Insider Trading

Introduction

Insider trading is the buying or selling of securities while in possession of material, nonpublic information, in breach of a fiduciary duty or other duty of trust and confidence. Insider trading is unlawful under SEC Rule 10b-5 and Rule 10b5-1. The prohibition on insider trading is designed to protect the integrity of securities markets and to ensure that all investors have equal access to material information.

The Classical Theory

Under the classical theory of insider trading, a corporate insider violates Rule 10b-5 by trading in the securities of their corporation while in possession of material, nonpublic information. The duty arises from the relationship of trust and confidence between the insider and the corporation’s shareholders.

Corporate insiders include officers, directors, and significant shareholders. The insider must either disclose the information or abstain from trading. The classical theory was established in SEC v. Texas Gulf Sulphur Co. (1968) and affirmed by the Supreme Court in Chiarella v. United States (1980).

The Misappropriation Theory

The misappropriation theory extends insider trading liability to persons who are not corporate insiders but who misappropriate confidential information for trading purposes. A person violates Rule 10b-5 by trading in securities based on material, nonpublic information that was misappropriated in breach of a duty of trust and confidence owed to the source of the information.

The Supreme Court adopted the misappropriation theory in United States v. O’Hagan (1997). The defendant, a lawyer at a firm representing a company, traded in options of the company’s target based on confidential information about the merger. The Court held that the lawyer breached a duty to his law firm and its client and was liable for insider trading.

Tipper/Tippee Liability

A tipper who discloses material, nonpublic information in breach of a duty may be liable for insider trading if the tipper receives a personal benefit from the disclosure. A tippee who receives and trades on the information may be liable if the tippee knows or should know that the information was disclosed in breach of a duty.

The Supreme Court in Dirks v. SEC (1983) held that the tipper’s personal benefit is an essential element. The benefit may be financial, reputational, or a reciprocal benefit. In Salman v. United States (2016), the Court held that a gift of confidential information to a trading relative is sufficient to establish the personal benefit requirement.

Rule 10b5-1 Trading Plans

SEC Rule 10b5-1 provides an affirmative defense to insider trading when a person trades pursuant to a pre-arranged trading plan adopted in good faith before the person became aware of material, nonpublic information. Rule 10b5-1 plans allow corporate insiders to engage in systematic trading without being subject to insider trading liability.

The SEC adopted amendments to Rule 10b5-1 in 2022, requiring a cooling-off period, prohibiting overlapping plans, and requiring good faith certification.

Enforcement

The SEC and the Department of Justice enforce insider trading prohibitions. The SEC may seek injunctions, disgorgement of profits, and civil penalties. Criminal penalties include imprisonment of up to 20 years and fines of up to $5 million for individuals and $25 million for corporations.

Conclusion

Insider trading is prohibited under the classical theory (corporate insiders trading in their own securities) and the misappropriation theory (outsiders trading on misappropriated information). Tipper/tippee liability extends to those who disclose or receive confidential information in breach of duty. Rule 10b5-1 provides a safe harbor for pre-arranged trading plans.