How the SEC Detects Insider Trading.

The SEC’s insider-trading investigations typically begin with an automated alert. However, these alerts will not result in insider-trading charges unless (or if) a human investigator decides to escalate the investigation further after observing evidence of a potential securities violation.

The Financial Industry Regulatory Authority (FINRA) also monitors the securities markets for “suspicious” trading activity and refers cases to the SEC. FINRA uses a variety of surveillance methods to do so.

Once an investigation begins, SEC investigators’ priority is to find evidence that links the trader (or traders) involved to an improper source of non-public information. This usually means finding evidence that the trader is (or is suspected to be) the recipient of non-public information from a person with a legal duty to keep it confidential. Investigators’ efforts often focus on:

• Traders who trade immediately prior to corporate news events that prove to move markets. However, while trading around the time of an event can be suspicious, this timing will not alone prove liability under the federal securities laws.
• Traders who are suspected of receiving information from a person with access to non-public information.
• Traders whose trading activity creates a significant financial profit (or prevents a loss).
• Trading patterns that are anomalous when compared to past trading activity.

The SEC’s Market Abuse Unit

The SEC’s Market Abuse Unit is a high-priority enforcement unit. This unit focuses its attention on certain high-priority types of “suspicious” trading patterns and refers high-priority targets to its enforcement agents for investigation.

FINRA’s Role in Detecting Insider Trading

According to data that it has previously released, FINRA generates more than 450 insider-trading referrals to the SEC per year. To detect “suspicious” trading around corporate news events, FINRA uses a proprietary surveillance system called SONAR that was first launched in 2001. SONAR compares securities’ unusual price and volume movements with news events that are likely to move the market. If it finds price or volume movements that are unusual before a news event, it flags the trading for review by a human analyst. If the analyst decides to pursue the matter further, he or she will refer the case to the SEC for investigation.

What Market Data Can Regulators See About My Trades?

The Consolidated Audit Trail (“CAT”) is one of the most powerful tools available to federal securities regulators. It includes a massive database of records that includes, but is not limited to:

• Customer orders and their paths through the financial markets.
• The time it takes to route a customer’s order from their broker-dealer to an exchange.
• The route an order takes across broker-dealers and exchanges.
• The specific time at which an order is placed, executed, modified, or cancelled.
• The trader’s trading position and the trader’s balance after executing an order.

The Consolidated Audit Trail only applies to transactions in covered securities. The CAT NMS Plan defines covered securities as NMS securities and OTC equity securities. While this means that the CAT covers a large segment of the securities markets, it does not cover every financial instrument.

The CAT Customer and Account Information System is another database that is connected to the Consolidated Audit Trail’s Consolidated Audit Trail (CAT) NMS Plan database. This system allows FINRA and the SEC to connect the brokerage identity (e.g., Broker-Dealer #XYZ) that is associated with a transaction to the trading customer identity (e.g., Customer #123).

By combining the CAT with information gathered from the CAT’s Customer and Account Information System and other sources, FINRA and the SEC can reconstruct a trader’s order lifecycle across various broker-dealers and trading venues. This allow regulators to see exactly what time a trader places an order, the time it reaches an exchange, and the time the order is executed. With the ability to identify the customer behind the order and the time of its execution, regulators can use this information to look for insider trading indicators, such as placing a bet before a news event that moves the market.

Only authorized regulatory users have access to information maintained by the Consolidated Audit Trail and the CAT’s Customer and Account Information System. Access to this information is governed by strict security and confidentiality controls.

The CAT NMS Plan requires that the CAT’s Central Repository hold on to records of broker-dealer transactions for at least six years. This means that traders can be subject to insider-trading enforcement action long after they have made a single trade.

MIDAS and FINRA’s Market Surveillance and Enforcement Systems

The Market Information Data Analytics System (“MIDAS”) is another tool that regulators use to monitor for suspected insider trading. MIDAS gathers market-feed data directly from the exchanges, which is market-level data (i.e., all trades and quotes for a given security) rather than customer-level data. By itself, MIDAS data does not allow regulators to identify specific customers.

FINRA’s Market Surveillance and Enforcement System is another system that it uses to detect insider trading. This system is used to detect patterns of suspicious trading and to identify individual traders that appear to be involved in illicit trading. FINRA’s surveillance coverage is broad but not exhaustive. It covers:

• All regulated broker-dealers.
• All NMS securities and OTC equity securities.
• Specified other securities and derivatives transactions.

What Trading Patterns Are Most Likely to Trigger Scrutiny?

