SECURITIES FRAUD AND INSIDER TRADING
Securities fraud encompasses a broad range of illegal activities, most of which involve deceiving investors by inducing them to make investment decisions based on false information, or manipulating financial markets by artificially raising or lowering the price of any stock, for example, through “pump-and-dump” schemes.
We have extensive experience successfully representing individuals and organizations being investigated and prosecuted for securities fraud and insider trading. In addition, we work hard, return phone calls, and do our very best to represent others the way that we would want to be represented ourselves. If you would like to discuss a matter with a skilled federal criminal defense attorney on our team, please contact us at (404) 658-9070.
The Federal Securities Laws
Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 broadly prohibit the use of “manipulative and deceptive devices” in the trading of securities. Rule 10b-5 makes it illegal to “employ any device, scheme, or artifice to defraud”; to “make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading”; or to “engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”
The Securities Act of 1933, sometimes called the “truth in securities” law, requires that investors in publicly traded companies receive financial and other significant information concerning securities being offered for public sale, and prohibits deceit, misrepresentations, and other fraud in the sale of securities.
Securities fraud is also a crime under the federal criminal code, which prohibits mail fraud, wire fraud, and securities fraud (18 U.S.C. §§ 1341, 1343, and 1348 respectively). Insider trading prosecutions typically involve charges under these statutes in addition to claims under Section 10(b).
Common Securities Fraud Scenarios
The most common types of securities fraud cases we see involve alleged false statements or omissions of information about a security that are material to an investor’s decision to buy or sell that security and are intended to influence the investment decision. For example, we have successfully handled several securities fraud cases in which the government has alleged that issuers of investments made material misstatements and failed to disclose material information in offering documents used to solicit investors in private placements. We have also handled securities fraud actions based on allegations that a company, and/or its directors and officers, failed to disclose material information to investors or used fraudulent accounting practices to misrepresent the company’s financial health.
Other kinds of securities fraud schemes include:
Pyramid Schemes: In a pyramid scheme, paying participants recruit additional participants to invest in the program. The “returns” paid to earlier participants are paid with money contributed by later participants. Because there are no real investments, a pyramid scheme can only generate money by promising high returns to new participants, and the returns to the new participants can only be paid by recruiting new participants. Pyramid schemes fail when new participants can no longer be recruited.
Ponzi Schemes: Like participants in a pyramid scheme, investors in a Ponzi scheme are paid by the contributions of new investors. In a Ponzi scheme, however, earlier investors do not recruit new investors. Rather, one person, usually a fund manager, solicits and collects investments from new investors and uses the contributions from the new investors to pay “returns” to earlier investors. The money is never actually invested as promised. Like pyramid schemes, Ponzi schemes are inherently unsustainable, requiring a constant influx of cash from new investors in order to pay earlier investors. These schemes collapse when new investors cannot be attracted or when a large number of investors ask to pull their money out.
Pump-and-Dump Schemes: “Pump-and-dump” schemes involve purchasing the stock of small (“microcap”) companies at very low prices and then spreading false information to drum up interest in the stock and artificially increase its price (the “pump”). The shares are then sold at an artificially high price (the “dump”), leaving those who bought shares at the inflated price with significant losses as the stock crashes.
Churning: Churning is when a securities broker, who has discretionary power over a customer’s account, engages in excessive buying and selling of securities in the customer’s account for the sole purpose of generating commissions that benefit the broker.
Insider Trading
Insider trading is a type of securities fraud that derives from Section 10(b) and Rule 10b-5’s prohibition against the use of “manipulative and deceptive devices.” Insider trading typically occurs when a person purchases or sells a security, on the basis of material nonpublic information about the security or the issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively to the issuer of the security or the shareholders of the issuer, or to any other person who is the source of the material nonpublic information. A person trades “on the basis of” material nonpublic information when he or she purchases or sells securities “while aware of” the information. 17 CFR § 240.10b5-1.
Insider trading is generally prosecuted under one of two theories: the “classical” theory and the “misappropriation” theory.
Classical Theory of Insider Trading
The paradigmatic example of illegal insider trading is that of a corporate insider who, in violation of a fiduciary duty to shareholders, trades in the securities of his corporation on the basis of material, non-public information (e.g., an upcoming merger or acquisition) that he has obtained as a result of his position within the corporation. The classical theory of insider trading is premised upon the idea that a corporate insider has access to material, nonpublic information by virtue of his position, and that his position thus gives rise to a duty either to disclose that information to others in the securities market or to refrain from using it for his own personal benefit. When the insideruses confidential information without disclosing it to the rest of the securities market, he is said to have violated the duty owed to shareholders and engaged in fraud prohibited by Section 10(b) and Rule 10b-5.
