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Securities Fraud and Insider Trading: How They Differ and Potential Defenses

Securities Fraud and Insider Trading: How They Differ and Potential Defenses

Securities fraud and insider trading are two types of white collar crimes that involve violations of securities laws. While they are related, there are important differences between them. This article will explain what securities fraud and insider trading are, how they differ, and potential defenses that can be raised if accused of either crime.

What is Securities Fraud?

Securities fraud refers to deceptive practices in connection with the buying and selling of securities (stocks, bonds, etc). There are several laws that prohibit securities fraud, but the main ones are Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 1.

Section 10(b) makes it illegal to use manipulative or deceptive devices in connection with the purchase or sale of securities. Rule 10b-5 further defines manipulative and deceptive practices to include 2:

  • Employing any device, scheme or artifice to defraud
  • Making untrue statements of material fact or omitting material facts
  • Engaging in any act, practice or course of business that operates as fraud or deceit

Some examples of securities fraud include 3:

  • Pump-and-dump schemes: Promoting a stock through false or misleading statements in order to inflate the price so insiders can sell their shares at a profit.
  • Churning: Excessive trading by a broker in a client’s account to generate commissions.
  • Misrepresenting information in SEC filings, press releases, or other communications that investors rely on when deciding to buy or sell stock.

The key elements the government must prove are 4:

  • The defendant made a misstatement or omission of material fact
  • The misstatement or omission was made in connection with the purchase or sale of a security
  • The defendant acted intentionally, knowingly or recklessly
  • The misstatement or omission was relied upon by investors
  • The reliance resulted in injury (e.g. financial loss)

Securities fraud charges can be brought civilly by the SEC or criminally by the Department of Justice. Penalties include fines, disgorgement of profits, and prison sentences.

What is Insider Trading?

Insider trading refers more specifically to buying or selling securities based on material, nonpublic information in violation of a duty of trust 5. 

There are two main theories of insider trading liability:Classical Theory: This applies to corporate insiders like directors, officers, and employees who trade stock in their own company based on confidential information obtained through their position. They have a fiduciary duty not to exploit this inside information for personal benefit.Misappropriation Theory: This applies to corporate outsiders who misappropriate material, nonpublic information in breach of a duty and then trade on it. This could include attorneys, investment bankers, accountants, consultants or others who receive confidential information about a deal or other market-moving event.Information is considered “material” if there is a substantial likelihood it would affect the stock price or be important to investors. Examples include earnings reports, new product launches, mergers and acquisitions, regulatory approvals/denials, etc.To prove insider trading, the government must show:

  • The information was material and nonpublic
  • The defendant breached a fiduciary duty or other duty of trust and confidence by trading on the information
  • The defendant acted intentionally or recklessly

Like securities fraud, insider trading can lead to civil penalties from the SEC and criminal prosecution by the DOJ.

How Securities Fraud and Insider Trading Differ

While insider trading is a specific type of securities fraud, there are some key differences:

  • Securities fraud is broader and covers any kind of deceptive practice related to buying/selling securities. Insider trading focuses specifically on trading based on confidential information.
  • Securities fraud requires a misstatement or omission. Insider trading does not require any misrepresentations as long as there is a breach of duty.
  • For securities fraud, the misstatement/omission just needs to be “in connection with” the securities transaction. For insider trading, the confidential information has to be the actual basis for the trade.
  • Securities fraud requires reliance on the misinformation by investors. Reliance is not an element of insider trading.
  • Securities fraud applies to any securities market participants. Insider trading laws focus on corporate insiders and those who misappropriate confidential information.

So in summary – all insider trading is securities fraud, but not all securities fraud is insider trading. Insider trading is a more specific offense that involves breaching a duty of confidentiality.

Potential Defenses to Securities Fraud and Insider Trading

There are several potential defenses that may apply in securities fraud and insider trading cases:

Lack of Scienter

Scienter refers to intent or knowledge of wrongdoing. The government must prove the defendant acted intentionally, knowingly or recklessly. Lack of fraudulent intent can be a defense.

Reliance on Legal Counsel

Good faith reliance on advice of legal counsel may help negate scienter and show the defendant did not act willfully.

Statute of Limitations

There is a 5-year statute of limitations for securities fraud and insider trading. Old cases where evidence has gone stale may be difficult to prosecute.

No Duty/No Breach Arguments

In insider trading cases, the defense may argue the defendant did not actually owe a fiduciary or confidentiality duty, or did not breach any duty owed.

Immaterial Information

The defense can claim the allegedly nonpublic information was not important enough to affect the company’s stock price and therefore not “material.”

Truth on the Market

If the information was already known by the market through other public disclosures, then it may undermine claims the information was nonpublic or caused investor losses.

Personal Benefit Test

In tipper-tippee insider trading cases, the government must show the tipper received some personal benefit for breaching their duty by tipping confidential information. Defense can argue there was no benefit.

Lack of Knowledge

The defendant can claim they did not know the information was confidential or material when they traded or tipped others.

No Securities Transaction

Insider trading requires proof of an actual securities trade based on the inside information. Absent a securities transaction, there may be no insider trading violation.

Compliance with Company Policy

Adherence to a company’s insider trading compliance policy helps demonstrate good faith efforts to comply with the law.

Lack of Control

For company executives, lack of control over the alleged misstatements or omissions can help defend against liability. Plaintiffs must prove executive had control or influence over the misinformation.In sum, securities fraud and insider trading laws play an important role in promoting market integrity and investor confidence. But they also carry stiff penalties, so anyone facing charges should consult an experienced white collar defense attorney to assess whether viable defenses exist. The specific facts and circumstances of each case will determine which defenses may apply.

References

1

 https://www.law.cornell.edu/uscode/text/15/78j

2

 https://www.law.cornell.edu/cfr/text/17/240.10b-5

3

 https://www.sec.gov/fast-answers/answerssecuritiesfraudhtm.html[4] https://www.justice.gov/archives/jm/criminal-resource-manual-1731-securities-fraud

5

 https://www.investopedia.com/terms/i/insidertrading.asp https://www.sec.gov/fast-answers/answersinsiderhtm.html https://www.law.cornell.edu/cfr/text/17/240.10b5-1
https://www.justice.gov/archives/jm/criminal-resource-manual-1736-elements-insider-trading-violations https://www.sec.gov/news/speech/speecharchive/1998/spch221.htm https://www.jenner.com/a/web/im88RixK1rTzJkUBhGE7jc/4HaE92/sadeghi-riely-practical-guidance-nov-2022.pdf https://www.skadden.com/-/media/files/publications/2022/11/scienter_defenses_in_securities_fraud_actions.pdf

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