First-Time Trading Shortly Before Corporate Announcements

Trading in a security for the first time shortly before a significant corporate announcement can raise red flags with the SEC and FINRA. Generally, the closer a trader is to placing a trade to a public announcement, the stronger the inference of insider trading.

Options Trading

Options trading is also a risk factor in the SEC and FINRA’s efforts to detect insider trading. This is particularly true in situations where highly leveraged out-of-the-money options are used to speculate on news events.

Coordinated Trading

Coordinated trading across family, friend, and corporate accounts is also an area in which the SEC and FINRA target suspected insider traders. In coordinated insider-trading schemes, those with access to material non-public information typically execute trades across several accounts to avoid drawing attention from individual brokerage account activities.

Trading Volume Relative to Personal Wealth

SEC and FINRA investigators compare the size of a trader’s trade against the trader’s apparent financial resources. For example, if an individual places a concentrated bet that is far in excess of their assets or borrows funds to place a trade, this can strengthen an allegation of insider trading.

Statistically Improbable Trading Performance

Making a single highly profitable trade shortly before news moves the market is a major red flag. However, consistently making highly profitable trades before corporate news events may prompt investigators to utilize statistical analysis to determine the likelihood of impropriety. This type of analysis helps the SEC and FINRA determine how likely it is that a trader’s success is simply due to skill, luck, and timing as opposed to the possession of non-public information.

Trading Through Offshore or Third-Party Accounts

Finally, the SEC and FINRA may have heightened attention toward traders that trade through offshore accounts, third-party accounts, and other entities. While not every offshore account or third-party account indicates criminal conduct, many traders attempt to hide their identity to avoid scrutiny from regulators. When coupled with other suspicious traits such as trading shortly before significant corporate news, this can exacerbate the risk of scrutiny.

How Does the SEC Connect a Trade to Inside Information?

Even when investigators have proof of a highly suspicious trade, this does not provide them with direct evidence of insider trading. In most cases, this will mean that investigators will have to gather circumstantial evidence to link a trader to an information source and prove the trader’s liability for insider trading. This typically involves:

• Using phone records, financial records, and other evidence to establish timing. By establishing that the trader received communication from a putative information source shortly before placing a suspicious trade, investigators will be able to strengthen the case for a liability-bearing inference of insider trading.
• Using financial records to establish how the trade was funded. Using financial records, the SEC and FINRA are able to trace funding for suspicious trades and uncover third-party account connections.
• Compiling the company’s “access list” and listing those who worked on deals involving confidential corporate information.
• Using subpoena power to uncover evidence that the trading recipient can connect them to an inside source. With subpoena power, the SEC can compel testimony, interview witnesses, and obtain records such as a subject’s financial records, travel records, phone and email records, and more.
• Interviewing witnesses. Interviewing potential witnesses provides the SEC and FINRA the opportunity to examine their relationships with individuals suspected of insider trading. By questioning witnesses and examining potential traders’ explanations for why they executed their trades, investigators can more accurately measure the likelihood that their suspicions are grounded in the evidence of wrongdoing.

The SEC’s Investigative Subpoena Power

Under Section 21(b) of the Securities Exchange Act, the SEC has the authority to issue subpoenas to parties it believes have testimony and records that are relevant to and material to an active investigation. While the SEC does not have to meet the high standards for issuance of a search or seizure warrant in a criminal trial, its investigative subpoenas are also subject to challenge.

• Subpoena Challenges. When subject to SEC investigative subpoenas, individuals and companies may be able to assert privilege, challenge the subpoena’s relevance, object to its overly broad scope, or seek to demonstrate an unreasonable burden to comply.
• Subpoena Enforcement. In general, the SEC must seek enforcement by a district court when a subpoena recipient refuses to comply with an investigative subpoena. Once the SEC has secured enforcement, the subpoena recipient will be legally compelled to comply unless they can seek further intervention by the district court.

Todd Spodek and the attorneys at Spodek Law Group handle federal cases of this kind from New York, Brooklyn, Queens and Los Angeles.

When Does Suspicious Trading Become Illegal Insider Trading?

Most insider-trading cases in federal court will fall under the SEC’s Rule 10b-5. Liability under Rule 10b-5 requires evidence of deception, use of material non-public information, breach of a duty, and scienter (i.e., the intent to deceive, manipulate, or defraud). Trading on material non-public information is considered a form of deception when the trader has, or receives from someone who has, a duty to keep that information confidential and breaches this duty by trading while possessing it. There are two primary theories under which a trader can breach a duty of confidentiality, and incur liability for insider trading. These theories are:

The Classical Theory of Insider Trading

Classical liability arises when corporate insiders (i.e., officers, directors, employees, or those who acquire confidential information through their position within the corporation) trade on the basis of confidential information they’ve acquired by virtue of their relationship to the company. When corporate insiders breach their duties to their corporation and its shareholders, they can be held liable for insider trading, even if they never disclose the confidential information to anyone else.

