Insider trading is perhaps the best-known violation of the securities laws. The news is littered with high level corporate executives, celebrities, athletes and politicians who find themselves in hot water for insider trading. These examples are just the tip of the iceberg. The SEC investigates many people for insider trading and brings, on average, approximately 50 insider trading enforcement actions each year against a wide variety of defendants, including lower level corporate employees, attorneys, physicians, students, teachers, accountants and so on.[1]
In this module we will survey the law concerning insider trading. First, we will identify the reasons insider trading is prohibited. Second, we will explore the key elements of the insider trading violation. Third, we will analyze the two key insider trading theories: the classical theory, and the misappropriation theory and look at liability of both the “tipper” and “tippee.” Finally, we will identify regulations and special rules that help prevent insider trading.
Two overarching rationales exist for the prohibition against insider trading: preserving fiduciary duties and maintaining fair and orderly markets.
Fiduciary Duty
Insiders who gain valuable, non-public knowledge concerning a company typically owe fiduciary duties to the company and its shareholders, including the duties of trust and confidence. Material, nonpublic information is the property of the company–not the insider. Insiders should not be permitted to use that information for their personal advantage. The duty of trust proscribes placing their own interests above the shareholders’ interest. The duty of confidence prohibits disclosing private information about the company.
Consider that shareholders elect the board of directors, directors hire the CEO, the CEO hires the next-level managers, and so on. Every position within a company is traceable to the shareholders who have directly or indirectly placed their trust in the position holder. Therefore, the law posits that they should return trust and confidence to the shareholders. Because company directors, executives and employees are in a position to access non-public corporate information solely by virtue of the positions that were bestowed upon them by the shareholders, the fiduciary duties of trust and confidence apply.
As the SEC held in In re Cady, Roberts & Co.,[2] and the Supreme Court later recognized in the seminal insider trading decision, Chiarella v. United States, when corporate insiders gain access to non-public information, they have a duty to either disclose the information to the market or abstain from trading altogether.[3] This rule is known as the “disclose or abstain rule.”
Fair and Orderly Markets
A secondary reason for prohibiting insider trading is to maintain investor confidence in securities markets. Insider trading undermines faith in the fairness and integrity of the securities markets.[4] Still, there are limits to this principle. As the Supreme Court stated, the federal securities laws do not recognize a “general duty between all participants in market transactions to forgo actions based on material, nonpublic information.”[5] Breach of a fiduciary duty somewhere along the way is essential to an insider trading charge. In the absence of a breach, trading on inside information may actually be beneficial because it allows the market to discover the true value of the security.
This situation arose in Dirks v. Securities and Exchange Commission. Motivated by a desire to expose fraud, corporate insiders informed a stock analyst that their company was “cooking the books” and engaging in widespread financial reporting fraud. They did not personally benefit financially or otherwise from sharing the information with the analyst. Because they did not breach a fiduciary duty, the analyst did not violate the insider trading prohibitions when he informed clients of the fraud.[6]
Elements of Insider Trading Rules
The insider trading prohibition flows from the antifraud principle embodied in Section 10(b) of the 1934 Exchange Act, which prohibits “any manipulative or deceptive device or contrivance” used “in connection with the purchase or sale of any security.”[7] Trading on inside information operates as a fraud against the company and its shareholders because it is assumed that inside information belongs to the company and will not be used for improper, personal reasons.
The SEC has promulgated insider trading rules, which are set forth in Rule 10b5-1. These rules prohibit “the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.”[8]
The SEC, the company, or a shareholder in the company may pursue a claim for insider trading. A typical insider trading claim requires proof of these elements:
(1) The defendant had access to “material” information;
(2) The information was “non-public”;
(3) The defendant purchased or sold the company’s security;
(4) The transaction was “based on” the inside information;
(5) There was a breach of the duty of trust or confidence; and
(6) The defendant acted with “scienter.”[9]
Material Information
Information is “material” if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision in light of the information available to the investor.[10] A statement or omission is immaterial if it is meaningless, trivial or inconsequential.
An example of material information would be if the company’s revenues for the quarter were 50% lower than anticipated. An example of immaterial information would be if the company decided to hire an additional administrative assistant to handle scheduling for the CEO.
Non-Public Information
“Nonpublic” information is unavailable through publicly accessible sources. For example, an anticipated earnings release that is known only to the company’s internal and external accountants and that has not yet been disclosed to a single analyst or investor is clearly “nonpublic.” By contrast, an earnings release that has been published by a Form 10-Q filed publicly with the SEC and posted on the company’s website is clearly “public.”
Sometimes, whether information is public or nonpublic is unclear. If only a very limited group of outsiders is aware of the information–for example, analysts, brokers, or institutional investors–it may be considered nonpublic. As the audience grows, it loses some of its confidentiality. If a large group of outsiders is aware of the information by virtue of widespread rumors, it may be considered public information, even if the company has not yet officially made it known to investors.
Purchase or Sale of a Security
The insider trading prohibition reaches purchases and sales of securities. We often think of insider trading as someone buying a security before an announcement. Many insider trading cases, however, involve selling securities to avoid losses before bad news is announced.
