Chapter 6
Market Manipulation and Insider Trading
Richard J. Bergin
Nathan B. Ploener
Timothy P. Hedley
Securities and Exchange Commission (SEC) Chair Mary Jo White said in September 2013 that a “robust enforcement program is critical to fulfilling the SEC’s mission to instill confidence in those who invest in our markets and to make our markets fair and honest.”1 Passed in the wake of the most recent financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) represented the most comprehensive financial regulatory reform since the Great Depression.
The passage of Dodd-Frank ushered in an era of increased regulatory scrutiny, particularly in the financial services sector and on potential market abuses. This has resulted in heavy enforcement activity by a variety of U.S. and foreign agencies including the U.S. Securities and Exchange Commission (SEC), the U.S. Department of Justice (DOJ), the U.S. Commodity Futures Trading Commission (CFTC), and the United Kingdom’s Financial Conduct Authority (FCA). These enforcement efforts have focused on market abuse cases, including market manipulation and insider trading.
Market Manipulation
We define market manipulation as the attempt to interfere with the legitimate forces of supply and demand in a market in order to improperly influence the price or the price-setting mechanism. Successful market manipulation can be costly, as it introduces economic inefficiencies to and undermines the integrity of the market in which the manipulation occurs.
A wide range of markets have been manipulated, from interest rates to commodities to equities to foreign exchange. In fact, market manipulation can touch upon firms in financial services, energy, transportation, metals and mining, and agribusiness, among others. Among these markets, the majority of manipulative instances belong to one of three distinct types of market manipulation: abuse of market power, fraud, and uneconomic trading/bidding.
Abuse of Market Power
In the strictest economic sense, market power refers to the ability of an individual or firm to raise or influence the price of a service, security, commodity, etc., above its marginal cost. In markets that are perfectly competitive, market power does not exist. Every firm takes the price set by the market forces of supply and demand.
By contrast, in markets where imperfect competition is present, a market participant may have market power. If a firm has market power, it is a “price maker” rather than being a “price taker” and is able to shape the price. The extent to which a firm can shape the price determines the extent of its market power. Manipulation of the market involves the exercise of this ability to shape prices. Traditionally, this is achieved through the use of the firm’s high overall market share and/or concentration to create a price movement that is beneficial to the positioning of the trader with market power.2
Because few markets are perfectly competitive, the mere possession of market power may not be illegal. It is the abuse of market power, or the excessive exercise of this market power (as defined by the relevant regulation), that may be illegal.
Certain financial markets may be more prone to the traditional exercise of market power than others. Commodity futures markets, which are standardized contractual agreements to buy or sell a particular commodity, of a particular grade/quality, in a specific quantity, at a designated delivery location, and at a predetermined price in the future, may be at a greater risk of falling prey to the exercise of market power than traditional equity markets are.
This stems, in part, from the fact that, at the time that a particular futures contract expires, the supply of the specific grade of the commodity called for in the futures contract, for delivery at the specified location, is essentially fixed. Contracts (or the physical commodity itself) in other grades, or for other delivery locations or dates in the future, do not meet the specific criteria of the particular futures contract in question and thus cannot satisfy the demands of those individuals who own that contract. As a result, market power for the particular contract in question can be achieved by controlling a sufficient concentration of the futures contracts and/or the underlying physical commodity.
Types of Manipulation Using Market Power. Two common manipulative schemes using market power are a “squeeze” and a “corner.” A squeeze is a situation in which, due to a lack of adequate supply, a futures contract’s open interest, the total number of futures contracts long or short in a delivery month that have been entered into and not yet settled,3 exceeds the supply that can be delivered. A corner refers to a situation in which a trader has established a large position in the physical commodity, as well as ownership of long futures contracts for that commodity. The trader then withholds some of his physical commodity from the market. As a result, the open interest of the futures contract is greater than the deliverable supply of the physical commodity.
In order to cover their positions upon expiration of the contract, traders who have sold futures or who are committed to sell the commodity, and who are thus considered to have a short position (“the shorts,” who benefit from price decreases), must agree to a cash settlement with their counterparties. The counterparties are those who have purchased futures or whose position commits them to buy or take delivery of the commodity, and who thus have a long position (“the longs,” who benefit from price increases).
Alternatively, those traders who are short can purchase the commodity in the spot market, and then physically deliver the commodity to the longs in order to settle their obligation. However, in both a squeeze and a corner, because the longs outnumber the deliverable supply, the longs have market power and can influence the price. As a result, in order to satisfy their obligation to the longs, the shorts are forced to pay a higher price than they otherwise would have, either to settle in cash with the longs or to purchase the underlying physical commodity and then deliver it to the longs.4
Fraud
In the context of market manipulation, fraud refers to the distortion of the legitimate forces of supply and demand, or perception thereof, by disseminating false or misleading information. Fraud often manifests itself in the form of a rumor or report that induces market participants to act a certain way, but which later turns out to be false. However, fraud can take other forms, such as orders or executed trades that are fraudulent in nature. The purpose of such orders or trades is typically to insert false information into the market. For the fraud to be successful, the false information that enters the market must be believed by other market participants long enough for the fraudster to capitalize on the actions of others and adjust his or her positions accordingly.
Types of Manipulation Using Fraud. There are several common types of manipulation that rely upon fraud.5 One of the best known of these manipulative schemes is the false rumor. For example, in the commodity markets, a trader with a sizeable long futures position may spread a rumor that, due to an impending drought that he just learned about, there will be a market shortage of the physical commodity. As a result, prices for futures will subsequently increase, allowing the trader who started the rumor to exit his futures position at an elevated price. False rumors are also found in equity markets and form the basis of both “pump and dump” and “short and distort” schemes.