Under the classical theory, one cannot commit insider trading unless the information is obtained as a result of a fiduciary relationship between the insider and the corporation whose securities are involved, and the insider trades in those securities without disclosing his superior knowledge.
“Temporary” insiders are also subject to liability under the classical theory of insider trading. Individuals who work for or provide services to a company on a temporary basis may be treated as insiders when they have access to the company’s material, nonpublic information. If the company’s expectation is that the temporary insider will keep the company’s nonpublic information confidential, then the temporary insider owes a duty not to use that information for his or her own benefit. Lawyers, accountants, actuaries, consultants, underwriters, financial printers, and analysts may be subject to insider trading liability if they are privy to their clients’ nonpublic information.
Tipper-Tippee Insider Trading Liability
The classical theory of insider trading also extends liability to “tippees.” Tippees are not insiders, but are individuals who receive material, non-public information about a security from an insider (the “tipper”) and who subsequently trade the security based on that information. Because the tippee’s duty not to trade on the inside information derives from the tipper’s fiduciary duty to the company and its shareholders, a tippee is only liable if the tipper breached that duty by disclosing the information to the tippee. For insider trading liability to attach to the tippee, the tippee must also have known that the tipper was breaching a duty by passing along the information.
Whether the tipper has breached a duty such that the tippee can be held liable depends on whether thetipper received some type of personal benefit from passing the information to the tippee. If the tipper has not received some personal benefit, then he has not breached his duty to shareholders and the tippee cannot have derivatively committed a breach. The personal benefit the tipper must receive need not be an objective, consequential personal benefit representing an actual or potential pecuniary gain. Rather, the Supreme Court has clarified that a tipper obtains a personal benefit when he or she makes a gift of confidential information to a “trading relative or friend.”
In cases where the tippee trades based on inside information in breach of his derivative duty, the tipper-insider is also liable for insider trading, even if the tipper-insider did not personally trade. The nontrading tipper may be required to disgorge the tippee’s profits, even where the tipper did not himself profit from the tippee’s trades.
Misappropriation Theory of Insider Trading
The misappropriation theory of insider trading significantly broadens the scope of liability under Section 10(b) and Rule 10b-5. Under the misappropriation theory, an outsider (a person with no connection to the corporation or its employees) can violate insider trading laws when he misappropriates confidential information for securities trading purposes, in breach of a fiduciary duty owed to the source of the information. The person does not have to owe a duty to the company or its shareholders. Under the misappropriation theory of insider trading, a person violates Rule 10b-5 whenever he (1) “steals” material nonpublic information, (2) via a breach of duty arising from a trusting or confidential relationship and, (3) thereafter transacts upon that information, (4) regardless of whether he or she owed any duties to shareholders of the company in whose stock he or she trades. SEC v. Clark, 915 F.2d 439, 443 (9th Cir. 1990) (citing SEC v. Materia, 745 F.2d 197, 201-02 (2d Cir. 1984)).
Penalties for Securities Fraud
Violations of federal securities laws are serious offenses that can result in significant civil and criminal penalties. A felony conviction for securities fraud under the federal securities fraud statute, 18 U.S.C. § 1348, carries a maximum sentence of 25 years’ imprisonment and can result in fines of millions of dollars. Violations of 15 U.S.C. §§ 78j(b) and 78ff and 17 C.F.R. § 240.10b-5 carry a statutory
maximum prison sentence of 20 years and a statutory maximum fine of $5,000,000.
In recent years, we have seen federal prosecutors increasingly use 18 U.S.C. § 1348 to pursue insider trading cases, including insider trading based on tipping. While the government must prove in tipping cases brought under Section 10(b) that, among other things, the tipper owed a fiduciary duty or duty of confidentiality to the shareholders or source of the nonpublic information and received a personal benefit, these elements are not required to prove fraud under 18 U.S.C. § 1348, which broadly covers schemes to defraud that have some nexus with a security.
Of course, it is not uncommon in securities fraud cases for the government to add on charges, including mail and wire fraud and money laundering. A conviction on any such charges will result in a significant increase in penalties.
In addition to criminal fines and imprisonment, the SEC may impose civil fines against corporations or individuals convicted of securities fraud. Those who are subject to regulation – investment advisors, broker-dealers, bankers, etc. – may also be debarred from the financial industry if convicted of securities fraud.
