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Navigating Insider Trading Risks: Issues and SEC Enforcement Trends Impacting Microcap Firms

Insider trading poses major risks for microcap companies. The Securities and Exchange Commission (SEC) aggressively enforces insider trading laws across markets, including microcap stocks. This article examines why insider trading occurs frequently within microcap firms, how the SEC detects and pursues violations, and what companies can do to mitigate risks.

Prevalence of Insider Trading in Microcap Stocks

Unfortunately, insider trading occurs with some regularity among microcap issuers. The structure and attributes of many microcap companies presents opportunities for abuse by executives, directors, and major shareholders.

Many microcaps have relatively limited internal controls and compliance policies compared to larger firms. This makes it easier for insiders to trade improperly on material nonpublic information for personal gain. And the typically light trading volume of microcap shares means insider buying and selling is more readily apparent and detectable through data mining tools.

Microcap companies also frequently compensate management, directors, advisors, and promoters using stock or options in lieu of cash. This arrangement gives insiders concentrated stakes and vested interests in impacting the company's share price, creating temptation to trade opportunistically around market moving events.

Common Types of Insider Trading Violations

Insider trading involves the trading of a security on the basis of material nonpublic information, in breach of a duty of trust or confidence owed either to the company issuing the security or the source of the information.

Typical scenarios of insider trading encountered in the microcap context include:

• - Officers or directors buying or selling company stock ahead of significant news announcements like clinical trial results, product approvals, major commercial agreements, mergers, acquisitions, or other market moving events.
• - Major shareholders with board representation or close company affiliations executing transacting in advance of key developments.
• - Attorneys, auditors, consultants or other professional advisors misusing material nonpublic information entrusted to them to trade a company's securities.
• - Friends, family members, business associates, or other tippees receiving illegal tips from true corporate insiders and improperly trading on the information.

The consequences of insider trading violations can be severe for both companies and individuals. In October 2022, the SEC charged three company insiders who traded a biopharma stock ahead of a cancer drug approval announcement with over $1.2 million in ill-gotten gains. The tipper received a sizable fine and industry bars, while the tippees received multi-year prison sentences on top of six-figure penalties.

Aggressive SEC Detection and Enforcement

Curbing insider trading has long been an SEC priority and area of enforcement focus. The agency's sophisticated data analytics capabilities are devoted to detecting suspicious trading patterns in real-time to identify potential insider trading for referral to the SEC's Division of Enforcement.

During fiscal year 2022, the SEC brought a plethora of insider trading enforcement actions. Defendants have included corporate officers and directors, major shareholders, professional advisors like attorneys and accountants, and tippees of material nonpublic information. The SEC pursues violations at companies of all sizes, including a substantial number of cases focused on trading within the microcap space.

When inspecting market activity, key red flags the SEC looks for are spikes in trading, volume, or unusual options activity occurring just ahead of material public announcements. Suspicious activity stands out more starkly in lightly traded microcap securities, prompting further investigation when observed. The SEC has found no shortage of microcap insider trading cases to pursue using its array of enforcement tools and remedies.

Steps to Mitigate Insider Trading Risks

Microcap companies and insiders should adopt robust policies, procedures, and compliance programs tailored to prevent insider trading violations given the heightened risks. Common measures include:

• - Implementing quarterly or event-specific trading blackout periods when insiders cannot trade.
• - Requiring insiders to pre-clear planned trades through the Chief Compliance Officer or General Counsel.
• - Limiting who has access to material nonpublic information and maintaining confidentiality.
• - Providing periodic training to insiders on their obligations under insider trading laws.

However, compliance technology and policies alone will not suffice. Equally important is instilling an enterprise-wide culture stressing ethical behavior and the sanctity of confidential information.

Proactive guidance from experienced securities counsel is key for microcap companies to navigate insider trading risks and adopt proportional preventative measures matching their risk profile. Please contact the attorneys at Lucosky Brookman if you need assistance designing or assessing an insider trading compliance program for your microcap firm.