In typical “pump and dump” schemes, the fraudster purchases the stock of a company, and then proceeds to tout the company’s stock as false and/or misleading statements enter the marketplace. The “pump and dump” initiator’s hope is that by hyping up the stock and the company’s prospects, other investors will be persuaded to buy the stock, allowing the fraudster to liquidate shares at a premium. Conversely, in “short and distort” schemes, the fraudster first short sells the company’s stock, and then spreads negative false or misleading information about the company in the marketplace. Here, the hope is that other investors will be prompted to sell, decreasing the stock’s price and enabling the fraudster to cover the short position at a depressed price.
Another type of manipulation via fraud is the act of “painting the tape” or “painting the screen.” In “painting the tape,” certain market participants attempt to create the illusion of significant trading activity (liquidity) in the market for a particular asset by repeatedly buying and selling the asset among themselves. In so doing, the traders who are “painting the tape” typically aim to generate outside interest in the asset that is being traded. The fraudsters’ hope is that other investors will enter the market for that asset. Once outside investors enter the market, those traders who were “painting the tape” offload their holdings to a third party, often at an inflated price.6
Uneconomic Trading/Bidding
It is typically assumed that individuals act as rational agents and seek to maximize the total satisfaction they receive from consuming a good or service. In the context of financial markets, rational economic agents participating in the financial markets seek to maximize their profits for each transaction in which they participate. By contrast, uneconomic trading or bidding refers to a transaction or bid submission in which the individual fails to act in accordance with the principle of profit maximization. Specifically, this means that the individual either buys or offers to buy at a price that exceeds an asset’s true value, or sells or offers to sell at a price below its true value. As a result, in that transaction or submission, the individual fails to maximize his potential profit (and could actually be losing money).
When this uneconomic trading or bidding is performed in an effort to create an artificial market price, it can be classified as a form of market manipulation. The manipulator may lose money on the individual uneconomic transactions, but ultimately aspires to reap the greatest potential profit by directionally affecting the price in a way that benefits other positions within his portfolio. By seizing upon certain moments when market liquidity is low, a trader may be able to have an outsized impact on the market price by flooding the market with what is then a large number of buys and/or sells relative to the depth and breadth of existing bids and/or offers at that exact moment.
Types of Market Manipulation Using Uneconomic Bidding.7 There are a handful of market manipulation schemes that make use of uneconomic trading or bidding. One of the most common examples is known as “banging the close.” Generally, “banging the close” refers to a trading practice in which a trader buys or sells an asset in large volumes during the closing or price-setting period (the period of time during which the settlement or benchmark reference price is determined) in an attempt to influence the resulting closing or benchmark reference price. “Banging the close” is often performed either to make one’s position in the security where “banging the close” occurs appear more favorable than it otherwise would have, or to benefit an even larger position in another security that is tied to the settlement or closing price of the security where the “banging” occurred.
Manipulation via uneconomic trading can occur at virtually any point throughout the trading day. In situations where uneconomic trading occurs during the day rather than during the closing or price-setting period, the manipulator often aims to induce the market to believe that his trading is motivated by valuable private information. In other words, the manipulator suddenly engages in trades that may appear uneconomic to other market participants, given all public information and other market participants’ private information at that time. However, the manipulator hopes to signal to the market that he possesses valuable private information that will affect the legitimate forces of supply and demand, and that renders his trading rational.
Therefore, the manipulator’s aim is to generate a cascade effect. The hope is that other market participants see the manipulator’s trades, become convinced that he knows something valuable that they do not, and subsequently initiate their own trades in the same direction. The typical manipulator hopes that this cascade effect lasts long enough, and carries the price far enough in the desired direction, that he is able to, before a price reversal, either successfully close his position in the manipulated security at an advantageous price or successfully use the price action to take offsetting positions in a related security at an artificially advantageous price.
In addition, market manipulation via uneconomic trading or bidding can also occur in markets where there may be only a handful of market participants, or where the market lacks a centralized exchange and consists of primarily private, bilateral transactions. In such instances, the lack of many market participants or a centralized exchange may render price discovery more difficult, as there may be no generally accepted market price at all points in time. In such markets, in order to ease price discovery, an index may be used as a proxy for the benchmark market price. In these cases, uneconomic trading or bidding behavior can be used to influence the price of the index and therefore manipulate the market price. Such instances may be referred to as “index-based manipulation.”
For example, in a market where the reference price is determined via index, and where the index is calculated as the average price of all executed trades by a predetermined group of traders over a certain period of time, one trader in the group may conduct a handful of sales at prices below the asset’s value. As a result, the final calculated index price is lower than it would have been had the trader executed only profit-maximizing sales. This, in turn, potentially enables the trader to subsequently purchase an even larger volume of the asset at prices tied to the index price, which is thus cheaper than it would have been otherwise.
A recent example of market manipulation accomplished (at least in part) by uneconomic bidding through the manipulation of an index, according to settlements with the CFTC, was the attempted manipulation of the London Interbank Offered Rate (LIBOR).8 LIBOR is an interest rate used as a benchmark for unsecured loans made between banks in the London interbank market and serves as a key benchmark for many interest rates around the world and is used as reference rate for both debt products (e.g., corporate bonds, college loans, and credit cards) and financial instruments (e.g., currency swaps and interest rate swaps). As of May 2015, more than $2.6 billion of penalties had been imposed for manipulative conduct related to LIBOR and other interest rate benchmark abuses by the CFTC alone.9
Regulatory Landscape
Since the financial recession of 2008–09, lawmakers and regulators have focused on ensuring the integrity of the financial markets, such as the alleged manipulation of the foreign exchange market, where average currency trading activity exceeds $5 trillion a day.10 According to Bloomberg, the U.K.’s FCA was the first regulatory agency to reveal that it was looking into allegations that foreign exchange dealers timed certain trades in an effort to influence prices and shared information with dealers at other banks.11 Since then, authorities on three continents have initiated their own investigations into allegations of market manipulation, collusion, and other forms of misbehavior in the foreign exchange market. As of mid-May 2015, more than 20 separate probes had been initiated and $9.9 billion in fines assessed in connection with the alleged manipulation in the foreign exchange market.12
Market manipulation is a complex area; not only does it involve a multiplicity of government regulators around the world, but it is also potentially governed by a wide range of laws and regulations within each geographical jurisdiction. For example, market manipulation actions in the United States can be initiated by several regulatory agencies, including the DOJ, SEC, CFTC, and Federal Energy Regulatory Commission (FERC). The involvement of a particular agency depends not only on the market in question, but also on the manipulative schemes allegedly employed.