Defenses to Securities Fraud and Insider Trading
Defenses to securities fraud often involve negating one of the elements of the offense. For example, defense counsel may be able to show that you did not intentionally or recklessly misrepresent material facts or intentionally or recklessly omit material information. If the government cannot prove the requisite state of mind, its case will not succeed.
In insider trading cases, experienced defense counsel may also be able to show that the trades in question were not made while you were aware of material nonpublic information; that the information you possessed was not in fact “nonpublic” (that is, that it had already been leaked or disclosed and was therefore publicly available) or would not have been “material” to potential investors in deciding whether to buy or sell the security in question; or that you had no knowledge that the information was confidential. In some cases, there might be a question as to whether the allegedly illegal transaction even involved a “security.” If you consulted with an attorney prior to engaging in the challenged transaction, you might be able to interpose an advice of counsel defense. In the case of tipper-tippee liability, defense counsel should explore whether the tippee was in fact a “trading relative or friend,” since not every social acquaintance will meet this standard for purposes of establishing the requisite personal benefit.
At the end of the day, whether someone has committed securities fraud or insider trading is highly fact-specific. You must consult qualified defense counsel with experience defending these types of cases as soon as you believe you might have exposure under the securities fraud or insider trading laws, and certainly if you have been contacted by the SEC or DOJ.
FAQs
I received an SEC subpoena. Do I have to respond?
An SEC Subpoena is a serious matter, and careful, timely compliance is essential. It is also essential that you seek the advice of experienced counsel before attempting to respond on your own. The worst thing you can do is ignore the subpoena and hope it goes away. Keep in mind that receiving a subpoena does not necessarily mean you did something wrong. The SEC might be investigating another person or entity for securities fraud and believe you have relevant information. Nevertheless, dealing with the SEC presents many traps for the unwary. It is always in your best interest to consult with an attorney before talking to the government about a federal investigation relating to securities fraud and/or insider trading. This is especially so if you believe you could have any criminal exposure, since the SEC will share evidence obtained in its civil investigation with the Department of Justice, which can bring criminal charges. A skilled criminal defense lawyer with experience handling parallel investigations and proceedings can evaluate your potential criminal exposure and determine how best to minimize that exposure while responding to the SEC. The early engagement of experienced defense counsel is key to developing a cohesive, global defense strategy and ensuring that nothing is done in the SEC case that could compromise your position in any potential or actual criminal case.
The subpoena I received includes a background questionnaire. Do I need to complete this?
Background questionnaires accompanying SEC subpoenas are entirely voluntary. Their purpose is to expedite your testimony by allowing the SEC to skip some basic and often tedious questions at the outset. Because the questionnaire is voluntary, you may skip any questions you choose. The only requirement is that the responses you do provide must be accurate. There is no downside to completing the questionnaire since if you fail to complete it, the SEC will simply ask you the questions during your testimony.In addition to saving time, completing the questionnaire will foster good will and help ensure that you are viewed by the SEC staff as cooperative.
I received a request from the SEC to produce documents voluntarily. Should I comply?
The SEC staff cannot issue subpoenas until a formal order of investigation issues. Therefore, the SEC will often ask for early voluntary production of documents. We generally advise clients that there is little to no upside to refusing to cooperate with requests for voluntary production. First, if you refuse to comply with a voluntary request, the SEC will simply obtain the formal order and issue a subpoena. Second, it is usually less burdensome to comply with an informal request than with a subpoena, which the SEC will inevitably issue if you refuse to provide the requested information voluntarily. Third, providing information on a voluntary basis will cause the SEC to view you as cooperative, which can only help when trying to negotiate a favorable resolution.
I passed my company’s inside information to a neighbor and he used it to make trades, but he did not pay me or give me anything of value for the information. Can I still be prosecuted for insider trading?
It depends. If your neighbor is a friend, then you may have significant exposure under the insider trading laws. If it can be shown that your neighbor is simply a personal acquaintance, with whom you have only a casual social relationship, then your tip to him likely would not constitute insider trading absent some tangible benefit that represents at least a potential pecuniary gain.
I overheard an executive of a large company privately discussing his company’s upcoming merger with another company. I acquired positions in the company and told my family and friends to do the same. Have I committed a crime?
Section 10b-5 does not criminalize trading based on information an insider inadvertently disclosed. Tippee liability depends on the tipper’s breach of a fiduciary duty. Because the executive you overheard had no idea you were listening to his private conversation, he did not breach his fiduciary duty to his company’s shareholders.