The U.S. SEC is the regulation and enforcement agency that oversees the markets’ activities, including the ways securities are issued. The SEC was created in 1934 to prevent the kinds of abuses that led to the stock market crash of 1929. The SEC regulates the public offering of new securities by requiring that all companies file a prospectus before proposed offerings commence. To protect investors from fraudulent issues, a prospectus contains pertinent information about both the offered security and the issuing company. False statements are subject to criminal penalties.

The SEC also enforces laws against insider trading, the use of special knowledge about a firm for profit or gain. Suppose, for example, that you work for a pharmaceutical company that is working to develop a major new drug that, if approved for use, will lead to the stock in your company doubling or even tripling in value. You have just seen test results that prove the value of the drug and know that it will now be approved for general use in the next six months. You could tell your friends and family members to buy your company’s stock so they can make large sums of money. Doing so, however, would be against the law. In general, it is illegal for an employee of a firm to tell others about an anticipated event that may affect the value of that firm’s stock, such as an impending acquisition or a merger, before news of that event is made public. Those in possession of such insider knowledge would have an unfair advantage over other investors.

In March 2011, the U.S. Attorney began a criminal trial in New York against Raj Rajaratnam, founder of Galleon Group, on charges that the billionaire fund manager profited from illegal stock tips with a network of financial insiders. Reports indicate the accused gained profits of up to $60 million by using illicit information, confidential company information not available to the public, revealing that stock prices of various companies would be increasing or falling. In conjunction with his arrest in 2009, charges were leveled against 26 others in the case—executives and securities traders—19 of whom pleaded guilty. In May 2011, Rajaratnam was convicted on 14 charges and faced possible maximum prison sentences totaling up to 205 years. He was finally sentenced to serve 11 years in prison, the longest ever for an insider-trading violation. In addition to the criminal trial, he faces civil charges brought by the SEC. As a U.S. Attorney stated some years previously, “Insider trading is a crime. Corporate executives are prohibited from enriching themselves while the public remains in the dark about the true financial condition of their companies.”¹⁸

The SEC offers a reward to any person who provides information leading to a civil penalty for illegal insider trading. The courts can render a penalty of up to three times the illegal profit that was gained, and the reward can, at most, be 10 percent of that penalty.

Along with the SEC’s enforcement efforts, the stock exchanges and securities firms have adopted self-regulation by participating with the Financial Industry Regulatory Authority (FINRA) in detecting and stopping insider action and violations of other industry regulations. Established in 2003, FINRA’s mission is to protect U.S. investors by overseeing the nation’s brokerage firms and securities representatives. The major U.S. stock markets are under a contract that allows FINRA to regulate those markets by writing rules, examining securities firms, enforcing the rules, and enforcing federal securities laws as well.