The DOJ may become involved in cases of alleged market manipulation where antitrust concerns have been raised regarding the potential violation of laws governing the organization, behavior, and actions of businesses aimed at promoting fair competition to the benefit of consumers. In particular, the DOJ may become involved in instances where collusion (an agreement, usually secretive in nature, made between firms or individuals to limit or prevent open competition via deceptive or fraudulent means in order to gain a market advantage), a cartel (a group of firms or individuals that explicitly agree to coordinate their activities in a market), and/or the abuse of market power are alleged to have been used to manipulate the market.
The SEC, by contrast, tends to use a broad, fraud-based rule to deal with manipulation in connection with the purchase or sale of securities—chiefly, any note, stock, bond, or debenture.13 The SEC has typically brought actions related to alleged manipulation under Rule 10b-514 even though it is a general antifraud rule rather than a rule intended to curb manipulation.15 Rule 10b5 maintains that it is illegal for any person, directly or indirectly, in connection with the purchase or sale of any security to (1) employ any device, scheme, or artifice to defraud; (2) make any false statements of material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances in which they were made, not misleading; or (3) engage in any act that would operate as a fraud or deceit upon any person.16
The anti-manipulation rules of FERC, FTC, and CFTC are all based on this antifraud provision of the SEC. As a result, their language is similar to that of the above. However, it is important to note that the areas to which each of these antifraud rules applies are distinct. For example, the FERC’s anti-manipulation rule is specific to the energy markets.17 The FTC’s market manipulation rule applies “in connection with the purchase or sale of crude oil, gasoline, or petroleum distillates at wholesale.”18 The CFTC’s focus, by contrast, is on conduct in connection with the purchase, sale, or termination of any swap (an agreement between two parties to exchange a series of future cash flows) or contract of sale of any commodity in interstate commerce, or for future delivery.19, 20
Given the litany of market manipulation rules administered by several distinct regulatory agencies, fines stemming from manipulative activities have been substantial and increasing. As illustrated in Figure 6.1, fines for market manipulation in the United States have increased from $163 million in 2009 to $2.8 billion in 2015.21
Figure 6.1. U.S. Market Manipulation Penalties, 2009–2015
Source: Author; compiled using data available in press releases issued by four government entities: CFTC, OCC, SEC, and FERC and available on their websites
One agency that has been especially active in the area of market manipulation has been the CFTC, whose enforcement capabilities changed with regard to market manipulation following the passage of the Dodd-Frank Act. Historically, there has been little written, explicit evidence of manipulative intent in matters alleging market manipulation. As a result, the CFTC has had to rely almost exclusively on trading or market data to draw an inference of manipulative intent. Additionally, demonstrating that prices were affected by a factor inconsistent with the legitimate forces of supply and demand can be a complex task requiring economic and statistical analyses. As a result, the CFTC faced a difficult task proving cases of market manipulation and so had limited success prosecuting perfected market manipulation cases prior to the passage of Dodd-Frank.
As a result of the Dodd-Frank amendments to the Commodity Exchange Act (CEA), which became effective in August 2011, the CFTC has more powerful enforcement tools. This, coupled with the CFTC’s increased focus on manipulative actions, has caused a substantial growth in the number of enforcement actions and monetary penalties assessed by the CFTC in market manipulation cases.
Among the changes ushered in by Dodd-Frank that grant the CFTC new and enhanced enforcement tools, the CEA now has an antifraud provision as well as an updated artificial price provision; these changes are codified in Regulations 180.1 and 180.2. Rule 180.1, the antifraud provision, prohibits “the employment, or attempted employment, of manipulative and deceptive practices,” making it unlawful for any registered entity to intentionally or recklessly:22 (1) use manipulative devices or schemes to defraud; (2) make misleading or false statements and material omissions; (3) employ practices that operate or would operate as a fraud; and (4) deliver any misleading or inaccurate reports concerning conditions that tend to affect the price of any commodity.23 As such, it is important to note that violation of Rule 180.1 does not require proof of an artificial price, nor does it require proof of actual knowledge; it merely requires that an entity is shown to have intentionally or recklessly engaged in, or attempted to engage in, the fraudulent behavior.
At the same time, Rule 180.2, the CEA’s updated artificial price provision, states that it is unlawful for a person “directly or indirectly, to manipulate or attempt to manipulate the price” of any swap, commodity, or futures contract.24 In contrast to Rule 180.1, Rule 180.2 does require a specific showing of intent; mere recklessness does not suffice. Rule 180.2 extends its application to include swaps (in addition to commodities and futures contracts) and to include direct, indirect, attempted, or actual manipulation.
In order to prove actual manipulation by applying Rule 180.2, the CFTC may bring charges of attempted manipulation. In such cases, the CFTC is required to show that (1) there was intent to affect the market price; and (2) there was some overt act in furtherance of that intent.
