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.
It violates the antifraud provisions of the Uniform Securities Act (and federal antifraud law).
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
Insiders: Disclose or Abstain
Corporate insiders (officers, directors, and employees) owe a duty to the company's shareholders:
- Trading on MNPI breaches that duty
- An insider must either disclose the information publicly or abstain from trading
- They cannot trade while keeping the information secret
Outsiders: Trading on Confidential Information
A person who is NOT a corporate insider can still commit insider trading by trading on MNPI taken from the source of that information (such as an employer or client) for trading purposes:
- The person need not be an insider of either company involved; trading on confidential information taken from a source you owe a duty to is prohibited
Example: An attorney at a law firm learns about a pending merger while working on the deal and trades on the information without telling the firm. This is illegal insider trading, even though the attorney is not an insider of either company.
Tipping
A tipper who passes MNPI to another person (a tippee) can be liable for improperly disclosing the information in breach of a duty to keep it confidential, even if the tipper never trades.
A tippee who trades on the information is liable if they knew or had reason to know that the information was disclosed in breach of a duty.
Exam Tip: Gotchas
Both the tipper AND the tippee can be liable. The tipper is liable for leaking information in breach of a duty; the tippee is liable for trading while 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; combining public information through expert analysis is legitimate
- 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
| Element | Required? | Detail |
|---|---|---|
| Material information | Yes | Must be significant to a reasonable investor |
| Nonpublic information | Yes | Not yet disseminated to the public |
| Breach of duty | Yes | A duty of trust or confidence |
| Trade executed | Yes | Merely possessing MNPI without trading is not 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.