Insider Trading Penalties: Civil and Criminal Consequences.

Civil and criminal insider trading liability both generally require: (i) material nonpublic information, (ii) a breached duty, and, (iii) culpable knowledge. Although the SEC has broad authority to pursue civil enforcement for insider trading, it cannot impose federal imprisonment. The Justice Department conducts criminal prosecutions, and it usually seeks terms of imprisonment only in cases involving substantial profit, egregious circumstances, or previous enforcement history.

Prison Sentences and Fines

The Sarbanes-Oxley Act of 2002 amended Section 32(a) of the Exchange Act to raise the maximum term of imprisonment for willful securities law violations to 20 years. Under Section 32(a), criminal insider trading carries up to 20 years of imprisonment for each criminal offense. The section also authorizes criminal fines of up to $5 million for individuals and up to $25 million for business entities (with higher fines available in some cases).

Additional Criminal Charges

Defendants who are accused of insider trading can face additional federal criminal charges in many cases as well. False statements, obstruction of a pending enforcement action, conspiracy to defraud, money laundering, and related offenses are among the federal criminal charges that the Justice Department brings in conjunction with illegal trading.

Collateral Consequences

Wrongfully using or disclosing nonpublic information can also jeopardize a defendant’s professional status and eligibility to serve as a corporate officer or director. The SEC, state licensing authorities, and other bodies have broad authority to seek a range of collateral consequences for intentional misconduct.

Martha Stewart’s Case

Martha Stewart is one of the most well-known figures in the history of insider trading enforcement. However, Stewart did not serve time in prison for insider trading. Instead, Stewart served time for obstruction, false statements, and conspiracy to obstruct the SEC’s investigation.

When does trading on confidential information become illegal?

Federal Insider Trading Laws and Rules

Federal insider trading cases rely on multiple statutes, SEC rules, and court-created doctrines. In addition to the federal criminal code and other federal statutes, federal insider trading cases frequently involve Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, which jointly impose broad liability for insider-trading fraud. While these statutes and rules are central to federal insider trading enforcement, the underlying legal principles that often turn the tide in insider trading cases are federal courts’ duty doctrines.

Three Key Types of Insider Trading Liability

When it comes to federal insider trading cases, the courts recognize three key types of liability. Each type of liability relies on the legal concepts of “breach of duty” and “culpable knowledge.” While breaching a legal duty is necessary to establish insider trading liability in all cases, the courts’ duty doctrines vary depending on the specific scenario involved. The three key types of insider trading liability include:

• Classical Liability for Insiders
• Misappropriation Liability for Outsiders
• Liability for “Tippees”

Classical Insider Trading Liability

Classical insider trading liability applies when corporate insiders (including executives, board members, and shareholders) engage in transactions with corporate shareholders. In cases involving classical insider trading liability, the insiders violate their fiduciary duties to the shareholders in the transactions in which they engage.

Misappropriation Liability

Misappropriation liability is based on a different theory of insider trading liability. Rather than relying on a corporate insider’s fiduciary duties to company shareholders, misappropriation liability applies when a defendant trades based on confidential information that was misappropriated in violation of a duty owed to the information’s source.

Tippee Liability

Tippee liability depends on the tipper’s breach of duty as well as the tippee’s knowledge of that breach. While the landmark U.S. Supreme Court case Dirks v. SEC holds that “tippees” only face insider trading liability if they know that the tipper breached a duty of confidentiality, the case also states that such liability “runs to all those who have received the information and who know or should know that it was passed to them in breach of the duty of confidentiality.”

Personal Benefits and Nonpublic Information

In “tipper” insider trading cases, established standards for tippee liability under the Dirks rule also typically require that the tipper received some form of personal benefit in connection with providing the material nonpublic information. For example, in the 2016 case Salman v. United States, the U.S. Supreme Court recognized that “gifting” confidential information to relatives or friends counts as a personal benefit. However, if a “tipper” inadvertently or accidentally discloses confidential information, the tipper’s accidental disclosure alone does not necessarily establish the personal benefit required by the Dirks rule.

How difficult is insider trading to prove?

Burden of Proof

The U.S. Securities and Exchange Commission (SEC) generally proves civil liability for insider trading by a preponderance of the evidence. For criminal insider trading liability, the Justice Department generally must establish guilt “beyond a reasonable doubt.”