Dodd-Frank also amended section 4c(a) of the CEA, which addresses “Prohibited Transactions,” by adding a new section (section 5) titled “Disruptive Practices.” New CEA section 4c(a)(5) prohibits any person from engaging in any trading, practice, or conduct, subject to the rules of a registered entity, that (1) violates bids or offers; (2) demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period; or (3) constitutes “spoofing,”25 the practice of bidding or offering with the intent to cancel the bid or offer before execution.
Violating bids (offers) refers to the practice of buying a contract on a registered entity that is higher than the lowest available offer price (or selling a contract on a registered entity at a price that is lower than the highest available bid price). Regarding CEA section 4c(a)(5)(B), the CFTC interprets this prohibition as applying to any trading, conduct, or practice during the closing period, as well as any trading outside of the closing period that would disrupt orderly transactional execution during the closing period.26
Compliance Program Controls
The increased enforcement powers of the CFTC, coupled with its intent to aggressively pursue investigations, has increased the need for businesses that engage in trading to reevaluate the compliance training of all employees; this is particularly relevant for a firm’s traders, compliance personnel, executives, and risk managers. At the same time, it has also increased the need for such firms to augment internal monitoring of their traders’ communications, trading strategies, and trading behavior. Both the level of economic risk (due to increasing fines and penalties imposed around the globe) and the accompanying reputational risk require a compliance culture capable of reducing the risk of regulatory violations.
Preventative Controls The primary tools for prevention in the area of market manipulation are education and compliance training, particularly for a firm’s traders, compliance personnel, executives, and risk managers. Education and compliance training should focus on the applicable laws and regulations so that the traders are made aware of dos and don’ts and what trading activity is likely to draw regulatory attention. The training should be broad enough in scope to cover the various markets and regulations applicable across all relevant jurisdictions. Training should also focus on communications, both internal and external. Adequate supervision of trading strategy and traders is also critical. Finally, a reasonable value-at-risk (the potential loss in value, over a defined period of time, for a given portfolio and statistical confidence interval) limit, consistent with the business needs of an enterprise, can help reduce and prevent a business from attracting regulatory scrutiny.
Detective Controls
Trader Surveillance. As part of a robust compliance program, it is important to monitor traders’ communications. The lessons of the benchmark manipulation cases illustrate how revealing chats, instant messages, and e-mails can be used as key evidence in the investigations. Internal monitoring of such communications enables a firm to stay on top of any potential regulatory violations by catching questionable discussions or practices before they are scrutinized by regulatory agencies and the financial media. As part of an automated monitoring system, a glossary of key search terms can be developed, and regular searches of traders’ communications can be performed continuously on an automated platform.
In addition to communications monitoring, it is important to monitor trading activity closely. This too can be done on an automated basis, and it ideally should include all positions (both on- and off-exchange) to ensure that the enterprise is within all applicable position limits; a comparison of a trader’s activity to what has previously been defined as his “normal” or baseline trading behavior and patterns; an analysis of anomalous price movements in any relevant financial markets; and an inquiry as to what the intended purpose was of the observed trading. It may therefore be necessary for compliance personnel to periodically hold discussions with the firm’s traders about their trading strategies. A review of trading authority (i.e., what transactional actions can be performed, by whom, and under what parameters) can also be a useful way to keep tighter control over the amount of risk that traders can maintain in their respective books.
Examples of Detection Methods. Although we will discuss several potential methods for detecting the main types of market manipulation, it is crucial to recognize that there is no single statistical test or indicator that can be used to detect all possible forms of market manipulation. This is due to the fact that the detection of market manipulation often relies upon the use of statistical tests that are designed to identify behaviors in markets that are anomalous or are potentially indicative of manipulation. Since no two markets are alike, a test may detect a type of manipulation in one market but not in others. Thus, any screen for manipulation should be carefully tailored to the specific market (and, if applicable, to the particular manipulative method) by well-qualified individuals to ensure its robustness and utility.
Signs of Market Manipulation via Exercise of Market Power. There are several market phenomena that may indicate market manipulation via the exercise of market power. Specifically, abnormally high market concentration or market share may suggest attempts to manipulate a market. Also, if one has access to trading data of the purportedly manipulating party, a strong correlation between the manipulator’s trading activity and subsequent market price movements could indicate market power. If every time the alleged manipulator purchased a security, the security then quickly increased in price, it might be due to the alleged manipulator’s buying activity caused the price increase. This would indicate that the alleged manipulator likely possessed market power, which could then be abused.
In addition, the existence of anomalous prices that cannot be explained by underlying fundamental factors could be caused by market manipulation. For instance, if the price of a commodity futures contract cannot feasibly be reconciled with the cost to purchase the commodity in the spot market, store it, and then ship it for delivery upon expiration of the futures contract, this decoupling of the spot and future markets could point to a manipulated market.
Signs of Market Manipulation via Fraud. Several items may point to the existence of market manipulation via fraud in certain forms. For instance, a sudden and marked uptick in press releases, Twitter traffic, and/or Internet forum posts pertaining to a stock with a small capitalization, coupled with an initial increase of the stock’s price on low buying volume, may be indicative of an effort to “pump” up the stock’s price. In equity markets, such stocks are generally more susceptible to “pump and dump” schemes, as there is usually a dearth of reliable information about them.
Additionally, the thinly traded nature of many microcap stocks makes it easier to disrupt the normal forces of supply and demand. In circumstances where “painting the tape” is alleged to have occurred, trading data can be instrumental in determining whether this is the case. For bilateral transactions conducted over the counter (rather than on an exchange), a pattern of repeated buys and sells, for the same asset and with the same counterparty or group of counterparties, could indicate an attempt to “paint the tape.”
