Insider Trading and Securities Fraud: A Wall Street Nightmare

Javier Cordero

Rawls College of Business, Texas Tech University

BLAW-3391: Business Law I

Mr Jairo Hernandez

December, 2022
What is Insider Trading?

Insider trading is an issue that dates back many years. By 1906, the United States had

already seen its major insider trading scandal when, allegedly, directors of the Union Pacific

Railroad delayed the announcement of a dividend increase so they could buy stock in the

company before the anticipated price spiked. As the Security and Exchanges Commission (SEC)

explains it, “insider trading refers generally to the buying or selling of a security, in breach of a

fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic

information about the security” (SEC, 2022). In the United States, there are many federal

organizations and agencies that oversee and regulate issues related to insider trading, for

example, the Security and Exchanges Commission (SEC), the Internal Revenue Service (IRS),

the Financial Industry Regulatory Authority (FINRA) and even state organizations such as the

District Courts for both the Southern and the Eastern District of New York. This essay will give

insight into one of the most terrible crimes in the financial sector, naming the most famous cases,

the legal aspects of the crime, its connection to the topic of business law, different industries

involved and even different contingency plans that financial institutions have developed to stay

away from trouble.

The case of S.A.C Capital

When asked, most people would say that the most famous case of insider trading involves

american businesswoman and TV personality Martha Stewart. While it is indeed the most

popular case of this crime, it is far from being the largest. Back in 2013, Preet Bharara, the then

United States Attorney for the Southern District of New York, encountered himself with what

could be the largest case of his career as a prosecutor: a crackdown on insider trading in the

hedge-fund industry.

Bharara, alongside many prosecutors from the Federal Bureau of Investigation (FBI) and

the Security and Exchange Commission, had tapped into the phone logs of one of Wall Street’s

most profitable hedge funds. Bharara was considering a criminal indictment for Stephen A.

Cohen, the founder of S.A.C Capital.

As the investigation took place, Bharara was able to find evidence of insider information

being shared to Cohen’s subordinates. This information regarded the earnings reporting for the

company Dell, who were supposed to miss the expected earnings at the end of Q3 in 2010. As

Cohen analyzed this information, he decided to slowly close his position on Dell, avoiding a loss

of approximately $1.7 million.

In order to avoid taking this matter to federal court, Cohen had to take a plea deal where

he would declare himself guilty of insider trading. Alongside this, Cohen would also have to

close his hedge fund so he could only trade using his own money and would have to downsize to

a family office.

Cohen’s case is one of many involving large hedge funds and financial institutions in

crimes like this one. It is true that S.A.C was indicted for a heavy amount of money, yet it is not

always the case. As it was previously mentioned TV star Martha Stewart was also indicted for
this crime back in 2001 after she sold all of her 3928 shares of ImClone a day before the stock

price plummeted due to the rejection of a product by the Food and Drug Administration (FDA).

The difference we encountered between these two cases was the sum of money they were

indicted for. While Cohen was indicted for well over $1.7 million, Mrs Stewart was indicted for

barely $50,000. Making it seem as a statement by federal prosecutors saying that they will indict

anybody for any sum, no matter their status.

Legal Aspects of Insider Trading

By now, it is very clear and easy to understand that insider trading is an unlawful act.

Insider trading is characterized by fraud, unfairness, and unethical business practices but, what

crimes are directly committed when engaging in an act like this? Or what laws are broken?

If you’ve participated in insider trading, you are technically guilty of securities and

commodities fraud, which is a white-collar crime. According to the official page of the Federal

Bureau of Investigation (FBI), a white-collar crime is a non violent felony charge that is usually

committed with the purpose of generating financial gains (FBI, n.d) . Individuals who are found

guilty of insider trading may be subject to penalties of up to $5 million and sentences of up to 20

years in prison. Business firms found guilty of insider trading may be fined up to $25 million,

and anyone who took part in the plan may receive a 20-year prison term. This can be resembled

in the case of S.A.C Capital, when they were demanded to repay the amount of money saved

from engaging in the insider trading scandal, as well as having to downsize to a family office and

restrain themselves from investing capital for clients.

Although anyone can engage in commodities and securities fraud by taking part in insider

trading schemes, stockbrokers are most frequently found to have committed this crime. However,

it has happened that whole companies have been charged with insider trading. Typically, these

businesses include brokerage houses, investment banks, and other corporations. You could be

charged with major crimes if you were even a small part of your company's securities and

commodities fraud.
Preventive Measures Against Insider Trading

Information is easier to get today than ever before. Content spreads like a wildfire once it

is out there. This has led big firms and investment banks to create certain internal regulations in

order to prevent crimes like this from happening. An example of this can be seen with the

monitoring of trading activity by compliance officers. Compliance officers are a critical figure in

any investment firm since they look to maintain order and “prevent anyone from going over the

line”. The surveillance of trading activity can discover large, irregular trades around those

material events and lead to investigations as to whether the trades were legitimate or the result of

inside information being provided to those who instituted the trades.

Similarly, many firms have implemented whistleblowers. Whistleblowers come forward

with knowledge that others are trading on inside information and provide tips to the SEC.

Employees of the corporation in question as well as those who work for its suppliers, customers,

or service providers are all examples of whistleblowers. Incentives provided by the law to

whistleblowers to come forward include obtaining 10% to 30% of the fines obtained from

successful insider trading charges. When the SEC launches an insider trading inquiry, the media

or self-regulatory organizations like the Financial Industry Regulatory Authority (FINRA) may

also serve as the agency's initial sources.

