Quick Answer
The antifraud rule reaches anyone who defrauds, misstates or misleadingly omits a material fact, or whose conduct operates or would operate as a fraud or deceit, in securities purchases or sales. The misappropriation duty of trust rule names three circumstances, among others. Registered brokers and dealers must maintain written procedures, scaled to their business, reasonably designed to prevent misuse.
Insider trading is not one provision. It is an antifraud rule that needs a trade, a rule that says when a duty of confidence exists, and a statutory duty the firm owes whether or not anyone ever trades.
What Does the General Antifraud Rule Forbid?
The rule is unlawful conduct by any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange. It is not written against broker-dealers, and it names no registration status at all.
It states three prohibitions.
- To employ any device, scheme, or artifice to defraud
- To make any untrue statement of a material fact, or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading
- To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person
All three close on the same condition: in connection with the purchase or sale of any security.
Exam Tip: Gotchas
- The rule needs a purchase or a sale. The closing clause governs all three prohibitions, so conduct with no securities transaction attached is outside this rule however deceptive it looks.
- The omission branch is conditional. An omission is unlawful where the omitted fact was necessary to make the statements made, in the light of the circumstances under which they were made, not misleading. Silence with no statement beside it is not the described conduct.
- Any person means any person. A tippee with no industry registration is inside the rule's reach on the same terms as a registered trader.
When Does a Person Owe a Duty of Trust or Confidence?
The misappropriation duty of trust rule supplies a non-exclusive definition of the circumstances in which a person has a duty of trust or confidence for purposes of the misappropriation theory. Its own preliminary note adds that the law of insider trading is otherwise defined by judicial opinions construing the general antifraud rule, and that this rule does not modify the scope of insider trading law in any other respect.
Its scope paragraph applies the rule to a violation of the antifraud statute and the general antifraud rule that is based on the purchase or sale of securities on the basis of, or the communication of, material nonpublic information (MNPI) misappropriated in breach of a duty of trust or confidence. Both limbs are in scope, so passing the information along is described as well as trading on it.
The rule then says a duty exists in the following circumstances, among others, which leaves the set open.
| Circumstance | What has to be true |
|---|---|
| An agreement | Whenever a person agrees to maintain information in confidence |
| A history of sharing confidences | Whenever the communicator and the recipient have a history, pattern, or practice of sharing confidences, such that the recipient knows or reasonably should know that the communicator expects confidentiality |
| A family source | Whenever a person receives or obtains MNPI from his or her spouse, parent, child, or sibling |
Only the family branch carries a rebuttal. Under its proviso the recipient may demonstrate that no duty existed by establishing that he or she neither knew nor reasonably should have known that the source expected the information to be kept confidential. That showing rests on two grounds together: the parties' history, pattern, or practice of sharing and maintaining confidences, and the absence of any agreement or understanding to maintain confidentiality.
The affirmative defenses for trading on the basis of material nonpublic information sit in the trading plan affirmative defense rule, which the outline places elsewhere. They are covered in the unit on IPOs, secondary offerings and safe harbor.
Exam Tip: Gotchas
- The list is open, not closed. The words "among others" precede the three circumstances, so a fact pattern outside all three does not prove that no duty exists.
- The family list names four relationships. Spouse, parent, child and sibling are the ones written down. A cousin or an in-law is not on that list, though the open chapeau still leaves room elsewhere.
- The rebuttal belongs to the family branch alone. Neither the agreement branch nor the history branch carries a proviso letting the recipient show no duty existed.
- Communication is in scope beside trading. The scope paragraph covers a purchase or sale on the basis of MNPI and the communication of it, so a tipper who never trades is inside the rule's reach.
What Must the Firm Itself Do About Material Nonpublic Information?
The insider trading policies and procedures requirement binds every registered broker or dealer. Each shall establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of that broker's or dealer's business, to prevent the misuse in violation of the Exchange Act, or the rules or regulations under it, of material, nonpublic information by that broker or dealer or any person associated with it.
Three qualifiers in that sentence are easy to lose.
- Written. The procedures have to exist on paper or its equivalent, not merely in practice.
- Reasonably designed. The standard is not proof against every case.
- Scaled to the business. The design takes into consideration the nature of that firm's business, so a one-desk firm and a full-service dealer do not owe the same document.
Exam Tip: Gotchas
- This duty can be broken with no trade at all. A firm that never misused a single piece of information still fails the requirement if it has no written policies and procedures reasonably designed to prevent misuse, or has them and does not enforce them.
- The coverage runs to associated persons. The duty is to prevent misuse by the broker or dealer or any person associated with it, so a procedure aimed only at the firm's own account is short.
- The general antifraud rule is the mirror image. It needs a purchase or sale, and this statutory duty needs none.
What Should You Check on Exam Day?
- Confirm a purchase or sale exists before applying the general antifraud rule; without one the conduct falls outside it.
- Ask which of the three duty circumstances the facts fit, and remember the list is open because it says "among others".
- Where the source is a spouse, parent, child or sibling, check whether the rebuttal facts are present on both grounds.
- Treat a firm that has no written policies and procedures, or does not enforce the ones it has, as already exposed even where no misuse occurred.
- Check whether the scenario is about communicating the information rather than trading; both are in scope.