Signs of Market Manipulation Using Uneconomic Bidding. There are several clues that may point to the existence of market manipulation via uneconomic trading or bidding. Possibly the most telling sign of attempted manipulation via uneconomic trading can be a litany of trades that appear to be losing money or that are not profit maximizing on an individual basis. Another indication of potential manipulation using uneconomic trading is a pattern of a noticeable surge in trading, by the same particular party, during the closing period or at times when the market is known to be relatively illiquid. A pattern of such behavior may be indicative of a concerted effort by the party to influence the closing reference price by “banging the close,” or an attempt to temporarily overwhelm the legitimate forces of supply and demand at times when the structure of bids and asks is likely to be most vulnerable to such behavior.
Responsive Controls If potential market manipulation is identified, there should be an internal investigation, preferably under the advice of counsel. All documents, trading records, and electronic records must be identified and preserved. A company should consider whether to self-report, depending on the outcome of the internal investigation. If the internal investigation indicates likely violative conduct, the company must evaluate how to mitigate. Should it suspend or terminate the responsible employees? Were red flags missed by supervisors or other personnel? Do there need to be stronger controls and monitoring? Dealing with these issues before the regulatory inquiry will likely mitigate regulatory and financial risk arising from manipulative conduct.
Summary and Future Trends
It is clear that market manipulation is an increasingly important area of focus for regulators. In recent years, billions of dollars of fines have been assessed in connection with market manipulation, predominantly touching upon the financial services, energy, and agribusiness. To further complicate matters, instances of alleged market manipulation may be targeted by several regulatory agencies, depending on the market in which the alleged manipulation took place and the alleged schemes employed to execute the manipulation. Given the substantial fines and myriad regulatory investigations that can befall a firm for engaging in manipulative behavior, legal counsel, executives, and managers should familiarize themselves with the three main types of market manipulation—market power, fraud, and uneconomic trading/bidding—as well as potential methods for preventing, detecting, and responding to alleged instances of manipulation.
It seems likely that there will be an increased number of examinations of potential instances of market manipulation, and, in turn, increased fines and regulatory oversight. Given the recent revelations of the LIBOR and foreign exchange investigations, renewed attention is being paid to benchmarks used in financial markets around the world.
Another important trend is regulators’ focus on traders’ discussion of their strategies and trades in chat rooms, instant messages, and e-mails as evidence of their purportedly manipulative intent. In three recent market manipulation cases—LIBOR, foreign exchange, and Athena Capital—these forms of written electronic communication were relied upon extensively by regulators. In the regulatory agencies’ settlements with the perpetrators, these forms of communication were excerpted and cited frequently, making it much easier for regulators to presume that the perpetrators were indeed acting with manipulative intent. This trend is likely to continue.
Insider Trading
The SEC defines illegal insider trading as “buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include ‘tipping’ such information, securities trading by the person ‘tipped,’ and securities trading by those who misappropriate such information.”27 There is also a legal form of insider trading, which takes place when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. Such trades must be reported to the SEC.
U.S. insider trading law is not proscribed by a specific “insider trading” statute or rule.28 Rather, the parameters of illegal insider trading have largely been based on court interpretations of the antifraud provisions of Securities Exchange Act Section 10(b) and Exchange Act Rule 10b-5. These provisions prohibit “manipulative or deceptive devices” in connection with securities transactions; insider trading is simply one manifestation of this deception.29
Illegal insider trading while in possession of material nonpublic information means that the individual was aware, at the time of his transaction in the security, of the information in question.30 The trader does not necessarily have to use or rely on the nonpublic material information as the impetus for buying or selling; rather, the individual merely has to trade while having such information.
Material information is information that a reasonable investor would consider important in making an investment or trading decision.31 It should be pointed out that the material information in question does not necessarily have to be the most important piece of information at the time; examples of information that has been considered “material” in prior insider trading cases include news regarding mergers or acquisitions, changes in company leadership, quarterly/annual earnings, and accounting restatements.
“Nonpublic information” refers to information that is not available to the general public. Generally, information is considered to be in the public domain if it has been disseminated via company press releases, publicly filed financial statements, financial publications, research reports, or by other means. An example of nonpublic information is information received under a confidentiality agreement or nondisclosure agreement.
Types of Insider Trading
While numerous insider trading cases have been filed that cover a variety of situations, there are generally considered to be two main types of insider trading—“classical” and “misappropriation.” Under the classical type of insider trading, corporate insiders (such as a company’s officers, directors, or employees) are prohibited from trading on material nonpublic information. This trading restriction on corporate insiders stems from their fiduciary duty to the security’s issuer (i.e., the corporation) and its shareholders to use company information (including material, nonpublic information) solely for the company’s benefit.
Note that in addition to these corporate insiders, there are individuals known as “constructive insiders,” “temporary insiders,” or “quasi-insiders” to which the prohibition on insider trading also extends. Temporary insiders are individuals such as external auditors, investment bankers, outside legal counsel, brokers, and other personnel external to a firm who, while providing services to the firm, receive confidential corporate information that may be material. These individuals, by the nature of their work, acquire the fiduciary duties of the traditional insider, provided the corporation expects these temporary insiders to keep the information confidential.32
As a result, both corporate insiders and temporary insiders are subject to what is known as the “disclose or abstain” doctrine. The “disclose or abstain” doctrine holds that corporate and temporary insiders in possession of material nonpublic information must either publicly disclose the information prior to trading or else abstain from trading altogether until the information is made public.
