Stock Trading Basics

Stock Trading Basics: How Does the SEC Prove Insider Trading?

Trading stocks online is legal, but insider trading of any kind is not. Learn what the SEC must show the court in order to prove insider trading occurred.

Trading stocks online or via the old-fashioned method remains a popular form of investment in the United States. While both individual investors and stock trading companies are wise to do research, insider trading can result in both civil and criminal penalties.
Insider trading laws include Section 10(b) of the Exchange Act and federal Rule 10b-5. These rules prohibit stock trading based on “material non-public information.” This is information that the public can’t find out, but that would affect the public’s decisions whether to buy or sell shares or options if the public knew it. For instance, negotiations of mergers and acquisitions usually have a significant impact on the stock prices of the companies involved; therefore, confidentiial information about planned mergers or acquisitions is often considered material non-public information.
Not all trades based on material, non-public information are considered insider trading, however. In order to be held liable for insier trading, a person trading stocks must also have a fiduciary duty to keep the information confidential and not to trade on it. This duty, however, can usually be extended to just about anyone who knows the information.
Insider trading differs from suspicious trading, according to the SEC Actions blog. An SEC investigation into possible insider trading often begins with a suspicious trade. However, merely because a stock trade looks suspicious does not mean it is illegal.
The U.S. Securities and Exchange Commission, or SEC, often responds to news of suspicious trading by investigating the trades. Finding evidence of insider trading is often difficult, however, according to SEC Actions. Because direct evidence of insider trading may be scarce, the SEC is allowed to prove insider trading cases in court by using circumstantial evidence. Circumstantial evidence is evidence that allows a person to infer that insider trading occurred, even if it does not directly prove that insider trading occurred.
For example, consider the 2010 case SEC v. Horn, decided in the Northern District of Illinois. Dr. Horn was an ophthalmologist who performed surgeries in several surgery centers owned by LCAV, and who also owned and traded LCAV stock, including buying put options and call options as well as trying out a short sale. Dr. Horn’s trading decisions did well, earning him several hundred thousand dollars. The SEC, however, found Dr. Horn’s trades suspicious, and soon sued him for violating Rule 10b-5 and Exchange Act Section 10(b).
Despite investigations that included talking to Dr. Horn multiple times, however, the SEC had no direct evidence that Dr. Horn used material nonpublic information to purchase put or call options or to trade his LCAV stock. Instead, the SEC tried to prove in court that Dr. Horn had commited insider trading by using only circumstantial evidence. The SEC proved that Dr. Horn made successful stock trades and that LCAV frequently released a report that contained information about the business’s health, which Dr. Horn could have read if he had wanted to.
In court, however, the judge ruled that the SEC had failed to prove that insider trading occurred. Even though the SEC was allowed to use circumstantial evidence, the court held that none of that evidence showed a connection between Dr. Horn’s stock trades and any material, nonpublic information. Instead, the SEC had merely shown that Dr. Horn (a) traded his stock and (b) could have learned about the company’s financial health if he had wanted to – but the SEC did not show he actually researched any information about LCAV.
Among other things, the Horn case demonstrates that the SEC is not all-powerful when it comes to investigating and prosecuting insider trading or suspicious trading circumstances. Sometimes, a suspicious-looking trade is entirely innocent. However, as the Horn case demonstrates, a suspicion is not the same thing as proof.
Nevertheless, investigating suspicious trades and bringing insider trading cases to court when necessary remains a big part of the SEC’s work. Insider trading harms investors and the economy by undermining the value of transparency, allowing some people to profit at the expense of the general public. In a free market, information must be freely available in order for every investor to have the same chance to gain a competitive edge. If insiders trade too frequently on information the rest of the public cannot possibly receive, the public will lose confidence in the market and may eventually stop investing altogether, according to Investopedia.
Stock trading, commodities trading, and futures trading all offer ways to make money grow and support the U.S. markets. Trading can take on a number of forms, including day trading and online trading, also known as virtual trading. Many people trade stocks online individually using online stock trading platforms, while others rely on investment brokers and other stock trading professionals. Investigating an investment broker’s background, including his or her history with the SEC, is a wise step, especially for first-time investors.