Scienter and “Willfulness” in Federal Insider Trading Cases

A federal court will not impose criminal insider trading liability unless the prosecution can prove that a defendant acted with “scienter” (or, in some cases, recklessness). While this standard of intent is generally sufficient to establish liability under most federal criminal securities provisions, criminal liability under the Exchange Act requires that the government establish a “willful” violation. With respect to criminal liability under Section 32(a) of the Exchange Act, this means that a defendant’s conduct must be “the result of a conscious and voluntary act, not an act of negligence or an accident.” However, Section 32(a) also does not require that a defendant have knowledge of the specific securities rule that applies.

How Do the Government Prove Insider Trading Liability?

Federal law enforcement agencies generally rely on a combination of direct and indirect evidence to prove insider trading liability in civil and criminal cases. In most cases, this evidence includes:

• Trading records
• Communication logs
• Relationship data
• Evidence of access to confidential information
• Evidence of “scienter” or “willfulness”

What role do trading records play in insider trading cases?

Trading records help federal investigators establish the financial transactions that are central to the allegations at hand. While trading records may also show suspicious timing, trading records alone do not establish a breach of duty, scienter, or willfulness.

However, trading records can be essential for proving insider trading liability under certain circumstances. When combined with other evidence, including records of the parties’ communications, relationship data, and evidence of access to confidential information, trading records can support an inference of “scienter” or “willfulness” in many cases.

Still, trading records alone do not address all of the legal elements required to establish liability for insider trading. The elements of “scienter” and “willfulness” are generally unique to insider trading liability, and proving scienter or willfulness will be key in establishing (or fighting) federal insider trading charges.

What about investor reliance and economic loss?

Insider trading enforcement actions are essentially fraud cases involving the use of material nonpublic information in securities transactions. As a result, government enforcement agencies generally do not need to prove that investors relied on a defendant’s statements or transactions. Similarly, government enforcement agencies generally do not need to establish that investors suffered economic losses.

How much can the SEC seek for insider trading?

Penalties under Section 21A of the Securities Exchange Act

Section 21A of the Securities Exchange Act is the principal statutory provision that authorizes the SEC to pursue disgorgement and civil penalties. Under Section 21A, the SEC generally may seek a penalty of up to three times the defendant’s gain (or a penalty of up to three times the amount of loss that the defendant avoided). Importantly, these Section 21A penalties can be assessed in addition to disgorgement and prejudgment interest.

Civil Penalties vs. Compensatory Treble Damages

How Does Section 21A Account for “Avoided Losses”?

With respect to the amount of a defendant’s “gain” or “avoided losses,” Section 21A measures profits and losses based on the security’s value after the material nonpublic information at issue was disseminated to the public. For example, if an insider sells shares at $100 per share and sells them prior to a public announcement that results in the price dropping to $50 per share, that insider has “avoided loss” of $50 per share.

What Are the Legal Limits on Disgorgement?

In the 2020 case Liu v. SEC, the U.S. Supreme Court took a narrow approach to disgorgement, making clear that disgorgement must be “limited to the amount of a wrongdoer’s net profits.” While the SEC continues to assert broad authority to seek disgorgement as a remedy, the court’s holding in Liu limits the SEC’s ability to recover “gross” profits when that amount exceeds what the wrongdoer actually gained through a fraudulent securities transaction.

How Does the SEC Calculate Prejudgment Interest?

When imposing disgorgement and civil penalties in administrative orders, the SEC calculates prejudgment interest pursuant to the formulas provided in Section 6621(a)(2) of the Internal Revenue Code. Under the formulas at Section 6621(a)(2), the appropriate rate of interest is the “underpayment rate” for the month ending before the date on which the liability accrued. The applicable rates are compounded quarterly, but the rates have historically remained under 1% to 2%.

Although 1 to 2 percent sounds relatively low, compounding the rate of prejudgment interest can substantially increase the amount that will ultimately become due. Because this makes accurate interest calculations challenging, it is best for all parties to carefully determine the appropriate amount of prejudgment interest with the help of competent counsel.