The misappropriation type of insider trading pertains to certain parties that would not fall under the classical definition. Specifically, it posits that an individual is prohibited from trading when he misappropriates confidential information in a breach of a duty of trust or confidence owed to the source of the information.33 In this case, misappropriation insider trading does not require a corporate insider to breach his fiduciary duty. Instead, the misappropriation theory is applicable in circumstances where a mutual expectation of trust and confidence exists between the source of the information and the alleged wrongdoer.34 In the case of U.S. v. O’Hagan, “a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information.”35
A well-known example of misappropriation insider trading is the 1986 criminal insider trading case U.S. v. Winans, et al. R. Foster Winans was a reporter at the Wall Street Journal who contributed to a column called “Heard on the Street.” He was charged with operating a scheme in which he would trade stocks that were the subject of upcoming Wall Street Journal articles in a way that was likely to affect the prices of the stocks in which he traded.36 The district court held that while Mr. Winans did not owe a duty to the shareholders of the companies in whose stock he had traded, he did owe a duty to his employer, the Wall Street Journal. Since Mr. Winans took confidential information about the timing and content of articles from his employer, the court ruled that the trading was a fraud on his employer.37
Thus, in either classical or misappropriation insider trading, it may be considered illegal if a person trades a security while in possession of material nonpublic information that was inappropriately obtained. A person may also be found culpable of insider trading if, rather than trading on his own behalf, that person shares the information with another individual, who then uses that information to transact in the relevant company’s securities. In such a scenario, known as “tipping,” the individual who shares the material nonpublic information is referred to as the “tipper,” and the individual who receives and trades on the information is known as the “tippee.” In this situation, both the tipper and the tippee can be held liable for insider trading.38
Recent Enforcement Trends
As Figure 6.2 shows, insider trading prosecutions continue to be a major emphasis for the SEC and its Enforcement Division. The SEC brought 87 insider trading enforcement actions in fiscal year 2015; this represents a marked uptick compared to prior years, where the SEC brought roughly 50 separate cases every year, as shown in Figure 6.2.
Figure 6.2. Insider Trading Cases 2009–2015
Source: Author; compiled using data available from the SEC’s website
The SEC’s vigor in pursuing insider trading cases has been closely matched by that of the DOJ, and particularly by the Southern District of New York (SDNY). From October 2009 through July 2015, the SDNY charged 56 individuals with insider trading, securing 51 convictions.39 These insider trading actions initiated by the SDNY have charged a variety of individuals, including those employed at hedge funds, consulting companies, law firms, government agencies, technology firms, and pharmaceutical companies, among others.
As noted earlier, much of the existing insider trading law in the United States stems from the evolution of case law, based on Section 10(b) of the Securities Exchange Act of 1934, and for tender offers under Section 14(e)40 of the Securities Exchange Act of 1934. Criminal insider trading actions, by contrast, are initiated by the DOJ, but are also predominantly brought under Sections 10(b) and 14(e) of the Securities Exchange Act of 1934.
Section 10(b) of the Securities Exchange Act of 1934 is an antifraud provision, stating that it is unlawful for any person “to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.”41
Rule 10b-5, which was advanced by the SEC in 1942 in order to implement Section 10(b), states that it is unlawful for any person to: “(a) employ any device, scheme, or artifice to defraud; or (b) make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or (c) 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 a security.”42
While Section 10(b) and Rule 10b-5 do not directly and explicitly prohibit insider trading, the antifraud provisions have been interpreted to address a broad range of fraudulent behaviors, including insider trading. In 2000, the SEC promulgated Rules 10b5-1 and 10b5-2 to provide clarity on certain issues pertaining to illegal insider trading. Rule 10b5-1 addressed the issue of whether a trader had to trade on the basis of the material nonpublic information—i.e., use the information, to be liable for insider trading, or only had to be in possession of such information.43 Rule 10b5-2 was designed to provide clarity on misappropriation insider trading and prescribes when personal and other nonbusiness relationships may create “duties of trust or confidence.”44, 45
Government Investigations of Insider Trading
The SEC’s investigation teams across the country have the ability to open and conduct investigations, which are typically staffed by one or two attorneys, along with trade surveillance specialists and possibly accountants. The SEC’s Market Abuse Unit drives the Division’s innovations, identifying insider trading schemes and investigating insider trading rings and expert networks using data analytics and other tools. Potential red flags include unusual price spikes before major corporate announcements such as mergers and acquisitions, price rises before earnings releases, unusually large trades, use of margin accounts, and options trading in accounts that have not historically traded them.
It is rare that insider trading targets admit wrongdoing to prosecutors. As a result, many cases are largely based on circumstantial evidence showing that the persons had access to and possession of the information in light of their employment and nature of their job, had communications at relevant times with others possessing material nonpublic information, and then traded and/or tipped at opportune times. In criminal investigations, prosecutors use additional tools, including undercover agents, wiretaps, search warrants, and flipping witnesses in an effort to make their cases. Communication between civil and criminal prosecutors should be expected, as they commonly work together.
Responding to an SEC or DOJ Insider Trading Investigation
The response to any government investigation involving insider trading depends on the facts and circumstances of the case, as well as where persons or entities fit within any alleged scheme. For public companies and regulated entities, cooperation and provision of relevant trading data may be the best course of action; however, such an approach has to be determined and coordinated through counsel. In the M&A context, for example, investigators need to establish a timeline of events to understand which persons (from the acquirer, target, or legal or consulting firm advising on such transactions or otherwise) knew about the transaction, when they knew, and the communications such persons had with colleagues, friends, and family. Prosecutors routinely request that companies provide “chronologies” so that they can piece together the timeline and understand the facts.
The government will also likely want access to corporate communications including e-mail, voice mail, and any recorded conversations (broker-dealers). Providing quick access to such data, including searching various locations, backups, and possibly translating or transcribing conversations, are among the things that prosecutors may request.
