Quick Answer
Insider trading liability can reach the insider, tipper, tippee, and controlling person as information moves through a chain. A tipper who tips for a personal benefit is liable without trading, and a tippee who trades is liable if they knew or should have known the tip breached a duty. 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, employee, or more-than-10% shareholder who possesses material nonpublic information (MNPI) | Directly liable for trading on MNPI because they owe a duty of trust and confidence to the company and its shareholders; an employee owes that duty for company MNPI learned through the job, including from a coworker or a conversation at work |
| 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 only if the tipper breached a duty by disclosing it for a personal benefit, and the tippee knew or should have known of that breach and that 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 can be liable even if they never trade. An officer who breaches a corporate duty by giving confidential merger information to a close friend as a trading gift can face liability when the friend trades. The deliberate gift supplies the personal benefit; merely mentioning a merger does not automatically establish that element.
- A tippee does not have to be a corporate insider. Anyone who trades on a tip can be liable if the tipper breached a duty by sharing it and the tippee knew or should have known of that breach and that the information was material and nonpublic.
- "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, given the circumstances, that the information was material and nonpublic and that the tipper was breaching a duty by sharing it.
- An officer's unannounced earnings figures may clearly be material and nonpublic, but tippee liability also depends on a disclosure in breach of duty for personal benefit and the recipient's knowledge of that breach. A claim of ignorance does not settle the issue; the facts surrounding the disclosure matter.
- 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" that a tip was material and nonpublic and shared in breach of a duty?
- Can you explain the purpose of an information barrier between investment banking and trading desks?