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Securities Fraud & Insider Trading: Definition, Regulations & Penalty

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  • 0:01 What Is Insider Trading?
  • 1:21 Exchange Act Section 10(b)(5)
  • 1:53 Penalties for Insider Trading
  • 3:00 Sec V. Martha Stewart…
  • 4:44 Lesson Summary
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Lesson Transcript
Instructor: Kat Kadian-Baumeyer

Kat has a Master of Science in Organizational Leadership and Management and teaches Business courses.

Securities fraud or insider trading is illegally trading stock on the open market using confidential information. It is usually done to gain an advantage over other traders.

What Is Insider Trading?

Insider trading is the act of using confidential or inside information about a publicly traded company to one's advantage to buy and sell stock, and it is illegal. You see, when an investor buys and sells stock, it is sort of like gambling at a casino. The only difference is, at a casino, there are no guarantees and winning is based mostly on luck.

In the stock market, buying is risky, but there are tools an investor can use to make the exchange less risky. Financial reports and a company's prospectus contain truthful financial disclosure. An investor will use this information to decide whether a stock has potential to pay dividends. A publicly traded company's prospectus is available for all to see. It has to be according to the Securities and Exchange Commission (SEC). This creates a level playing field for all parties who wish to invest.

Now, when a few investors have confidential information that the general population is not aware of, this creates an unfair advantage. This tipping is the process of supplying information not disclosed to the general public by those with a duty to maintain confidentiality.

The investors, privy to the information, can make stock purchases or dump stocks they own before any news hits the streets.

Exchange Act Section 10(b)(5)

The Securities Act of 1933 Section 10(b)(5) addresses insider trading by deeming it illegal for anyone, whether directly or indirectly, in any way:

(a) Intentionally commits a fraud

(b) Makes untrue statements or misrepresent financial information

(c) Operates a fraud against another person when buying securities

This means that it is illegal for any person to buy or sell securities using information obtained through confidential channels.

So what happens when a person is found guilty of insider trading? Let's see.

Penalties for Insider Trading

When a person is charged with the crime of insider trading, they may face both criminal and civil liabilities. It really depends on the specifics of the crime.

If a person willfully committed insider trading, the penalty will be much more severe than an act that may have had minimal, if any, intention.

How does a prison term of up to 25 years and fines of $5 million for individuals and up to $25 million for companies that engage in securities fraud sound? Not so fun, huh? Well, that may be just what an offender will face in many cases.

There is also a Mandatory Victims Restitution Fund Act of 1966 (MVRA) that orders restitution be paid to victims of an insider trading crime.

In a civil case, the penalty may be to give up all profits made from the trading frauds. They can even make the defendant disgorge, or reverse any losses he avoided by fraudulently using the information. Imagine that?

Let's take a look at a case that hit the tabloids not too long ago.

SEC v. Martha Stewart and Peter Bacanovic

Most of us know Martha Stewart for her tasty cakes and treats. Others may know her for her fun and interesting crafts. But in federal prison, she was known only for her status as an inmate.

Back in 2001, Martha Stewart and her then stockbroker, Peter Bacanovic, committed securities fraud by acting on inside information about a company called ImClone. Stewart obtained information from Bacanovic about ImClone's much-anticipated FDA approval of a cancer treatment drug.

You see, Bacanovic learned that Samuel Waksal, ImClone's CEO, and his daughter had sold their shares of company stock just prior to the FDA announcement. Once Bacanovic learned this, he ordered his assistant to sell Stewart's shares as well.

This is the important piece of the puzzle. Bacanovic violated the law when he acted on information that was not shared with the public. Information like this is valuable to any investor because it tells a story.

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