Insider Trading: How It Works, How the SEC Catches It, and What Happens When It Does

In 1986, the SEC brought its first major insider trading case against Ivan Boesky, who had built a fortune trading on information provided by investment banker Dennis Levine. Boesky paid $100 million in disgorgement and received a $100 million civil penalty, a record at the time, and served two years in federal prison. His cooperation led to the unraveling of a network of Wall Street traders that resulted in the largest insider trading investigation in history up to that point.

What made the Boesky case significant wasn’t just the scale. It was what it revealed about how insider trading networks actually function. Not as solo acts of individual greed, but as interconnected systems of information exchange where traders, analysts, investment bankers, lawyers, and even administrative staff all play roles.

That network structure hasn’t changed much. The technology and the surveillance methods have. The underlying human dynamics, the tipper-tippee relationship, the flow of material information through social networks, the rationalizations people use to tell themselves it isn’t really illegal, are as recognizable today as they were four decades ago.

The Legal Definition: MNPI

The phrase “insider trading” isn’t defined in any statute with the precision you might expect. The prohibition on it is derived from Rule 10b-5 under the Securities Exchange Act of 1934, which makes it unlawful to use “any device, scheme, or artifice to defraud” in connection with the purchase or sale of securities.

Courts and the SEC have developed this into a prohibition on trading based on “material, non-public information” (MNPI).

Material: Information is material if there’s a substantial likelihood that a reasonable investor would consider it important in deciding whether to buy or sell. Unannounced mergers are the clearest case. Earnings that will beat or miss expectations significantly are material. Clinical trial results for a drug company are material. Management changes can be material. Regulatory decisions are often material.

The test is objective, whether a reasonable investor would want to know, not subjective (whether you thought it was important when you traded).

Non-public: Information is non-public if it hasn’t been broadly disclosed to the market through channels like a press release, SEC filing, or earnings call. Information that was shared with one analyst in a private meeting is still non-public even if it wasn’t labeled “confidential.”

The combination of these two elements is what makes trading illegal. Trading on your hunch about a company, on publicly available analysis, or on information you developed through legitimate research isn’t insider trading, even if your analysis turns out to be right.

The Three Main Case Types

Classical Theory: The Corporate Insider

The original case for insider trading prohibition: a corporate insider, director, officer, employee, trades on information they possess by virtue of their position in the company. They’re trading against people who don’t have that information, and they’re breaching a fiduciary duty to shareholders by using company information for personal gain.

This is the most straightforward category. Corporate executives who sell stock before bad news is announced, employees who buy options before a merger they helped negotiate, lawyers who trade on deal information they learned while representing the acquirer.

Neil Dolinsky and Brian Fettner both faced SEC enforcement actions stemming from trading on information they had access to through their professional roles. The common thread is information asymmetry created by position.

Misappropriation Theory: The Outsider Who Steals Information

Not every insider trading defendant is a corporate insider. The misappropriation theory covers people who obtain material non-public information through a relationship of trust and confidence with the source, and then trade on it or pass it along.

A classic example: a financial printer’s employee reads deal documents being printed for a client, then trades on that information. The printer owes a duty of confidentiality to its client. The employee breaches that duty.

This theory expanded insider trading law significantly. It covers:

• Lawyers and accountants working on deals for external clients
• Investment bankers working on transactions for client companies
• Doctors who receive preliminary clinical trial data
• Government employees who learn about regulatory decisions before they’re announced
• IT staff who have access to communications systems where material information flows

The misappropriation theory was firmly established by the Supreme Court in United States v. O’Hagan (1997), where a Minneapolis attorney traded on merger information about a client of his firm.

The Tipper-Tippee Problem

This is where insider trading doctrine gets complicated and cases get difficult to prosecute.

A “tipper” is someone who provides material non-public information to another person (the “tippee”). If the tippee trades on that information, can both be held liable?

Under the Dirks v. SEC framework (1983) and its subsequent development, the answer depends on:

1. Whether the tipper received a personal benefit for passing the information (could be financial, could be reputational, could be a gift to a friend)
2. Whether the tippee knew or should have known that the tipper had breached a duty

This framework has led to some complicated litigation. In United States v. Newman (2014), the Second Circuit reversed insider trading convictions because the government hadn’t proven that the tippees (who were several steps removed from the original source) knew the original tipper had received a personal benefit. The Supreme Court later clarified in Salman v. United States (2016) that tipping to a close family member or friend is itself a personal benefit, even without a financial quid pro quo.

The practical implication: being several steps removed from the original source isn’t a defense if you knew the information had been improperly disclosed. But proving that knowledge becomes harder as the chain lengthens.

How the SEC Finds It

Automated Surveillance

The SEC’s Market Abuse Unit runs a system called Analysis and Detection Center that scans trading data looking for patterns that precede market-moving events. When a company announces an acquisition, the system looks backward: was there unusual options activity in the weeks before the announcement? Were there abnormal volume spikes? Did any traders accumulate positions far outside their normal patterns?

This works particularly well with options, which provide significant leverage on a small investment. If someone buys call options in a company two days before a surprise acquisition announcement, the profit can be 10x or 50x the investment. That kind of return on a correctly timed options position is a very bright flag.

The system doesn’t know who made those trades when it flags them. It knows that the statistical pattern is unusual and warrants investigation. From there, subpoenas to brokerage firms identify the account holders, and investigators start working backward from there.