Illegal insider trading can affect many types of companies and can have significant consequences for employees and corporations alike. For individuals, consequences include termination of employment, exclusion from the industry, reputational damage, hefty fines, and even jail time. For companies, accusations of insider trading can be highly damaging, even if ultimately shown to be untrue. Consequences include severe reputational harm, impaired ability to seek out new deals, an outflow of assets, substantial fines, and debilitated ability to conduct business moving forward. As a result, it is of vital importance that firms have programs in place to prevent insider trading, the ability to detect its potential occurrence, and the capability to respond swiftly and appropriately should insider trading transpire.
Prevention, Detection, and Response
From a company’s perspective, deterring insider trading through a variety of measures is likely to be the most desirable approach, as it may prevent allegations of improper trading in the first place. However, an effective compliance program may also need to include monitoring and detection capabilities so that anomalies can be followed up and allegations can be investigated.
In November 1988, Congress passed the Insider Trading and Securities Fraud Enforcement Act (ITSFEA), which amended the securities laws by requiring financial services firms and investment advisers to create and enforce written policies aimed at the prevention of insider trading. Section 15(f) of the Exchange Act requires broker-dealers to establish, maintain, and enforce policies and procedures designed to prevent the misuse of material nonpublic information.46 Section 204A of the Advisers Act states that every investment advisor shall establish, maintain, and enforce policies and procedures devised to prevent the misuse of material nonpublic information.47 Based upon these provisions, brokerage firms and investment advisers have an obligation to prevent, deter, and detect insider trading. In fact, the SEC has previously initiated actions against firms for failure to establish and maintain policies aimed at preventing insider trading, even in instances where no insider trading may have actually occurred. As such, there is both an expectation and a requirement that financial services firms have robust policies and controls in place to curtail such behavior.
Preventative Controls Insider trading may harm a variety of companies, but there is no single prevention program or set of procedures that works across all corporations in every instance. Rather, it is important that the policies and procedures are specifically tailored to the industry and operations of the firm. We will briefly touch upon insider trading compliance measures for three main groups of firms: publicly traded companies, financial services firms, and companies acting as temporary insiders.
Publicly Traded Companies. For those who work at a publicly traded company, education and training regarding the obligations of corporate insiders are paramount in order to avoid violating securities laws. It is critical that all employees (especially officers, directors, and others in possession of sensitive corporate information) have a strong understanding of the relevant regulations regarding their knowledge and handling of material nonpublic information, as well as their trading activities.
To supplement this, publicly traded companies should have their own explicit policies that prohibit insider trading and tipping; these policies should be often updated and circulated so as to keep employees abreast of their relevant responsibilities. Also, it is key that publicly traded companies try (to the greatest extent possible) to keep confidential, nonpublic information secure and on a need-to-know basis. In this way, there is decreased risk that someone who might be tempted to misuse the information ever comes into contact with it; doing so also narrows the pool of potential suspects should the company later discover that insider trading on the information did in fact occur.
Further, the adoption of “quiet periods” or “blackout” periods—periods when transactions in the company’s stock are prohibited (such as before the end of a fiscal period but prior to public release of financial results)—may be useful to prevent insider trading. It may also be beneficial to have company officers and directors adopt Rule 10b5-1 plans. These plans, which allow publicly traded companies’ insiders to transact in a predetermined number of shares at a predetermined time, can provide an affirmative defense to insider trading charges under Rule 10b5-1(c).48 Potential risk areas for publicly traded companies include nonpublic information regarding potential M&A transactions, share repurchase plans, quarterly or annual financial results, any major new product developments, and key personnel departures.
Financial Services Companies. In light of the obligations of registered broker-dealers and investment advisors to establish, maintain, and enforce policies and procedures devised to prevent the misuse of material nonpublic information, there other policies and programs these firms can implement to hinder insider training. For example, broker-dealers and investment advisors can hold periodic, mandatory trainings related to all pertinent insider trading regulations; in this way, employees can be taught and reminded about what is and is not permissible. Also, the offering of multiple services by a single firm (such as an investment bank) can precipitate potential conflicts of interest and therefore necessitate strict control over confidential information. In such firms, the establishment of informational barriers between those groups that have access to material nonpublic information and those groups that engage in trading is essential.
Financial services firms should also develop and maintain an updated watch list (a list of companies for which the firm has, or is likely to soon be in the possession of, nonpublic inside information as a result of some relationship) and a restricted list (a list of companies whose securities the firm and its personnel are typically prohibited from trading in as a result of the firm’s access to material nonpublic information for the companies in question). Select members of the legal and/or compliance department should closely monitor any transactions in the securities of entities on these lists to ensure that employees are adhering to company policy and not transacting in the securities, on behalf of the company or otherwise, for which the firm possesses material nonpublic information.
Further, broker-dealers and investment advisors should require all employees, if they have personal trading accounts, to either maintain such accounts with the firm only or submit all transaction confirmations to the firm’s compliance department for review. In this way, the firm can monitor all personal trading activity and raise questions if necessary. Finally, these firms should consider a system for continually reviewing all outgoing and incoming electronic communications, looking specifically for the transmission of any confidential or inside information. Notable risk areas for financial services firms include when research analysts change buy/sell/hold recommendations; when new macroeconomic research pieces are issued; and when firm personnel get advance notice of pending client trade orders.
Temporary Insiders. For firms with employees acting as temporary insiders due to the nature of their work, such as external auditors, it is important that such individuals understand the fiduciary duty that is created via their access to privileged, nonpublic information. As such, these firms should maintain written policies prohibiting insider trading and tipping, and ensure that all employees are clear on exactly what is and is not allowable. To this end, periodic training on insider trading issues and the handling of sensitive information can be very instructive. In addition, firms acting as temporary insiders should maintain a restricted list of companies that employees are expressly barred from transacting in until the firm no longer possesses any material nonpublic information. Also, these firms should periodically have all employees certify that they have not transacted in the securities of any restricted entities; here, annual questionnaires inquiring into the trading activities of employees, as well as intermittent audits of financial assets and brokerage accounts, may prove helpful.