Additional Remedies for Insider Trading

In addition to disgorgement and civil penalties, the SEC generally has the authority to pursue injunctions and other remedies for insider trading as well. With respect to insider trading enforcement, injunctions can serve to protect the market, prevent a party from trading based on misappropriated information, or prevent or stop an ongoing insider trading scheme. The SEC can also seek to prevent convicted defendants from serving as corporate officers or directors and can seek to bar professionals from the securities industry. Finally, the SEC will impose permanent bans when deemed necessary to protect investors, to punish wrongdoers, or to seek to preserve the reputation and integrity of the national financial markets.

If any of this describes your situation, it is worth talking it through with counsel. Spodek Law Group can be reached at 212-300-5196.

What is the maximum criminal penalty for insider trading?

Individual Criminal Penalties

Under Section 32(a) of the Securities Exchange Act, individual criminal insider trading penalties include:

• Up to 20 years of federal imprisonment for each criminal offense
• Criminal fines of up to $5 million per criminal offense
• Debarment from serving as an officer or director of a publicly traded company

If defendants face other criminal charges, the Justice Department will use a combination of the defendant’s criminal charges and the U.S. Sentencing Guidelines to determine the appropriate criminal sentence. For example, the Justice Department may seek 25 years of federal imprisonment for securities fraud under 18 U.S.C. §1348. As a result, defendants must be prepared to face the penalties associated with both insider trading and other potentially applicable federal criminal charges.

Statutory Maxima and “Stacked” Penalties

The insider trading and securities fraud penalties discussed above are statutory maxima. As a result, while each criminal insider trading offense allows for imposition of fines and other criminal sanctions, these penalties may apply on a per-count basis as well. When federal prosecutors “stack” criminal insider trading charges, a defendant’s exposure to statutory penalties can increase substantially. However, defendants who are acquitted on some or all counts may be eligible to avoid imprisonment under federal sentencing laws and the U.S. Sentencing Guidelines as well.

Alternative Fines for Individuals

In some cases, the Justice Department will seek to impose the alternative fine that is available for various federal criminal offenses under 18 U.S.C. §3571(d). With respect to federal insider trading offenses, Section 3571(d) applies if a defendant’s criminal insider trading offense “derived pecuniary gain to the defendant or caused pecuniary loss to another person.” In this situation, Section 3571(d) allows for a criminal fine equal to twice the gross gain or gross loss.

Actual Federal Sentences

Actual federal sentences are determined based on the U.S. Sentencing Guidelines as well as the federal statutory factors at 18 U.S.C. §3553(a). While these factors and guidelines limit defendants’ criminal exposure in many cases, defendants accused of insider trading still face significant risks. Under Guideline §2B1.4, the base offense level for federal insider trading offenses is 8. Pursuant to Guideline §2B1.4, the offense level increases based on the trading gain (or loss avoided) in the relevant insider trading case.

In addition to trading gain, multiple other factors can impact the offense level calculation in federal insider trading cases. These factors range from those that might exacerbate the penalties (e.g., role in the offense) to those that might lessen the penalties (e.g., cooperation). These factors can impact the maximum federal criminal penalty defendants face for insider trading.

Criminal Insider Trading Penalties for Companies and Entities

For criminal insider trading offenses, the fines authorized under Section 32(a) of the Securities Exchange Act apply on a corporate or business entity’s criminal fines as well. As a result, Section 32(a) authorizes criminal fines of up to $25 million for companies and business entities.

When does a Rule 10b5-1 plan provide protection?

Affirmative Defense

Under Rule 10b5-1, qualifying pre-planned trades do not provide immunity, but instead provide an affirmative defense in federal insider trading cases. Establishing affirmative defense is a multistep process, and as a result, any allegations of insider trading involving trades executed pursuant to Rule 10b5-1 plans will require scrutiny.

Adoption Prior to Knowledge of MNPI

Rule 10b5-1 plans generally qualify for affirmative defense status when adopted before the subject of the plan becomes aware of relevant material nonpublic information (MNPI). However, once a person becomes aware of relevant MNPI, he or she may be considered to have aware of the information for the purpose of evaluating whether a transaction based on that information violates Rule 10b5-1.

Lack of Control over Trade Timing, Price, and Amount

Another requirement for Rule 10b5-1 plans to qualify as an affirmative defense is for them to restrict the user’s subsequent influence over the time, price, or amount of securities to be traded. If a plan is adopted and later modified by a user who has access to MNPI, the plan may no longer qualify as a valid affirmative defense.

