Insider Trading

The manipulation tactics covered so far involve fake orders and market activity. Insider trading is different. It involves real trades, but made with an unfair information advantage that other investors don't have.

Definition

Insider trading is the buying or selling of a security while in possession of material nonpublic information (MNPI) about that security, in breach of a duty of trust or confidence.

Prohibited under SEC Rule 10b-5 and the antifraud provisions of USA Section 101.

Material Information

Information is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision.

Examples of material information:

• Earnings reports or earnings surprises (before public release)
• Mergers, acquisitions, or tender offers (before announcement)
• New product launches or regulatory approvals
• Changes in senior management
• Dividend changes (increases, cuts, suspensions)
• Stock splits or buyback programs
• Significant litigation or regulatory actions
• Credit rating changes
• Loss of a major customer or contract

Nonpublic Information

Information is nonpublic if it has not been disseminated broadly to the investing public through established channels (press releases, SEC filings, major news outlets).

• Once material information has been publicly released and the market has had time to absorb it, it is no longer "inside" information
• Selective disclosure to a few analysts or investors does NOT make information public
• The information must be broadly disseminated, not just shared with select individuals

The Classical Theory (Insiders)

Corporate insiders (officers, directors, and employees) owe a fiduciary duty to shareholders:

• Trading on MNPI breaches that fiduciary duty
• Insiders must either disclose the information publicly or abstain from trading
• This is known as the "disclose or abstain" rule

The Misappropriation Theory (Outsiders)

A person who is NOT a corporate insider but who misappropriates MNPI from the source of that information for securities trading purposes also commits insider trading:

• The fraud is against the source of the information, not necessarily against the other party to the trade
• Adopted by the Supreme Court in United States v. O'Hagan (1997)

Example: An attorney at a law firm learns about a pending merger while working on the deal. The attorney trades on this information without disclosing the trading to the firm. This is insider trading under the misappropriation theory, even though the attorney is not an insider of either company.

Tipping

A tipper who passes MNPI to another person (a tippee) violates the law if:

• The tipper breaches a fiduciary duty by disclosing the MNPI, AND
• The tipper receives a personal benefit from the disclosure (direct or indirect)

A tippee who trades on MNPI is liable if:

• The tippee knew or should have known that the tipper was breaching a duty, AND
• The tipper received a personal benefit

The personal benefit can be:

• Monetary (a quid pro quo)
• Reputational (enhancing one's standing)
• Relationship-based (a "gift" of the information to a relative or friend)

Exam Tip: Gotchas

• Both the tipper AND the tippee can be liable. The tipper is liable for breaching a duty in exchange for personal benefit; the tippee is liable for trading knowing the information came from a breach. "I was just passing it along" is not a defense.

What Is NOT Insider Trading

• Trading on publicly available information, even if not widely known, is NOT insider trading
• Using skill, research, or analysis to reach conclusions others have not reached is NOT insider trading (the "mosaic theory" approach)
• Possessing MNPI without trading on it is NOT a violation; the violation occurs when a trade is executed while in possession of MNPI

Elements Required for a Violation

Exam Tip: Gotchas

The exam may describe an agent who overhears MNPI at a restaurant. Can the agent trade? The answer depends on whether the agent has a duty of trust or confidence. Merely overhearing information does not create a duty. But if the agent receives the information from someone who breached a duty and the agent knows or should know this, the agent is a tippee and trading would be illegal. Also remember: passing MNPI without a resulting trade is not technically insider trading, though it may violate other rules.