How Does the SEC Track Insider Trading?

Basics

Insider trading has been a controversial topic in the finance industry for a long time. Contrary to widespread belief, not all insider trading is illicit. When corporate insiders, including directors, officers, and employees, trade their company's shares in compliance with securities laws, it is perfectly legal. These transactions, however, necessitate adherence to specific forms and reporting requirements mandated by the U.S. Securities and Exchange Commission (SEC).

Nevertheless, the illegal variant of insider trading captures the attention of media outlets. This unlawful practice involves individuals exploiting material and undisclosed information for personal gain. To maintain an equitable and unbiased capital market, the SEC tenaciously pursues cases of illegal insider trading. The consequences of unchecked misconduct can be dire, as it undermines public trust and obstructs market functionality. Notable figures such as Martha Stewart and former McKinsey global head Rajat Gupta serve as reminders that no one is immune to prosecution if they engage in such unlawful activities. Upholding the law remains paramount to the SEC's mission, ensuring a level playing field for all market participants.

Illegal Insider Trading

Illegal insider trading, a grave offense according to the SEC, encompasses the act of trading securities while possessing material, nonpublic information, thereby breaching fiduciary duties and the trust placed upon individuals. The SEC extends the scope of these violations to include transmitting such information through tipping, trading by those who received the tip, and trading by those who illicitly acquire such knowledge.

But what constitutes material information? Although lacking a precise definition, it broadly refers to any company-specific information that holds significant importance for investors contemplating stock transactions. This encompasses various aspects such as financial results deviating from expectations, business developments, security-related matters like dividend alterations, share splits or buybacks, acquisitions or divestitures, and the acquisition or loss of significant contracts or customers. As for "nonpublic information," it denotes data that has not yet been made available to the investing public.

Over the years, the SEC has relentlessly pursued insider trading cases involving a multitude of parties, including corporate insiders who traded securities based on confidential developments, individuals close to insiders who traded after receiving tips, employees of service firms (e.g., law, banking, brokerage, and printing) who stumbled upon material nonpublic information and capitalized on it, and government employees who accessed inside information due to the nature of their occupations.

Tracking Insider Trading: Unveiling the SEC's Methods

Proving insider trading can be arduous, as direct evidence is scarce, and the evidence primarily relies on circumstantial factors, as Thomas Newkirk and Melissa Robertson from the SEC's Division of Enforcement emphasized in their September 1998 speech.

To uncover illicit insider trading activities, the SEC employs various tracking methods:

1. Market Surveillance Activities: A crucial avenue for identifying insider trading involves meticulous market surveillance. The SEC employs sophisticated tools to detect illegal insider trading, particularly during pivotal events like earnings reports and significant corporate developments. Suspicious activities, such as anomalous, substantial trades aiming to maximize gains, often raise red flags and prompt thorough SEC investigations.
2. Tips and Complaints: Insider trading cases often come to light through tips and complaints received by the SEC. Dissatisfied investors or traders who have suffered losses may provide valuable information. Newkirk and Robertson highlighted instances where irate option writers contacted the SEC after writing out-of-the-money (OTM) contracts on a stock just before another company launched a tender offer. This tendency to leverage inside information to its fullest extent makes it easier to detect insider trading.
3. Whistleblowers and External Sources: Whistleblowers can play a significant role in exposing insider trading abuses. They may receive rewards ranging from 10% to 30% of the monetary penalties imposed on individuals who violate securities laws. However, given that insider trading often involves isolated instances perpetrated by a single insider, whistleblowers tend to excel at uncovering widespread fraud rather than isolated incidents of insider trading. Other SEC divisions, self-regulatory organizations like the Financial Industry Regulatory Authority (FINRA), and media reports also serve as valuable sources for leads on potential violations of securities laws.

By employing these multifaceted tracking approaches, the SEC strives to maintain market integrity and ensure that those who engage in illicit insider trading face the consequences of their actions.

SEC Investigations: Unveiling the Process

Unearthing Securities Violations

The SEC's Division of Enforcement springs into action when presented with preliminary information suggesting a potential securities violation. A comprehensive and confidential investigation follows, with the SEC employing various tools and techniques to combat insider trading more effectively.

To build a case, the SEC meticulously interviews witnesses, scrutinizes trading records and data, issues subpoenas for phone records, and employs other investigative measures. A notable example is the groundbreaking Galleon Group case, where the SEC utilized wiretaps for the first time to implicate numerous individuals involved in a far-reaching insider trading network.

Given the predominantly circumstantial nature of evidence in insider trading cases, SEC staff faces the challenge of establishing a chain of events and fitting together the puzzle pieces. A case from September 2011 exemplifies this process. An SEC action targeted a consulting executive and his associate, who exchanged confidential information about upcoming takeovers of biotechnology companies. The associate capitalized on this insider knowledge, accumulating a substantial number of call options, resulting in illegal profits of $2.6 million. The executive received cash payments from his associate in exchange for providing the tips. The SEC alleged that they communicated through in-person meetings and phone conversations, some of which were traced through the use of MetroCards and significant cash withdrawals made by the associate prior to their encounters.

Upon concluding an insider trading investigation, the staff presents their findings to the SEC for evaluation. Based on this review, the SEC may authorize the staff to initiate an administrative action or file a case in federal court. In a civil action, the SEC lodges a complaint with a U.S. District Court, seeking sanctions, injunctions, civil monetary penalties, and disgorgement of illicit profits. Administrative actions involve proceedings overseen by an administrative law judge who renders an initial decision containing factual findings and legal conclusions. Sanctions in such cases may include cease and desist orders, suspension or revocation of financial industry registrations, censures, civil monetary penalties, and disgorgement.

High-Profile Insider Trading Cases

The history of insider trading is marked by notorious scandals, with the 1980s unveiling the likes of Ivan Boesky, Dennis Levine, and Michael Milken. However, the new millennium has witnessed two significant cases. 

SAC Capital 

In 2013, SAC Capital, founded by the wealthy Steve Cohen, faced a staggering $1.8 billion fine for widespread insider trading. The SEC accused the firm of engaging in insider trading across more than 20 public companies from 1999 to 2010. Multiple traders and analysts associated with SAC Capital have been convicted or pleaded guilty, including Matthew Martoma. Martoma, a portfolio manager, received a nine-year prison sentence for trading on confidential information related to an Alzheimer's drug, resulting in illicit gains exceeding $276 million.

Raj Rajaratnam and the Galleon Group 

In 2011, billionaire hedge fund manager Rajaratnam received an 11-year prison sentence, the longest ever in an insider trading case. Rajaratnam, the founder of the Galleon hedge fund, also paid a penalty of $92.8 million for orchestrating an extensive insider trading ring involving 29 individuals and entities. The group included hedge fund advisers, corporate insiders such as Rajat Gupta and Anil Kumar, and Wall Street professionals. Rajaratnam's insider trading activities spanned over 15 publicly traded companies, enabling him to avoid losses exceeding $90 million and make illegal profits.

Conclusion

Insider trading is a serious offense in the US, carrying significant penalties. Violators can face imprisonment for up to 20 years, along with hefty fines. Individuals convicted of insider trading can be subjected to a maximum criminal fine of $5 million. These stringent penalties highlight the US government's determination to combat this unlawful practice effectively.

Despite the severe consequences, completely eradicating insider trading remains a challenge. Recent SEC data reveals an ongoing occurrence of insider trading cases, indicating the difficulty in fully curbing this illegal activity. The persistence of such cases underscores the need for continued vigil.