Connection to the Topic of Business Law

The explanation of these two processes used in order to prevent insider trading in major

brokerage firms is key to understanding the linking with the topic of business law. Here, we can

see how by complying with the various regulations and laws exposed by major federal agencies,

corporations are able to stay away from trouble. Additionally, it gives insight into how many of

these agencies act and operate when exposed to an issue like this one.

Other Crimes Derived From Securities Fraud

While it is true that insider trading is the most prevalent crime derived from the

committing of fraud with securities, there are many other crimes and violations that are worth

mentioning. One example of this is what regulators call front-running. Front-running is the

practice of trading a stock or any other financial asset by a broker who has prior knowledge of a

future transaction that will inevitably affect the price of the asset. A broker may also front-run if

they have inside information about their company's impending recommendation to clients to

purchase or sell an asset, which will almost surely have an impact on the asset's price. Another

example of a crime derived from securities fraud are hot tips. A hot tip is simply a valuable piece

of information about a certain financial instrument that may give a broker advantage in order to

generate a financial gain. While receiving or disseminating a "hot" stock tip based on market

research and analysis is lawful, the receiving of information from inside of a firm and acting on it

would provide the recipient with an unfair advantage and therefore would fall into insider

trading.
When is Insider Trading Legal?

Due to the notion that it is unfair to the typical investor, the word "insider trading" often

carries a negative connotation yet, insider trading is not always illegal. Based on everything else

that was exposed in this essay, it is difficult to find something about insider trading that could

possibly make it legal. Weekly legal insider trading takes place on the stock market. The attempt

of the SEC to keep a fair marketplace exists at the root of the legality issue. Basically, as long as

they notify the SEC of these trades promptly, it is permissible for corporate insiders to trade

company shares. The Securities Exchange Act of 1934 marked the beginning of the legal

disclosure of stock-related transactions. Directors and significant stockholders, for instance, are

required to report their holdings, transactions, and ownership changes. According to an official

public document published by the New York Stock Exchange (NYSE) explains it, the Securities

Exchange Act of 1934 is “an act that provides regulation of securities exchanges and of over-the-

counter markets operating in interstate and foreign commerce and through the mails, to prevent

inequitable and unfair practices on such exchanges and markets, and for other purposes.”

(NYSE, 2012)
Personal Take on the Issue

As a current employee of an international brokerage firm, I feel like my personal take on

the topic of insider trading is crucial for the success of this paper. For the past 3 months, I have

been working at a stock broker which falls into regulation of the Financial Industry Regulatory

Authority (FINRA) and have gotten a glimpse of what complying with their regulations is. I

personally deem insider trading as one of the most unlawful crimes and frauds that can happen in

this industry and personally, would prefer to stay away from it as much as I can for my personal

integrity and that of the firm. Directors at the firm constantly remind us how important it is to

comply with regulations imposed by FINRA and SEC not only when trading but also at the

moment of dealing with either national or international clients.

Conclusion

Taking into consideration all the aspects previously mentioned, we can see how insider

trading is a crime that has prevailed over time and keeps on to be an issue for federal regulators

nowadays. Cases like the one exposed above, showcase how the wealthy feed from greed and

avarice and therefore lead to commit crimes like this one. This has led to many federal agencies

to take preventive measures in order to ward off this fraud. Even investment firms themselves

have had to rely heavily on compliance so they can stay on good grounds. The various crimes

derived from the securities fraud explain in a very good way how there is a fine line between the

right and wrong. This has even led to a gray area between the legal and illegal aspects of the

crime, when sometimes it may be deemed as unlawful and other times as permissible. As a

young stockbroker, this information gives me great insight into what I should and should not

become in the future. Getting to know the dark side of the industry one is working is crucial

when drawing a line between right and wrong and complying with what the law states.

Developing this essay has led me to understand the importance of understanding the topic of

business law applied to an industry of my interest. This is because I truly believe that the

appliance of law to business will not only lead to compliance, but it will also lead to a much

more harmonized and transparent work environment, excluding the wrongful doings that can be

found in many businesses, that overall affect the global industry and economy.
Reference List

- Insider Trading | Investor.gov. (n.d.).

https://www.investor.gov/introduction-investing/investing-basics/glossary/insider-trading

- Front-Running Definition, Example, and Legality. (2022, May 19). Investopedia.

https://www.investopedia.com/terms/f/frontrunning.asp

- hot tip. (n.d.). In The Merriam-Webster.com Dictionary.

https://www.merriam-webster.com/dictionary/hot%20tip

- NYSE. (n.d.). Securities exchange act of 1934 - New York Stock Exchange. NYSE.

Retrieved December 8, 2022, from

https://www.nyse.com/publicdocs/nyse/regulation/nyse/sea34.pdf

- n.d. (2018, May 21). When is a stock tip considered insider trading? Bochetto and Lentz.

Retrieved December 7, 2022, from

https://www.bochettoandlentz.com/when-stock-tip-considered-insider-trading/#:~:text=T

here%20is%20nothing%20illegal%20about,it%20is%20a%20criminal%20act

- Sebastian, A. (2022, July 13). How insider trading is prevented in corporations.

Investopedia. Retrieved December 7, 2022, from

https://www.investopedia.com/articles/investing/092616/how-insider-trading-prevented-c

orporations.asp

- FBI. (2016, May 3). White-collar crime. FBI. Retrieved December 7, 2022, from

https://www.fbi.gov/investigate/white-collar-crime