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Securities Lawyer Jonathan Kurta
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What is Insider Trading and Why is it Illegal?

Illegal insider trading is a type of securities fraud where corporate insiders execute trades based on non-public information. Corporate insiders are individuals who may possess non-public material information regarding a company. These individuals may be accountants, consultants, attorneys, investment bankers, or employees of a company. 

Insider trading is not always illegal. Officers and directors must announce to the Securities Exchange Commission (SEC) when they trade their company’s securities. Investors can find records of these trades on the SEC’s Edgar database. Insider trading is not illegal unless insiders use non-public information to decide which securities to buy and sell.

To ensure an even playing field, the SEC wants every investor to have access to the same information about a security prior to executing a trade. Insider trading penalties can include serious prison time, but that is not always enough to dissuade fraudsters. As Jessica Hooper, the Head of FINRA’s Department of Enforcement, recently stated, “Insider trading by securities industry professionals erodes the public trust in our capital markets.”

History of Insider Trading Laws

  • The SEC’s insider trading policy originates from the Securities Exchange Act of 1934. This Act prohibits the use of “manipulative and deceptive devices” in connection with the purchase or sale of securities.
  • On September 14, 1988, Congress approved the Insider Trading and Securities Fraud Enforcement Act.
  • In 2009, FINRA created the Office of Fraud Detection and Market Intelligence (OFDMI). This followed the Bernie Madoff scandal when FINRA and the SEC realized the need for an office dedicated to fraud detection. For instance, Henry Markapoulos, a Bernie Madoff whistleblower, could not report the clear signs of a Ponzi scheme to a single department charged with investigating fraud. If such an office had existed, authorities may have arrested Madoff sooner.

How Does FINRA Catch Insider Trading?

OFDMI uses a system called SONAR to track price and volume movements in the stock market. SONAR stands for Securities Observation News Analysis and Regulation. It compares trades against trade data that goes back 20 years and looks for suspiciously well-timed trades.

Sam Draddy, the head of FINRA’s Insider Trading Surveillance unit, stated in a recent episode of FINRA’s Unscripted podcast, “If a stock is trading unusually compared to the 100-day average for the index it trades in, [SONAR] looks for news stories that might explain the uptick. For example, when Amazon acquired Whole Foods, SONAR flagged Whole Foods stock.” In that case, reporting on the merger helped explain the increased interest in Whole Foods stock.

Illegal insider trading often happens ahead of a major corporate merger. “Mergers are our bread and butter because that’s where people make their money,” says Draddy. When FINRA suspects insider trading based on non-public information about a merger, they must examine “the entire universe” of people with access to that information. This includes investment banks, law firms, accounting firms, public relations firms, and the printers who may have handled information about an upcoming merger.

While the OFDMI detects signs of insider trading, it passes the information on to the SEC’s Enforcement Division for legal action – FINRA does not have the power to enforce laws.

Insider Trading Penalties

Violators can face a maximum prison term of 20 years and fines that can equal twice the gains of the illegal trading. The maximum fine for individuals is $5 million, and the maximum fine for a publicly traded entity is $25,000,000.

How Common is Insider Trading?

One research paper suggests that illegal insider trading is alarmingly common despite steep penalties. The paper estimates that insider trading occurs ahead of one in five mergers and acquisition events and one in 20 quarterly earnings announcements.

Insider Trading Policy in FINRA Firms

Around 5% to 10% of insider trading cases involve FINRA-registered brokers. According to FINRA Rule 3111, each firm must establish a supervisory system reasonably designed to achieve compliance with applicable securities laws and regulations. If supervisors believe a broker has made a trade based on non-public information, they should flag the trade and begin an investigation.

Insider Trading Examples

Insider Trading: Top-Level Executives

In 2011, a court sentenced hedge fund manager Raj Rajaratnam to eleven years in prison, following allegations of insider trading. He had allegedly earned $53.8 million using tips from friends who serve as executives at IBM, McKinsey and Company, and Intel.

Research Analysts and Insider Trading

On October 29, 2020, Goldman Sachs fired one of their brokers following the discovery that the broker had purchased shares in two accounts after learning that his firm’s analyst would soon publish a research paper that upgraded the shares to a “buy” recommendation. The broker learned this from an email with the subject line “rating change heads up.”

The second time the broker tried to buy shares based on insider information, the firm locked the account because the size of the purchases in relation to the total value of the accounts triggered an alert. As a result of the allegations of insider trading, FINRA barred the broker.

Because of the sometimes close relationship between brokerage firms and analysts, FINRA Rule 2241 states that brokerage firms must “effectively manage conflicts of interest related to the interaction between research analysts and those outside the research department, including trading personnel.” In case brokers are privy to information in research reports before they are published, they obviously have an ethical as well as a professional obligation not to make trades based on that information.

Insider Trading Based on Quarterly Reports

In June of 2021, The Wall Street Journal reported that six friends in Silicon Valley shared unlawful stock tips, from which they allegedly earned $1.7 million. Nathaniel Brown, a former senior revenue manager at a computer-networking company called Infinera Corp., allegedly told friends about the company’s undisclosed quarterly results.

Did I Lose Money Because of Insider Trading?

It is difficult for individual retail investors to know if they suffered losses due to insider trading. Investors rely on regulators and whistleblowers to look out for insider trading – and it is unlikely that they catch it every time it happens. FINRA states on its website, “When it comes to insider trading, it really is like finding a needle in a haystack, with more than 15,000 different stocks, options, and bonds trading every day across millions of transactions.”

If you suspect insider trading, you can file a regulatory tip with FINRA. If you believe your portfolio suffered because your brokerage firm failed to supervise your broker, contact a securities lawyer for a free case evaluation. Call 877-600-0098 or use the contact form below to speak with a securities attorney today.

Securities Lawyer Jonathan Kurta
Written by: Jonathan Kurta

Jonathan Kurta is an accomplished securities attorney and a founding partner at Kurta Law.