Insider Trading

Insider trading is one of the most frequently tested prohibited activities on the SIE exam. Understanding what makes trading "illegal" (versus routine insider transactions) is critical.

What Is Insider Trading?

• Insider trading is buying or selling a security based on material nonpublic information (MNPI) in breach of a fiduciary duty or other relationship of trust and confidence
• It is NOT illegal to be an insider who trades; it is illegal to trade BASED ON material nonpublic information

Who counts as an insider?

• Corporate officers (CEO, CFO, etc.)
• Directors (board members)
• Shareholders who own more than 10% of a class of equity securities
• Employees, who owe the company a duty not to trade on its MNPI when they learn it through the job, including from a coworker or a conversation overheard at work
• A person who receives MNPI from an insider (a "tippee"), but only when the insider breached a duty by sharing it and the tippee knew (or should have known) of that breach

What makes information "material"?

• Information is material if a reasonable investor would consider it important when making an investment decision
• Examples: upcoming merger announcements, earnings surprises, major contract wins or losses, dividend changes before the board announces them, regulatory actions

What makes information "nonpublic"?

• Information that has NOT been disseminated broadly enough for the market to absorb it
• A press release does not make information "public" the moment it goes out. The test is fact-specific: has the news reached the market through channels investors watch, and has the market then had a reasonable chance to react?
• As a study guideline, not a fixed legal rule, treat information as still nonpublic if less than one full trading day has passed since release

Exam Tip: Gotchas

• Corporate insiders CAN trade their company's stock. Being an insider is not illegal. Trading BASED ON material nonpublic information is what violates the law.
• A tippee does NOT need to be a corporate insider. Anyone who knowingly receives a tip from someone who breached a duty of trust or confidence can be liable, even a friend or family member with no position at the company. Merely overhearing strangers, with no such duty in the chain, does not by itself create liability.
• Overhearing at work is no defense for an employee. The strangers exception does not cover an employee who overhears the company's own MNPI in a conversation at work, because MNPI learned through the job is MNPI the employee owes the company a duty not to trade on.
• "One full trading day" is a study guideline, not a statute. Courts decide case by case whether the market had a reasonable chance to absorb the news. Ten minutes after a release is never enough time under any version of that test.

The Legal Framework

• Federal securities laws authorize the SEC to seek civil penalties of up to 3x the profit gained or loss avoided (treble damages), and extend liability to controlling persons (supervisors and firms) that fail to prevent insider trading

Exam Tip: Gotchas

• Insider trading is prosecuted under the SAME antifraud rule as market manipulation. The difference is the type of conduct, not the legal authority.

When a Duty of Trust or Confidence Exists

Insider trading requires a breach of a duty. A duty of trust or confidence can arise from:

• A family or close personal relationship where confidences are normally shared (for example, spouses, or parents and children)
• An agreement to keep information confidential
• A history or pattern of sharing confidences, so the person had reason to know the information was meant to stay private

This is why someone outside the company can still be liable: they took on a duty when they received the information under one of these conditions.

Safe Harbor: Pre-Planned Trades

• An insider can set up a written trading plan in advance, before learning any material nonpublic information
• Trades that follow this pre-existing plan in good faith are an affirmative defense: they are not treated as insider trading, even if the insider later holds MNPI
• The plan must be adopted honestly and cannot be changed to take advantage of inside information

Tipper/Tippee Liability

• A tipper is the insider who shares MNPI with someone else
• A tippee is the person who receives the MNPI
• Both the tipper and the tippee can be liable when the tipper breaches a duty by disclosing the information for a personal benefit
• The tippee must trade on the information and know (or have reason to know) that the disclosure breached the tipper's duty; merely knowing the information is material and nonpublic is not enough
• "Should have known" is an objective standard: the test is what a reasonable person in the tippee's position would have recognized, not what the tippee claims to have known. A tippee cannot escape liability by claiming naivety when the circumstances make the MNPI nature obvious.

Think of it this way: A Chief Financial Officer (CFO) gives confidential merger information to a close friend as a gift, expecting the friend to trade. The friend knows the CFO is breaching a duty to the company and buys shares before the announcement. Both can be liable: the trading gift supplies the CFO's personal benefit, and the friend knowingly trades on the wrongful tip. A casual disclosure followed by a trade does not automatically establish those conditions.

Penalties

Trading on Inside Information by Non-Insiders

• Insider trading liability is not limited to corporate insiders. Anyone who obtains material nonpublic information and trades on it (or passes it to someone who trades) can be liable, even if they do not work for or own stock in the company
• Examples: a lawyer who learns about a deal while advising a client, an accountant reviewing a company's private financials, or a friend who is given a tip and trades on it

Exam Tip: Gotchas

• You do not have to be a corporate insider to commit insider trading. But liability still requires a duty of trust or confidence somewhere in the chain, owed to the company or to the source of the information. Merely overhearing MNPI from strangers, with no such duty, does not by itself create liability.
• An employee who learns the company's MNPI through the job is not a stranger to it. That includes MNPI from a coworker or from a conversation overheard at work: the employee owes the company a duty not to trade on it.

Firm Obligations: Information Barriers

• Broker-dealers and investment firms must maintain information barriers (sometimes called "Chinese walls") to prevent MNPI from flowing between departments
• For example, the investment banking division (which knows about upcoming deals) must be separated from the trading desk
• Federal securities laws specifically require firms to establish, maintain, and enforce written supervisory procedures to prevent insider trading
• Firms that fail to maintain adequate barriers face their own liability as controlling persons

What Should You Check on Exam Day?

• Can you explain why being a corporate insider is legal but trading on material nonpublic information is not?
• Do you know the maximum civil penalty the SEC can seek for insider trading?
• Can you state what the "should have known" objective standard means for tippee liability?
• Do you know what conditions must be met for a pre-planned trading plan to act as a defense?
• Can you explain why controlling persons can be liable even without trading themselves?