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 10% or more of a class of equity securities
- Anyone who receives MNPI from an insider (a "tippee")
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, regulatory actions
What makes information "nonpublic"?
- Information that has NOT been disseminated broadly enough for the market to absorb it
- Even after a press release, information is not considered "public" until the market has had adequate time to react (typically at least one full trading day)
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 receives and trades on MNPI can be liable, even a friend, family member, or taxi driver who overhears a conversation.
The Legal Framework
| Law/Rule | What It Does |
|---|---|
| SEC Rule 10b-5 | The broad anti-fraud rule that prohibits insider trading (same rule that covers manipulation) |
| Section 10(b) of the Securities Exchange Act of 1934 | Gives the SEC authority to prohibit manipulative and deceptive devices in securities transactions |
| Insider Trading Sanctions Act of 1984 (ITSA) | Authorized the SEC to seek civil penalties of up to 3x the profit gained or loss avoided (treble damages) |
| Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA) | Extended liability to controlling persons, increased criminal penalties, and required firms to maintain written policies to prevent insider trading |
- ITSA gave the SEC teeth; before 1984, the SEC could only seek disgorgement (giving back profits)
- ITSFEA expanded liability beyond the actual trader to supervisors and firms that failed to prevent it
Exam Tip: Gotchas
- Insider trading is prosecuted under the SAME rule as market manipulation (10b-5). The difference is the type of conduct, not the legal authority.
- ITSA (1984) = treble damages; ITSFEA (1988) = controlling person liability. These two acts are often confused on the exam.
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 for insider trading
- The tippee is liable if they knew (or should have known) that the information was material and nonpublic, AND that the tipper breached a duty by sharing it
Think of it this way: If a CFO tells her neighbor about an upcoming merger and the neighbor buys stock, both the CFO (tipper) and the neighbor (tippee) have violated insider trading rules. The chain of liability follows the information.
Penalties
| Type | Penalty |
|---|---|
| Civil (SEC) | Up to 3x the profit gained or loss avoided (treble damages under ITSA) |
| Criminal (DOJ) | Up to 20 years in prison and up to $5 million in fines for individuals |
| Controlling persons | Supervisors and firms that fail to prevent insider trading face civil penalties up to the greater of $1 million or 3x the profit/loss (under ITSFEA) |
Key Defenses
- SEC Rule 10b5-1 provides an affirmative defense if the trade was made under a pre-existing written trading plan adopted in good faith before the person became aware of MNPI
- SEC Rule 10b5-2 defines when a duty of trust or confidence exists (family relationships, confidentiality agreements, history of sharing confidences)
Exam Tip: Gotchas
- A 10b5-1 trading plan must be established BEFORE the person learns the MNPI. If someone creates a plan after learning inside information, the plan provides no protection.
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
- ITSFEA (1988) specifically requires 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