trading#Court_decisions

 

Insider trading. (n.d.). Retrieved November 04, 2016, from https://www.law.cornell.edu/wex/insider_trading

 

 

Investopedia.com (2003). Insider trading. In .

http://www.investopedia.com/terms/i/insidertrading.asp

 

Insider Trading How Jurisdictions Regulate It. Retrieved September 23, 2016, from https://www.iosco.org/library/pubdocs/pdf/IOSCOPD145.pdf

 

Kaplan, H., Matteo, J., & Pfeffer, A. (2012, April 20). The Law of Insider Trading. Retrieved September 23, 2016, from americanbar.org, http://www.americanbar.org/content/dam/aba/administrative/litigation/materials/sac_2012/29-2_the_law_of_insider_trading.authcheckdam.pdf

 

Levitt, Arthur, (1998, February 27). Speech by SEC Staff: A Question of Integrity: Promoting Investor Confidence by Fighting Insider Trading. Retrieved September 23, 2016 from https://www.sec.gov/news/speech/speecharchive/1998/spch202.txt

 

Newkirk, T. C., & Robertson, M. A. (1988, September 19). Speech by SEC Staff: Insider Trading – A U.S. Perspective. Retrieved September 23, 2016, from https://www.sec.gov/news/speech/speecharchive/1998/spch221.htm

 

Public Law 100-704- NOV. 19, 1988. Retrieved September 23, 2016, from https://www.gpo.gov/fdsys/pkg/STATUTE-102/pdf/STATUTE-102-Pg4677.pdf

 

 

Securities Exchange Act of 1934. (2016, January 24). Retrieved September 23, 2016, from https://en.wikipedia.org/wiki/Securities_Exchange_Act_of_1934

 

 

 

 

Policies and Procedures to Detect and Prevent Insider Trading. (2014, November 13). Retrieved November 04, 2016, from http://www.dcontainerships.com/about-us/policies-and-procedures-to-detect-and-prevent-insider-trading/

[1] Newkirk, T. C., & Robertson, M. A. (1988, September 19). Speech by SEC Staff: Insider

Trading – A U.S. Perspective. Retrieved September 23, 2016, from

https://www.sec.gov/news/speech/speecharchive/1998/spch221.htm

[2] Investopedia.com (2003). Insider trading. In .

http://www.investopedia.com/terms/i/insidertrading.asp

 

[3] Public Law 100-704- NOV. 19, 1988. Retrieved September 23, 2016, from https://www.gpo.gov/fdsys/pkg/STATUTE-102/pdf/STATUTE-102-Pg4677.pdf

 

[4] Securities Exchange Act of 1934. (2016, January 24). Retrieved September 23, 2016, from https://en.wikipedia.org/wiki/Securities_Exchange_Act_of_1934

 

[5] INSIDER TRADING HOW JURISDICTIONS REGULATE IT. Retrieved September 23, 2016, from https://www.iosco.org/library/pubdocs/pdf/IOSCOPD145.pdf

 

[6] 89-5 Insider Trading and Securities Fraud Enforcement Act of 1988. (1988). Retrieved September 23, 2016, from http://finra.complinet.com/en/display/display_main.html?rbid=2403

 

[7] Ibid.

[8] Ibid.

[9] Ibid

[10] Kaplan, H., Matteo, J., & Pfeffer, A. (2012, April 20). The Law of Insider Trading. Retrieved September 23, 2016, from americanbar.org, http://www.americanbar.org/content/dam/aba/administrative/litigation/materials/sac_2012/29-2_the_law_of_insider_trading.authcheckdam.pdf

 

[11]Newkirk, T. C., & Robertson, M. A. (1988, September 19). Speech by SEC Staff: Insider Trading – A U.S. Perspective. Retrieved September 23, 2016, from https://www.sec.gov/news/speech/speecharchive/1998/spch221.htm

 

[12] Public Law 100-704- NOV. 19, 1988. Retrieved September 23, 2016, from https://www.gpo.gov/fdsys/pkg/STATUTE-102/pdf/STATUTE-102-Pg4677.pdf

[13] Policies and Procedures to Detect and Prevent Insider Trading. (2014, November 13). Retrieved November 04, 2016, from

[14] Insider Trading. np. n.d. Retrieved November 04, 2016, from https://en.wikipedia.org/wiki/Insider_trading#Court_decisions

 

[15] Insider trading. (n.d.). Retrieved November 04, 2016, from https://www.law.cornell.edu/wex/insider_trading

 

 

[16] Hemingway, J. M. (2003). Save Martha Stewart? Observations About Equal Justice in U.S. Insider Trading Regulation. Retrieved November 04, 2016, from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=489005

 

[17] Bettis, J. C., Duncan, W. A., & Harmon, W. K. (2011). The Effectiveness of Insider Trading Regulations. Retrieved November 4, 2016, from Clute Institute, http://www.cluteinstitute.com/ojs/index.php/JABR/article/viewFile/5652/5733

 

 

[18] Ibid

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