Chapter 5: Ethical Practices and Obligations - J. Insider Trading

Question 1

Insider trading

Answer 1

The Securities and Exchange Act of 1934 requires that broker/dealers establish, maintain, and enforce written policies to prevent the misuse of nonpublic information by any person associated with the firm. This includes the establishment of what are known as Chinese walls. These are internal procedures that limit and control the passing of potentially sensitive, nonpublic information between the departments of a firm. In addition to the 1934 Act, there is also the Insider Trading and Securities Fraud Enforcement Act of 1988, which provides further clarification on the penalties for violating insider trading rules.

Question 2

Civil penalties – insider trading

Answer 2

Civil penalties for insider trading violations are determined by the court, and vary according to the circumstances. The maximum civil penalty is three times the profit gained or the loss avoided from the use of the information. This is also known as treble damages.

Question 3

Criminal penalties – insider trading

Answer 3

Criminal penalties for insider trading violations are more severe. The court will determine the penalty that will be imposed on any person who, at the time of the violation, directly or indirectly controlled the person who committed the insider trading violation. Penalties may include fines, expulsion, and incarceration. The monetary penalty may be up to $5 million for individuals, and up to $25 million for corporations. The prison sentence for individuals may be up to 20 years.

Question 4

Contemporaneous Traders - insider trading

Answer 4

Insiders are also subject to lawsuits by other investors who believe they were harmed by insider trading violations.

For example, if a contemporaneous trader was trading without the same information as the investor with the inside information, the trader was at a disadvantage and can file a lawsuit for damages against the person who is in violation of insider trading rules. This is known as a private right of action, or contemporaneous traders.

Question 5

Short-swing Profits

Answer 5

Short-swing profits result from trades or sales of securities held by a company insider for less than 6 months. The Securities Exchange Act of 1934 defines insiders as officers, directors and owners of 10% or more of the outstanding shares of any class of securities. These profits must be paid back to the corporation.

However, the insider remains responsible for taxes owed on the profit. If this happens, this is called a disgorgement, and the insider must provide the profit to the corporation; however, the insider is still required to pay taxes on the profit.