Cross-Border Coordination

Many insider trading cases involve accounts at foreign brokerages, which adds jurisdictional complexity. The SEC has mutual legal assistance treaties with many countries that allow it to obtain trading records from foreign jurisdictions. Cases involving trades through offshore accounts in Switzerland, Hong Kong, and other jurisdictions have resulted in successful prosecutions after the SEC used these treaty processes.

Roger Kao had trades routed through accounts that crossed multiple jurisdictions. A $30.8 million insider trading scheme that ultimately couldn’t be hidden behind the layers of intermediary accounts. Peter Dong Zhou had a similar cross-border structure.

Hung Chin’s case involved a combination of insider trading and hacking, accessing computer systems to steal non-public information directly, then trading on it, which added computer fraud charges on top of the securities violations. The $4.1 million scheme combined the insider trading framework with tactics more common to cybercrime investigations.

Communication Records

Insider trading investigations routinely involve analysis of phone records, text messages, email, and encrypted messaging. Modern traders know not to use Bloomberg chat for insider trading conversations, but they still make phone calls. They still text family members. The patterns of communication, who called whom, when, in proximity to what events, are often as useful as the content.

Several major insider trading prosecutions in the 2010s resulted from wiretap evidence obtained under Title III warrants, uncommon in white-collar cases but used in several high-profile investigations where the government believed telecommunications were being used to coordinate trading schemes.

What Prosecutors Have to Prove

In a criminal insider trading case, the government must prove:

1. The defendant traded in securities (or caused trading, in the case of a tipper)
2. The defendant possessed MNPI at the time of trading
3. The defendant knew the information was material and non-public (or, for misappropriation, that they stole it from someone who expected confidentiality)
4. The defendant willfully violated the securities laws (in criminal cases, the “willfulness” standard requires knowing wrongfulness, not just knowing the facts)

The toughest element is often proving knowledge. A trader can concede they had information that turned out to be correct while arguing they made independent trading decisions without relying on it. The government has to show the information actually drove the trading decision.

Circumstantial evidence fills this gap. Dramatic changes in position size right before announcements, trades in options when the investor had never traded options before, communications between the trader and a company insider right before trades, all of these are circumstantial evidence that gets presented to juries.

Civil vs. Criminal Charges

Insider trading violations can be addressed through either civil or criminal enforcement, sometimes both simultaneously.

Civil enforcement (SEC) doesn’t require proof of willfulness. The SEC needs to show a violation occurred and can obtain disgorgement of profits, interest, and civil penalties up to three times the amount gained.

Criminal enforcement (DOJ) requires proving the defendant acted willfully. Conviction can result in up to 20 years in prison and fines up to $5 million per individual violation (or up to $25 million for firms).

When the government believes the conduct was knowing and deliberate, both tracks run simultaneously. The SEC files its civil action; the DOJ files criminal charges. The defendant faces both a prison sentence and financial disgorgement. In high-profile cases, the SEC also seeks a bar from serving as an officer or director of a public company.

Cooperation agreements are common in insider trading prosecutions. A tippee who provides information about the tipper can receive substantial benefit. A tipper who implicates an entire network can receive reduced charges or non-prosecution agreements. The O’Hagan case and the Boesky case are early examples of this dynamic. The first major targets became cooperators who took down larger networks.

Small Trades, Big Problems

A recurring misconception is that you’re only at risk if you made a lot of money. You’re not. The SEC brings cases against people who profited modest amounts, thousands of dollars, because the conduct itself is the violation, not the scale of the profit.

Douglas Parigian’s case involves trades that, relative to the complexity of the investigation, weren’t enormous. What drove the prosecution was the pattern and the nature of the violation, not just the dollar amount.

This matters practically. People who learned inside information and made small trades sometimes conclude they’re safe because the amount wasn’t significant. The SEC’s surveillance catches statistical anomalies regardless of size, and once an investigation is open, the scope tends to expand.

Cooperation Timing

If you or someone you know is under investigation for insider trading, timing matters enormously. The difference between early cooperation, before charges are filed, when the government still needs information, and late cooperation can be years in prison.

Proactive cooperation through an attorney, providing information that helps the government build cases against more senior or central participants, often results in dramatically reduced charges or non-prosecution. The window for that kind of cooperation narrows once a criminal indictment is filed.

Pratima Rajan’s case is an example of how tipper-tippee liability flows through professional networks. The career pressures, the social dynamics, and the rationalization that information shared between colleagues somehow doesn’t count. Courts have consistently rejected that reasoning, and the SEC’s surveillance systems don’t distinguish between friends and strangers.

The Honest Services Wire Fraud Overlap

In some insider trading cases, the government brings additional charges under the honest services wire fraud statute (18 U.S.C. § 1346). This provision criminalizes schemes to deprive someone of “honest services”, usually their employer’s honest services, through bribery or kickbacks.

The overlap is relevant when the insider trading involves an employee who diverts a business opportunity or breaches their duty to their employer. The honest services charges provide an alternative path to conviction if the securities fraud theories face legal challenges.

Resources for Reporting

If you have information about insider trading:

• SEC tips: sec.gov/tcr (the SEC whistleblower program pays 10-30% of sanctions over $1M)
• FBI financial crimes: tips.fbi.gov
• FINRA complaints: finra.org/investors/have-problem/file-complaint

The SEC’s whistleblower program covers insider trading tips. If your information leads to a successful enforcement action resulting in more than $1 million in sanctions, you’re entitled to an award of 10-30% of what’s collected. See ConFraud’s full guide to the SEC whistleblower program for how the process works.