Insider trading, a complex practice of buying or selling a company's securities based on material, nonpublic information, has long been a contentious issue in financial markets. While the term typically evokes images of corporate executives secretly profiting from inside knowledge, the reality is more intricate and multifaceted.

Some forms of insider transactions are perfectly legal, while others can result in severe criminal penalties. Understanding the legal and illegal aspects of insider trading is crucial for investors, corporate executives, and legal professionals to stay informed and aware.

Insiders can legally trade their company's securities when the trades are not based on material, nonpublic information.

Insider trading is only unlawful when it violates specific provisions under U.S. law, particularly 18 U.S.C. 1348. This statute, a crucial part of the legal framework, establishes the criminal aspects of securities and commodities fraud and outlines the elements that make certain forms of insider trading illegal.

At the same time, insider trading is permissible, provided specific rules and guidelines are carefully followed.

18 U.S.C. 1348 says, "Whoever knowingly executes, or attempts to execute, a scheme or artifice -

(1) to defraud any person in connection with any commodity for future delivery, or any option on a commodity for future delivery, or any security of an issuer with a class of securities registered under section 12 of the Securities Exchange Act of 1934 (15 U.S.C. 78l) or that is required to file reports under section 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(d)); or

(2) to obtain, by means of false or fraudulent pretenses, representations, or promises, any money or property in connection with the purchase or sale of any commodity for future delivery, or any option on a commodity for future delivery, or any security of an issuer with a class of securities registered under section 12 of the Securities Exchange Act of 1934 (15 U.S.C. 78l) or that is required to file reports under section 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(d)); shall be fined under this title, or imprisoned not more than 25 years, or both."

The legality of insider trading depends on how and when it occurs, particularly whether it violates federal laws, specifically, 18 U.S.C. 1348. Understanding when insider trading crosses the legal line and when it remains permissible is crucial for investors, executives, and anyone involved in the financial markets.

When Does Insider Trading Become Illegal?

The notion of insider trading hinges on who is considered an "insider" and what constitutes "material, nonpublic information." An insider can be anyone with a duty to the company, such as a low-level employee who is not a statutory insider but still has a duty not to trade stock on nonpublic information.

A temporary insider, like a company outside lawyers and accountants who receive nonpublic information and have a duty not to trade, could also be an insider.

The legality of insider trading depends on how and when it occurs, particularly concerning whether it violates federal laws. As noted, Title 18 U.S.C. 1348 is the primary federal statute prohibiting fraudulent practices in connection with securities and commodities.

Insider trading becomes illegal when it involves a "scheme or artifice" to defraud someone or to obtain money or property by means of false or fraudulent pretenses. For insider trading to be considered illegal under this law, the following elements must be present:

• Possession of Material Non-Public Information (MNPI): The individual must have access to material information that is not available to the public. Information is deemed material if a reasonable investor would consider it important when making an investment decision, such as earnings reports, merger announcements, or leadership changes.
• Breach of Duty: The trader must owe a fiduciary duty or similar obligation to the company or its shareholders and breach that duty by using confidential information for personal gain.
• Intent to Defraud: There must be intent to deceive, manipulate, or defraud through the use of MNPI. This involves knowingly making trades based on confidential information for personal advantage or to benefit others.
• Use in a Securities Transaction: The trader must actually buy or sell securities based on this privileged information.

When all these elements are met, insider trading becomes illegal and can result in severe civil and criminal penalties, including fines and imprisonment.

Securities Exchange Act of 1934

The regulation of insider trading has evolved significantly over the past century. The Securities Exchange Act of 1934 was the first significant step in regulating insider trading.