The Misappropriation Theory of Insider Trading

The misappropriation theory applies to traders who deceptively utilize confidential information to deceive the confidential information’s source. This can include information acquired through family relationships, a trade secret from an employer, or other confidential information. While misappropriation liability applies if the confidential information does not originate from a public corporation, it still requires that the trader breach a duty of confidentiality to the confidential information’s source.

The “Tippee” Exception to Classical and Misappropriation Liability

In most insider-trading cases, investigators must also prove that the traders involved are liable as tippers or tippees. In order to incur insider-trading liability, the SEC or government must establish that the tipper breached a duty of confidentiality by disclosing the information to the trader, known as the “tippee.” This can apply in both classical and misappropriation scenarios. In order to incur insider-trading liability, a tipper must also receive, or intend to receive, a personal benefit from the disclosure. In some cases, gifting the confidential information to a trading relative or friend can satisfy this personal-benefit requirement. In order to incur civil liability as a tippee, the SEC must prove that the tippee knew, or had reason to know, that the tipper breached a duty of confidentiality.

Other Key Elements of Insider-Trading Liability

Along with the elements discussed above, the SEC (or, in a criminal case, the Department of Justice) must establish that the traders involved:

• Traded while in possession of confidential information. Possessing confidential information, by itself, does not violate Rule 10b-5; however, executing a trade while aware of that information may violate Rule 10b-5, subject to applicable defenses.
• Had scienter. In order for the SEC to establish insider-trading liability, it must also prove that the trader had scienter. Depending on the claim, the SEC can establish the element of scienter through evidence of the trader’s intentional or reckless conduct.

Can Legitimate Research or a Trading Plan Explain the Trade?

Legitimate Explanations

While the SEC and FINRA use suspicious-trading indicators to investigate potential insider trading, it is also possible for traders to offer innocent explanations for their transactions in covered securities. For example, a trader’s consistent prior trading history, contemporaneous research conducted by the trader, or a news event in the broader securities market may support an innocent explanation. During a preliminary review, investigators will look for credible information to support a trader’s innocent explanation. In some cases, this will be sufficient to explain the trade’s timing and value, and regulators will not proceed with the investigation further.

Rule 10b5-1 Plans

The best way to avoid scrutiny when trading in a public company’s securities is to establish a Rule 10b5-1 plan before trading. Under Rule 10b5-1(c), a trader who establishes a binding contract to trade in securities at a future date, and that trader does so before they become aware of material non-public information, has an affirmative defense against insider-trading liability. Trading plans can be extremely useful for company executives, who often receive compensation in equity and must ensure they do not violate Rule 10b-5 when executing stock options or selling their shares. However, Rule 10b5-1 plans do not provide blanket immunity from SEC and FINRA investigations. To successfully raise the Rule 10b5-1 affirmative defense, traders must also prove that they “acted in good faith with respect to the trading arrangement.”

• “Cooling-Off Period.” For companies’ directors, officers, and other individuals who possess or have access to confidential corporate information, Rule 10b5-1 plans impose a “cooling-off period.” The duration of the cooling-off period varies, and directors and officers generally have more stringent requirements. For example, the duration of a director’s or officer’s Rule 10b5-1 cooling-off period is the later of: (i) 90 days from the date of the plan’s adoption, or (ii) two business days after the issuer discloses its financial results for the fiscal quarter in which the plan was adopted, subject to a maximum of 120 days. Others covered by the rule, such as employees and consultants, typically have a 30-day cooling-off period.

Could an SEC Inquiry Lead to Criminal Insider Trading Charges?

If the SEC determines that a trader is likely liable for insider trading, it will proceed with one of three forms of action.

1. No Enforcement Action

The SEC may determine that while the trader’s conduct warranted further scrutiny, the agency does not have sufficient evidence to establish liability. In this case, the inquiry will end without enforcement action.

2. Negotiated Settlement

The SEC’s primary goal in civil enforcement cases is to recover illicit gains and preserve the integrity of the securities markets. This means that in many cases, it will seek a negotiated settlement that avoids the risks and expense of litigation. The financial burdens for accepting a negotiated settlement can be significant; however, securities litigation in federal court is even riskier for all parties involved.

