Insider Trading

Insider trading differs from the manipulation tactics covered earlier. Those involve fake orders and market activity; insider trading involves real trades made with an unfair information advantage 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) violates the law if two conditions are both met:

• The tipper breaches a duty of trust or confidence by disclosing the MNPI, AND
• The tipper receives a personal benefit from the disclosure

A tippee who trades on the information is liable if two conditions are both met:

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

The personal benefit does not have to be cash. It can be monetary (a quid pro quo), reputational, or a relationship benefit, such as a gift of information to a trading relative or friend.

Exam Tip: Gotchas

Both the tipper AND the tippee can be liable, but the personal benefit has to actually flow to the tipper, not just be suspected. A tipper who leaks MNPI purely by accident, with no benefit flowing back to them, has not violated the tipping rule. The tippee's own knowledge requirement is about the duty breach, not the benefit itself: a tippee who knew or should have known the tipper was breaching a duty is liable once the tipper in fact received a personal benefit, even if the tippee never learned exactly what that benefit was. "I was just passing it along" is not a defense once a benefit is present.

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 (sometimes called the mosaic theory)
• 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 tipper breached a duty for a personal benefit, and the agent knew or should have known of that breach, the agent is a tippee and trading would be illegal, whether or not the agent knew the specific benefit involved. Also remember: passing MNPI without a resulting trade is not technically insider trading, though it may violate other rules.

What Should You Check on Exam Day?

• Insider trading requires all four elements together: material information, nonpublic information, a breach of a duty of trust or confidence, and an executed trade.
• Insiders must disclose or abstain; outsiders can still be liable under the misappropriation theory for trading on confidential information taken from a source they owe a duty to.
• A tipper is liable only when a duty breach is paired with a personal benefit; a tippee is liable only when they knew or should have known of both the breach and the benefit.
• Skill, research, and analysis of public information (mosaic theory) is not insider trading, and merely possessing MNPI without trading is not a violation.