Rule 10b5-1 Cooling-Off Periods

Cooling-off periods, which recently became effective under Rule 10b5-1, act as a mandatory waiting period before trades under the plan may be executed. The duration of a cooling-off period under Rule 10b5-1 generally depends on whether the person trading is an officer or director of the company and whether the company is an issuer.

• With respect to officers and directors of the subject companies, the cooling-off period generally expires upon the later of (i) 90 days after the plan’s adoption or (ii) two business days after the company’s next public release of financial results, with a cap of 120 days.
• With respect to other persons, the cooling-off period is 30 days, except that issuers do not generally have a cooling-off period.

Rule 10b5-1 Certifications

In order for a Rule 10b5-1 plan to qualify, companies’ directors and officers must certify two specific matters upon adoption: (i) that they are not aware of any MNPI at the time of adoption, and (ii) that they are acting in good faith with respect to the plan.

2022 Rule 10b5-1 Amendments: Overlapping Plans

The 2022 Rule 10b5-1 amendments restricted the adoption of overlapping trading plans. While individuals used to have considerable leeway when adopting multiple plans, current Rule 10b5-1 restrictions limit the use of overlapping plans.

Good Faith

Finally, Rule 10b5-1 requires that individuals who execute Rule 10b5-1 plans act in good faith not only at the time they adopt the plan, but during the plan’s entire operation. Trading under a plan in bad faith can undermine the plan’s validity and leave the trader vulnerable to liability.

Can other civil claims and deadlines increase exposure?

Section 21A’s Controlling-Person Penalties

When Does Section 21A Control-Person Liability Apply?

Section 21A authorizes controlling-person penalties under specific circumstances. These circumstances include: (i) the controlling person “disregarded the fact that it was likely that the controlled person would commit insider trading,” or, (ii) the controlling person “recklessly failed to take appropriate steps to prevent” the controlled person’s commission of insider trading.

Private Claims under Section 20A of the Exchange Act

Section 20A of the Exchange Act allows certain contemporaneous traders to seek recovery for insider trading. “Contemporaneous traders” are the investors who traded with the subject of the alleged insider trading in the securities market at or around the same time as the defendant.

Section 16(b) “Short-Swing” Liability

In addition to the remedies the SEC pursues under Section 21A, the issuer, or a shareholder suing on the issuer’s behalf, can pursue short-swing profit recovery under Section 16(b) of the Exchange Act. Unlike Section 21A liability, liability under Section 16(b) does not require scienter, willfulness, or an associated breach of duty.

Limitation Periods and the Five-Year Rule

Under 28 U.S.C. §2462, federal administrative agencies (including the SEC) are subject to a five-year limitation period for disgorgement and civil penalties in most cases. However, there are several notable exceptions that allow for longer limitation periods.

• Disgorgement Claims Based on Scienter

Pursuant to Section 21(d)(8) of the Exchange Act, the SEC may pursue disgorgement of any profit that a defendant has acquired through a scienter-based violation of the federal securities laws. While §2462 generally applies, the SEC can also seek to recover profits dating back ten years in certain cases involving scienter.

• Injunctions, Industry Bars, and Officer-Director Bars

In addition to disgorgement, the SEC can seek injunctions, industry bars, and officer-director bars against defendants. While §2462 generally applies in many cases, the SEC may also seek to establish injunctions, industry bars, and officer-director bars in cases involving fraud and other scienter-based offenses. In cases involving scienter or the threat of scienter-based injuries, the limitation period is ten years.

• Exception for “Wrongful Conduct”

There is a general exception to the five-year limitation period provided in Section 2462 that may allow for a longer time period in some cases. If a defendant’s “wrongful conduct” constitutes a “continuing offense,” the five-year limitation period starts when the continuing offense ends. While the most common exception applies only in securities fraud cases, the SEC generally asserts the existence of various continuing offenses, including insider trading offenses.

Get Advice on Your Situation

If you want someone to look at the specifics of your case, Spodek Law Group handles federal criminal defense nationwide from New York and Los Angeles. The firm has been practicing since 1976 and its motto is simple: we owe loyalty to only you. Call 212-300-5196.