For firms acting as temporary insiders, it is crucial that all privileged and confidential information is treated with the utmost care. Only those employees directly working on the relevant project, and who absolutely need to have access, should come into contact with material nonpublic information. This information, if in physical form, should be secured at the end of each day so that nonessential personnel cannot access, review, or otherwise see the information. If in electronic form, the information should be stored on a secure, encrypted device or in a protected server environment so that it is accessible only to authorized personnel. Potential risk areas for temporary insiders can include information related to an internal investigation concerning wrongdoing by company personnel, discovery of material accounting errors or misstatements, and analyses concerning potential damages amounts for those embroiled in litigation.
Detective Controls While a set of robust policies and procedures can go a long way toward the prevention of insider trading, it is also necessary to have systems and programs in place to detect insider trading, should it occur. As mentioned above, one way of potentially detecting insider trading in real time is the implementation of an automated trade surveillance system. At the level of the company, an automated trade surveillance system would automatically monitor all trading activity, using a bevy of screens and flags to highlight seemingly anomalous trading behavior potentially consistent with insider trading. Parameters around which potential flags could be crafted include the size of a particular trade; the frequency of transactions; the length of time positions are held; the time at which orders are submitted; the profitability of a trade; the industry sector in which a transaction is initiated; the type of financial instrument bought or sold; and a variety of other criteria.
In doing so, it is important to develop a baseline trading pattern or decision rule(s) against which the transactions of traders and portfolio managers will be evaluated. After this baseline or threshold has been established, each subsequent transaction can be compared to the appropriate point of reference. It is important to keep in mind, however, that the calibration of this baseline scenario or decision rule(s) will have a significant impact on which trades are ultimately flagged as potentially anomalous. Miscalibration of the relevant screens and screening specifications can result in flags that produce a large number of false positives, or conversely, that fail to catch truly problematic behavior.
Another way of potentially detecting insider trading is an automated review of electronic communications at the firm. This review would include all available communications, with a likely emphasis on communications between disparate groups within the company that would have no reason to share information; communications between firm personnel and third parties; and communications between investor relations, executives, directors, and all other parties. While such an automated review would clearly not catch all possible attempts to share material nonpublic information, it would focus on key words and phrases. Further, this review could provide additional scrutiny during sensitive periods, such as during any quiet periods or immediately after the close of a quarter or fiscal year.
Responsive Controls The response to any government investigation involving insider trading depends on the facts and circumstances of the case, as well as where persons or entities fit within any alleged scheme. For public companies and regulated entities, cooperation with the authorities and the provision to them of relevant trading data may be the best course of action; however, such an approach has to be determined and coordinated through counsel.
In the M&A context, investigators need to establish a timeline of events to understand which persons (from the acquirer, target, or legal or consulting firm advising on such transactions or otherwise) knew about the transaction, when they knew, and the communications such persons had with colleagues, friends, and family. Prosecutors routinely request that companies provide “chronologies” so that they can piece together the timeline and understand the facts. The government will also likely want to have access to corporate communications including e-mail, voice mail, and any recorded conversations that may be relevant.
Should potential illegal insider trading or tipping have occurred at a firm, the best path forward is a rapid response. Investigation scope and strategy will depend on the facts and circumstances; to this end, the firm should conduct an investigation aimed at determining the exact extent of any illicit activity. Such an investigation can be performed internally, although an inquiry assisted by, or conducted independently by, an outside third party may prove more beneficial.
The initial thrust of an insider trading investigation should determine whether the issue was an isolated incident or a symptom of a larger, systematic deficiency; in the former case, individual punishment may be appropriate, while in the latter case, there may be the need for more drastic reforms on a group-level or firm-wide basis.49 As part of this investigation, a forensic review of files, including communications, trading confirmations, and other relevant records, should likely be performed by lawyers or external consultants. Such a review allows for an accurate re-creation and piecing together of information that existed at the time of the trading, providing greater insight into the situation. A company should also consider whether to self-report to regulatory agencies, depending on the outcome of internal investigation.
During the investigation, or in the event that insider trading allegations for an entity or an individual proceed all the way to trial, it may be necessary to retain a statistician, economist, or financial expert to study the instance(s) of alleged insider trading. In particular, these individuals can study the informational releases in question, assessing both the materiality and magnitude of the information at issue. These professionals may also assess whether the purported insider information was truly nonpublic at the time, as well as gauge whether there was other, material public information that may have motivated the observed trading behavior.
Conclusion
It is clear that insider trading will continue to be an important area of focus for regulatory agencies. The SEC’s increasing reliance upon administrative proceedings for insider trading matters is something that bears watching. In 2014, of the 77 civil insider trading penalties that were imposed by the SEC, 13 were imposed via administrative proceedings, or nearly 17%; this represents an increase from the 14% seen in 2013.50 Administrative proceedings offer the SEC several advantages over federal district courts, including a streamlined discovery process and the ability to introduce hearsay evidence.51
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Howard A. Scheck was a major contributor to the content of this chapter. Mr. Scheck is a partner in KPMG’s Forensic practice in Washington, DC. He specializes in assisting counsel in conducting accounting-related investigations and in defending companies and individuals involved in SEC enforcement inquiries.
Sean P. Macdonald and Gurhan Uslubas were major contributors to the content of this chapter. Mr. Uslubas, based in New York City, and Mr. Macdonald, based in Boston, are both senior associates in KPMG’s Forensic practice specializing in dispute advisory services.