Insider Trading and Material Nonpublic Information

The Series 24 expects principals to know how the federal anti-fraud framework applies to insider trading: which rule defines awareness, which rule reaches misappropriation, what the firm must do to prevent misuse of MNPI, and how the SEC and private plaintiffs collect damages.

The Prearranged Trading Plan Rule: Trading "On the Basis Of" MNPI

A purchase or sale is "on the basis of" material nonpublic information if the trader was aware of the MNPI at the time of the trade. Awareness alone is sufficient; the SEC does not need to prove the MNPI motivated the trade.

The Prearranged-Plan Affirmative Defense

The trader is not "on the basis of" MNPI if, before becoming aware of the information, the person:

• Entered into a binding contract to purchase or sell the security
• Instructed another person to purchase or sell the security for the trader's account
• Adopted a written prearranged trading plan for trading the security

A valid prearranged trading plan must specify the amount, price, and date of trades, or include a written formula or algorithm for these terms, and must not permit the trader to influence trades after adoption.

Plan Conditions (2022 Amendments, Effective Feb 27, 2023)

The SEC tightened the prearranged-plan conditions in December 2022. The current conditions:

Effect of Plan Modification

A trader who modifies the plan after becoming aware of MNPI loses the affirmative defense. A modification that changes amount, price, or timing is treated as a new plan adoption and re-triggers the cooling-off period.

Exam Tip: Gotchas

• A prearranged trading plan only provides an affirmative defense if all conditions are met. A trader who modifies the plan after becoming aware of MNPI loses the defense. The 2022 amendments tightened cooling-off periods and added good-faith certifications; older "set and forget" plans may no longer qualify.
• The 90-day cooling-off period for officers and directors is "the longer of", capped at 120 days. The cap matters: even if the company's earnings disclosure is delayed, the maximum cooling-off period need not exceed 120 days.

The Misappropriation Theory Extension to Non-Business Relationships

The family-and-non-business-relationship insider-trading rule defines when a person owes a duty of trust or confidence that, if breached by trading on MNPI obtained from a non-issuer source, gives rise to misappropriation insider-trading liability.

A duty exists when:

• The person agrees to maintain information in confidence
• The persons have a history, pattern, or practice of sharing confidences such that the recipient knows or reasonably should know the speaker expects confidentiality
• The information comes from a spouse, parent, child, or sibling (presumption of confidentiality)

Misappropriation vs Classical Theory

The misappropriation theory closes the gap left by classical insider trading: a person who is not an insider of the issuer can still be liable if they breach a duty to the source of the information.

Exam Tip: Gotchas

• Family members are presumed to have a duty of confidence under the family-and-non-business-relationship insider-trading rule. A son who hears his father (an executive) discuss earnings at the dinner table and trades the stock is liable on misappropriation theory unless he rebuts the presumption.
• The misappropriation theory does not require an issuer connection. A defendant who has no relationship to the issuer can still be liable if they breach a duty to the source of the MNPI.

The Information-Barrier Requirement

Every registered broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI by the firm or any associated person.

The policies must reflect the firm's specific business:

• Investment-banking firms need stricter information barriers between IB (the side that learns deal-specific MNPI) and trading and research (the public side)
• Pure retail firms can have simpler procedures because they are less likely to encounter MNPI in the ordinary course

Common elements of an information-barrier program:

• Watch list (deals the firm is working on, monitored but trading not yet restricted; CONFIDENTIAL within compliance)
• Restricted list (issuers the firm cannot trade for the firm or its customers without compliance approval; usually publicly disseminated within the firm)
• Physical and electronic access controls (separate file rooms, locked drawers, IT-segregated systems)
• Employee-trading reviews under the supervisory transaction-review framework
• Trade-monitoring surveillance that flags trades by personnel with potential MNPI access

Exam Tip: Gotchas

• The information-barrier requirement is a written-policies-AND-enforcement obligation. Having a policy on paper is not enough. The firm must train its personnel, monitor compliance, and respond when red flags surface. A failure-to-supervise charge under the FINRA supervisory-system requirement typically pairs with an information-barrier charge.
• Watch list is internal and pre-public; restricted list is firm-wide and post-public. The exam tests this distinction. A name moves from watch to restricted when the firm's involvement becomes public or when the deal is announced.

Liability to Contemporaneous Traders

The contemporaneous-trader civil liability provision creates a private right of action: any person who violates the Exchange Act or rules thereunder by trading on MNPI is liable to any person who, contemporaneously with the violation, traded the same class of security on the other side of the market.

• "Contemporaneously" is interpreted by courts to mean roughly the same trading day or short window
• Damages are capped at the profit gained or loss avoided by the violator
• The action is independent of SEC enforcement; private plaintiffs can sue without waiting for the SEC
• The court may offset the damages by amounts the violator pays in SEC disgorgement or fines

SEC Civil Penalties for Insider Trading

The SEC may seek civil penalties up to 3 times the profit gained or loss avoided ("treble damages") from any person who violates the Exchange Act's antifraud provision or the tender-offer fraud rule by trading on or communicating MNPI.

Controlling-Person Liability

Controlling persons (typically the employer firm) may face civil penalties up to the greater of $1,000,000 or three times the profit/loss if:

• The firm knew or recklessly disregarded the violation, AND
• The firm failed to take preventive steps (i.e., failed to maintain or enforce information barriers under the information-barrier requirement)

The controlling-person provision is what gives the failure-to-supervise concept teeth in insider-trading cases. A firm that lets a registered person trade on MNPI through inadequate barriers can be liable for up to 3x the rep's gain, plus the rep's own treble damages.

Statute of Limitations

The SEC may bring an insider-trading civil penalty action up to 5 years from the date of the trade.

Exam Tip: Gotchas

• SEC treble damages apply to controlling persons (the firm) when the firm failed to maintain or enforce information barriers. A failure to supervise that enabled an associated person's insider trading exposes the firm to up to 3x the violator's gain.
• The contemporaneous-trader action is private; the SEC treble-damage action is SEC-enforced. Both can run in parallel. A single insider trade can produce SEC treble damages, contemporaneous-trader civil suits, and criminal exposure under the Exchange Act.

SEC Investigations, Injunctions, and Prosecution Powers

The Exchange Act's general enforcement provision authorizes the SEC to:

• Conduct investigations of suspected Exchange Act violations
• Issue subpoenas for testimony and documents
• Seek injunctions in federal court to halt ongoing violations
• Refer matters for criminal prosecution by the Department of Justice

These investigative and enforcement powers are the procedural backbone for the substantive civil and criminal penalties. The SEC investigates, brings civil treble damages for insider trading, and refers willful cases to DOJ for criminal prosecution.