How Do Attorneys Calculate Illicit Profits in Insider Trading Cases?

Insider trading is a big no-no in the financial world. It refers to buying or selling stocks based on material, non-public information that gives an unfair advantage. But how do lawyers and regulators calculate the ill-gotten gains from insider trading to punish the perpetrators? Let's break it down.

What is Insider Trading?

Insider trading happens when someone uses confidential information to make stock trades that the general public doesn't have access to. This gives them an unfair edge in the market. For example, say a CEO learns that their company is about to release a major new product. Before the news is public, the CEO buys a bunch of company stock. When the product launches, the stock price skyrockets, and the CEO makes a killing. Insider trading comes in two main flavors:

• Trading by true company insiders - The CEO example above is a classic case. Other insiders may include directors, officers, large shareholders, or anyone else with access to non-public info.
• Trading by outsiders who misappropriate information - This could involve hacking, bribery, eavesdropping, or getting tips from insiders.

Either way, it boils down to unfairly profiting off confidential data. Insider trading betrays investors' trust in the stock market as a level playing field. That's why it's illegal under U.S. securities law.

How Do They Catch Insider Traders?

Insider trading often goes undetected. But securities regulators like the SEC have ways to sniff it out:

• Looking for suspicious trading patterns, like someone making oddly-timed or very profitable trades.
• Running computer screens to detect unusual activity in advance of big news events.
• Poring over trading records, emails, phone logs, and other documents during routine investigations.
• Receiving tips from whistleblowers and cooperating witnesses.

Once regulators identify questionable trading, they dig deeper to build their case. The trader may get a Wells notice from the SEC, which means enforcement action may follow. Next comes document requests, sworn testimony, and subpoenas. If the evidence holds up, the SEC files charges.

What Penalties Do Insider Traders Face?

The SEC wields a mix of civil and criminal remedies against insider trading:

• Civil penalties - The SEC commonly seeks disgorgement of illicit profits plus interest, civil fines up to three times the profit gained or loss avoided, and permanent trading bans.
• Criminal prosecution - The Department of Justice can file criminal charges for insider trading. This may lead to prison time plus massive criminal fines based on the gain or loss avoided.
• Private lawsuits - Defrauded investors can sue insider traders for damages under federal securities laws.

The monetary penalties aim to strip offenders of their ill-gotten returns and then some, as a deterrent. But how do the regulators attach numbers to the wrongful profits?

How Are Illicit Profits Calculated?

Figuring out the amount to disgorge from insider traders involves some financial forensics. Here are some key guidelines:

• Calculate total profit or loss avoided from all tainted trades.
• Resolve ambiguities against the violator.
• Avoid crediting the violator for unrelated factors that may have influenced trading profits.
• Account for prejudgment interest to compensate for time value of money.

There are a few common methods used to compute insider trading profits:

The Disgorgement Method

This approach calculates ill-gotten gain as the difference between the purchase or sale price of the security and its market price after public disclosure of the inside information. For example:

• Insider buys shares at $10 before news release
• News comes out and stock price rises to $15
• Disgorgement amount = $15 (sale price) - $10 (purchase price) = $5 per share gain

Courts often favor this straightforward method. But it doesn't account for what would have happened absent the insider info. The stock price may have risen anyway, even without the tip-off.

The Differential Method

This method compares the actual return on the tainted trades to what the return would have been without the unfair advantage. It aims to strip only the incremental gain attributable to insider trading. To reconstruct the "but-for" scenario, experts use control groups like:

• The overall market change during the same period
• The stock's historical volatility
• Returns of peer companies in the same sector

The differential approach is more complex but gives credit for gains unrelated to wrongdoing. Defendants argue for it, while the SEC disfavors it.

The Civil Penalty Method

For civil fines, the SEC can seek up to three times the profit gained or loss avoided. This multiplier is meant as a stiff deterrent. The base gain may derive from either the disgorgement or differential method. Insider traders sometimes get slapped with the treble civil fines, especially if there are aggravating factors like repeat offenses or obstruction of justice.

The Sentencing Guidelines Method

For criminal cases, federal sentencing guidelines provide a formula to calculate the offense level, which sets the recommended prison term. The "gain resulting from the offense" factors heavily into this formula. The guidelines use the disgorgement model as the main component. But judges can tailor the ultimate sentence based on the facts and circumstances.

Key Takeaways

Figuring out illicit profits in insider trading requires financial sleuthing. While there are different models, the core goal is to recapture unfair gains and deter future violations. Lawyers, economists, accountants, and other experts work together to analyze trades, reconstruct alternative scenarios, and quantify damages. The billion-dollar penalties in some recent high-profile cases show how profitable insider trading can be, and how severely the authorities come down on it. At the end of the day, insider trading undercuts fairness, trust, and ethics in the stock market. That's why regulators spare no effort to detect it, prove it, and punish it.

References

U.S. Securities and Exchange Commission, "Insider Trading." https://www.investor.gov/introduction-investing/investing-basics/glossary/insider-trading Cornell Law School, "Insider Trading: An Overview." https://www.law.cornell.edu/wex/insider_trading The Motley Fool, "How the SEC Tracks Insider Trading." https://www.fool.com/knowledge-center/how-the-sec-tracks-insider-trading.aspx Berkeley Law, "Methods for Calculating Disgorgement." https://www.law.berkeley.edu/wp-content/uploads/2015/04/Securities-White-Paper-C-Sporkin-2015-FINAL.pdf Forbes, "How Is Insider Trading Detected and Prosecuted?" https://www.forbes.com/sites/insider/2019/12/20/how-is-insider-trading-detected-and-prosecuted/?sh=24a3e4ca7c16