If the trader accepts a negotiated settlement, they must agree to pay the SEC the profits they gained (or losses they avoided) while paying additional civil penalties, disgorging any interests earned, and agreeing to other restrictions. For company executives, these restrictions can include being barred from serving as the director, officer, or controlling shareholder of a public company.

3. Wells Submission and Civil Litigation

In some cases, the SEC will insist on proceeding with litigation in federal district court. If an individual or company does not reach a settlement, they will have the opportunity to file a “Wells” submission. A Wells submission is the recipient’s response to the SEC’s intent to bring one or more charges in an enforcement action. In the Wells submission, the individual or company attempts to dissuade the SEC from proceeding with litigation by addressing the SEC’s allegations and proposing an alternative remedy.

What if the SEC Thinks the Trader Committed a Criminal Violation of the Securities Laws?

If the SEC believes that a trader has committed a criminal violation of the securities laws, it may refer the matter to the U.S. Department of Justice (DOJ). The DOJ is responsible for prosecuting federal criminal insider-trading charges, and it may establish criminal liability for violations that rise to the level of a federal crime.

While a referral to the DOJ increases the risk of criminal charges, a referral is not enough to establish insider-trading liability in federal court. The SEC’s civil enforcement action is very different from the DOJ’s criminal insider-trading case. The major differences include:

• Testimony. In some cases, a trader may believe that they can avoid insider-trading liability because the government cannot establish that the trader received inside information or used confidential information to execute a suspicious trade without a witness’s direct testimony. However, direct testimony is not the only form of evidence that the government can use to establish this connection. Instead, the government will often rely on circumstantial evidence to prove the transmission of non-public information and the trader’s knowledge. This is most often the case in situations where the SEC and DOJ are targeting suspected insider traders who execute their trades through a network of multiple interrelated accounts.
• Burden of Proof. The burden of proof is also different. When pursuing an insider-trading claim, the SEC must prove its claims by a preponderance of the evidence. However, the DOJ must prove criminal insider-trading charges beyond a reasonable doubt.
• Penalties. The potential penalties under the federal securities laws are also vastly different. While Rule 10b-5 does not carry criminal penalties, Section 32(a) authorizes federal prosecutors to pursue criminal charges in cases involving “willfully” committed violations of the securities laws. This statutory provision, among others, allows for up to 20 years’ imprisonment for securities violations that rise to the level of a federal crime. If the DOJ is able to pursue a conviction, it can impose financial penalties in addition to imprisonment.

How Accurate Are Insider Trading Alerts and Detection Claims?

Are the SEC and FINRA able to detect insider trading using fixed thresholds?

Neither the SEC nor FINRA have a fixed threshold for deciding whether suspected insider trading warrants charges. While investigators can establish that a trader’s success was statistically improbable, and use this statistical evidence as circumstantial proof of insider trading, the statistically improbable success of a trader is not sufficient on its own to prove a violation of the federal securities laws. Instead, establishing insider-trading liability requires establishing each of the elements listed above.

What is the detection rate for insider trading?

The detection rate for insider trading is difficult to calculate because there are two main challenges. First, the detection rate requires calculating the percentage of detected violations out of all actual violations. However, because those who commit insider trading violations rarely admit guilt, it is virtually impossible to determine the total number of actual insider trading violations. Second, the detection rate depends on how “detected” is defined. This leads to a few other challenges:

• What is the false-positive rate for insider-trading alerts? A false-positive rate is the ratio between a trader’s execution of an innocent trade and a trader’s execution of an illicit trade. To determine this rate, investigators must know the total number of alerts they receive. Then, investigators must determine how many of those alerts were cleared by establishing that no insider-trading violation took place.
• How many cases of insider trading does the government detect and prosecute annually? The SEC and FINRA have previously disclosed enforcement totals that show how many times they have pursued insider-trading allegations. However, these enforcement totals represent the number of charged cases, not the number of detected or undetected violations.
• What evidence is the SEC and FINRA able to use in court? When a trader’s execution of a trade is offered as evidence in federal court, the trader must satisfy authentication and evidentiary requirements. Once prosecutors or regulators satisfy these requirements, the government can use the information as evidence.

Speak With a Federal Defense Lawyer

If you are dealing with any part of what this article describes, the next step is a conversation with a lawyer who handles these cases. Spodek Law Group is a second generation criminal defense firm practicing since 1976, representing clients nationwide from offices in New York, Brooklyn, Queens and Los Angeles. Call 212-300-5196 to speak with our team.