However, it wasn't until the 1960s that the SEC began to pursue insider trading cases more aggressively under Rule 10b-5, which prohibits fraud when buying or selling securities. Consider the following insider laws, rulings, and regulations:

• In 1961, the SEC's decision in In re Cady, Roberts & Co. (40 S.E.C. 907) established that corporate insiders have a duty either to disclose material nonpublic information or abstain from trading. This disclosed or abstain principle is now foundational to insider trading regulation.
• In 1968, SEC v. Texas Gulf Sulphur Co. expanded the scope of what counted as insider trading. Now, anyone possessing material nonpublic information must either disclose it to the public or refrain from trading.
• In 1984, the Insider Trading Sanctions Act increased penalties for insider trading.
• In 1988, the Insider Trading and Securities Fraud Enforcement Act further increased penalties and established "controlling person" liability,
• In 2000, Rule 10b5-1 allowed for pre-planned trading arrangements for insiders
• In 2002, the Sarbanes-Oxley Act accelerated reporting requirements for insider transactions.
• In 2010, the Dodd-Frank Act established a whistleblower program for reporting securities violations.
• In 2022, Amendments to Rule 10b5-1 enhanced disclosure requirements and restrictions on insider trading plans

When Is Insider Trading Legal?

Insiders can legally trade their company's securities under specific conditions. The key is that these trades must not be based on material, nonpublic information.

While illegal insider trading violates securities laws, there are specific cases where insider trading is legal. Company executives, board members, and employees frequently buy and sell their own company's stock. If they adhere to established regulations and avoid using MNPI for personal gain, these transactions are completely lawful.

Here are some common circumstances under which insider trading remains legal, helping to demystify the boundaries of the law:

• No Use of Material Non-Public Information (MNPI): It is legal to execute a trade without using confidential or material non-public information. For example, if an executive trades shares based on publicly available data, market trends, or personal financial planning, this activity does not violate insider trading laws.
• Proper Reporting to the SEC: Under Section 16(a) of the Securities Exchange Act of 1934, corporate insiders-such as officers, directors, and major shareholders-are required to report their trades to the Securities and Exchange Commission (SEC). Timely reporting ensures transparency and allows regulators to monitor insider activity. When insiders disclose their trades as required, those transactions are typically lawful.
• Trading During Established Windows: Many publicly traded companies establish "trading windows" specific periods during which insiders are allowed to buy or sell company stock. These windows typically open after the release of quarterly financial results, when MNPI is less likely to exist. Trading during these windows, with prior authorization from compliance departments, is a legal way for insiders to manage their stock holdings.
• Pre-Planned Trades Under SEC Rule 10b5-1: One of the most effective ways insiders can legally trade company stock is by establishing a 10b5-1 trading plan. This rule allows individuals with potential access to MNPI to set up a pre-arranged schedule for buying or selling shares. The plan must be established in good faith at a time when the insider does not possess MNPI. Once the plan is set, trades can occur automatically, even if the insider later gains access to confidential information.
• When the "insider" has filed SEC Form 4: This must be provided to the SEC to report changes in their ownership of the company's securities. This includes transactions such as purchases, sales, or exercises of stock options. Under SEC regulations, insiders are defined as officers, directors, or owners of more than 10% of a company's stock. They are required to file Form 4 within two business days of relevant transactions

Defending Against Insider Trading Accusations

Insider trading cases are complex, requiring a skilled federal criminal defense attorney to navigate intricate financial laws and protect your rights. A good attorney will know how to implement key defense strategies either to prove your trades were legal or to minimize penalties. Common defenses include:

• Claiming Legal Exceptions: Your attorney may prove that the trades followed SEC rules (e.g., timely reporting, legal trading windows, etc.).
• No MNPI: Showing that the information you were using was public and/or non-material.
• Procedural Issues: Proving government adherence to investigation protocols, such as evidence handling, vague statutes, or procedural violations.
• Penalty Reduction: Advocating for leniency by highlighting factors like no prior offenses, cooperation, or minimal financial gain.

For more information, contact our criminal defense law firm, Eisner Gorin LLP, based in Los Angeles, California.

Related Content:

• 18 U.S. Code 1348 - Securities Fraud
• Securities Exchange Act of 1934
• Laws That Govern the Securities Industry