Quick Answer
Insider trading liability can reach the insider, tipper, tippee, and controlling person as information moves through a chain. A tipper is liable without trading if they received a personal benefit, and a tippee is judged by an objective should-have-known standard. Information barriers separate departments handling material nonpublic information from trading desks.
Insider trading liability extends beyond the person who actually trades. It can reach anyone in the chain of information, from the original source to the person who passes it along.
Who Can Be Liable?
| Party | Role | How Liability Arises |
|---|---|---|
| Insider | Corporate officer, director, or 10%+ shareholder who possesses material nonpublic information (MNPI) | Directly liable for trading on MNPI because they owe a fiduciary duty to the company and its shareholders |
| Tipper | Person who passes MNPI to another person | Liable even if they did NOT trade themselves, as long as they received a personal benefit from tipping and the person they tipped trades on the information |
| Tippee | Person who receives MNPI from a tipper and trades on it | Liable if they knew or should have known the information was material and nonpublic |
| Controlling person | Employer, supervisor, or firm that fails to prevent insider trading | Liable under the Exchange Act controlling-person provision for failing to maintain adequate procedures |
Think of it this way: Picture a chain of dominoes. The insider tips off a friend, who tips off another friend, who trades. Every domino in that chain can face liability, not just the one that actually fell into the trade.
Exam Tip: Gotchas
- Controlling persons (supervisors, firms) can be liable even if they personally did NOT trade. Their failure to prevent insider trading creates liability.
- A tippee who receives MNPI but does NOT trade is not liable. Liability requires actually trading on the information (or tipping someone else who trades).
The Information Barrier
- Broker-dealers must maintain information barriers (also called "ethical walls") to prevent the flow of MNPI between departments
- Example: The investment banking department learns about a pending merger. This information must NOT reach the trading desk.
- The purpose is to prevent the firm's traders from acting on information obtained through the firm's advisory relationships
Exam Tip: Gotchas
- The information barrier must separate departments that regularly handle MNPI (investment banking, mergers and acquisitions) from trading and sales departments. The barrier is about preventing information flow, not physical separation.
Key Takeaways on Liability
- Tippers are liable even if they never trade. A corporate officer who tells a friend about an upcoming merger is liable as a tipper if that friend trades on the information, even though the officer never bought or sold a single share.
- A tippee does not have to be a corporate insider. Anyone who trades on a tip, knowing or having reason to know the information is material and nonpublic, can be liable.
- "Should have known" is an objective test, not a subjective one. The law does not require the tipper to say "this is inside information." The question is whether a reasonable person in the tippee's position would have recognized the information as material and nonpublic given the circumstances.
- A neighbor who is a corporate officer sharing earnings figures before the public announcement gives the tippee every reason to know the information is nonpublic, even if the neighbor never used the phrase "inside information." Claiming naivety does not defeat liability when the context would put any reasonable person on notice.
- Liability follows the information. Every person in the chain (insider, tipper, tippee) can face liability, and the firm and its supervisors can be liable as controlling persons if they failed to maintain procedures to prevent the misconduct.
What Should You Check on Exam Day?
- Can you explain the difference between a tipper and a tippee under insider trading liability rules?
- Do you know why a tippee who receives MNPI but never trades is not liable?
- Can you explain how a controlling person can be liable without personally trading?
- Do you know what test determines whether a tippee "should have known" information was material and nonpublic?
- Can you explain the purpose of an information barrier between investment banking and trading desks?