“Based on”
A transaction is “based on” or “on the basis of” material non-public information if the defendant knew that she was aware of insider information. This is sometimes referred to as “knowing possession.” The information need not be the only factor in the decision to buy or sell or even a major factor. Rather, the information need only be “a factor, however small.”[11]
Fiduciary Duty
Trading on the basis of inside information is not prohibited unless someone breached the duty of trust or confidence to the corporation and its shareholders. An investor who learns nonpublic information innocently — or even cleverly — does not violate the insider trading prohibitions in the absence of a breach of duty.
For example, in its seminal Chiarella decision, the Supreme Court dealt with a situation in which a financial printing company employee, hired by the acquiring company, learned the identities of takeover targets and invested in their securities. The takeover targets were not disclosed in the drafts received by the printing company, but the employee was able to ascertain their identities from other information in the documents. The employee was convicted of violating Section 10(b)’s prohibition against insider trading. The Supreme Court reversed the conviction because the employee owed no fiduciary duty to the takeover targets–he was not employed by them and had not agreed to keep their information confidential.[12]
Similarly, in Dirks v. SEC, a stock analyst did not breach the insider trading prohibitions because the company insiders who provided him with inside information were trying to expose the company’s fraud, rather than trying to personally benefit from the information. There was thus no breach of fiduciary duty.
Scienter
Scienter is a state of mind embracing intent to mislead, manipulate or defraud.[13] Scienter also embraces situations in which the person “recklessly” disregarded a known risk that its conduct is deceptive. “Recklessness” is more than mere negligence and requires proof of conduct that is highly unreasonable, and which represents an extreme departure from the standards of ordinary care.[14]
In the context of insider trading, the act of trading on the basis of inside information is considered a fraud on the company and its shareholders. If one is in possession of material nonpublic information, a fair inference may be drawn that the person intentionally – or at least recklessly – defrauded the company and its shareholders.
The scienter requirement becomes trickier when an insider tips someone who then trades. Scienter would require that the trader knew that the information came from an insider or was reckless in not inquiring as to the source and confidential nature of the information.
Liability for Insider Trading
Classical Insider Trading
The classical theory of insider trading applies to company insiders who trade in the company’s securities on the basis of material nonpublic information about the company. A “classical” insider is a director, officer or employee of a company. They access company information by virtue of their position within the company. They cannot trade on the information without breaching their duty of confidence and loyalty to the company. They therefore must abstain from trading or disclose the information before trading.
“Temporary insiders” are also prohibited from trading on inside information. Temporary insiders include those who have “entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes.”[15] Temporary insiders may include lawyers, accountants, underwriters and consultants.
Misappropriation Insider Trading
The misappropriation theory of insider trading applies to corporate “outsiders.” A corporate outsider violates Section 10(b) when she “misappropriates confidential information for securities trading purposes, in breach of a fiduciary duty owed to the source of the information.”[16] This also requires a breach of a fiduciary duty, but the duty is not owed to the company itself, but to someone else.
In the seminal Supreme Court decision, United States v. O’Hagan, a law firm partner was accused of insider trading. The law firm represented a company that was going to acquire a target company through a tender offer. A law firm partner, who did not work on the transaction, learned of it through other firm attorneys working on the matter. He purchased stock in the target company. Although he owed no duty to the target company, since his firm represented only the acquiring company, the information concerning the tender offer was confidential. The only reason the law firm knew about it was because the acquiring company had hired them. Thus, the law firm partner breached his fiduciary duty to his law firm to keep client information confidential, and this breach was sufficient to trigger the insider trading prohibition.[17]
The SEC has promulgated Rule 10b5-2 to identify cases in which a duty of trust or confidence arises such that a breach of the duty would constitute misappropriation. These include:
(1) when a person has expressly agreed to maintain the confidence of information;
(2) when the person sharing and the person receiving the information have a history of sharing confidences; and
(3) when family members share information.[18]
Tipper and Tippee Liability
Many insider trading cases, including the Martha Stewart conviction,[19] involve investors who receive information from a company executive or employee or an outside consultant who does work with the company. The person who relays material nonpublic information is the “tipper.” The person who receives information is the “tippee.” Sometimes, there may be multiple steps. Consider a corporate insider who tips a close friend who then tips a relative. The corporate insider is a tipper, the close friend is a tippee and then a tipper, and the relative is a tippee.
A tipper violates the insider trading prohibition only when he shares material nonpublic information in a manner that breaches a fiduciary duty, which occurs when the insider “personally will benefit, directly or indirectly, from his disclosure.”[20] A financial benefit may be the receipt of cash or other property. In the absence of a financial benefit, there may be a breach of the fiduciary duty if the insider receives a personal benefit, such as a “reputational benefit that will translate into future earnings,” or making a “gift of confidential information to a trading relative or friend.”[21]
A tippee is liable only if there has been a breach of fiduciary duty by the tipper or the original source of the information. As the Supreme Court has stated, “there must be a breach of the insider’s fiduciary duty before the tippee inherits the duty to disclose or abstain.”[22]
Monitoring and Preventing Insider Trading
Insider trading investigations generally follow public announcements that impact companies’ stock prices. Examples include tender offers, mergers, and earnings news, and product launches.[23] Regulators may be tipped off by whistleblowers, disgruntled employees, competitors or market professionals.
Alternatively, insider trading investigations may be data-driven.[24] Exchanges maintain detailed records of trades and can trace the trades to specific account numbers and broker-dealers that facilitated the trade. Broker-dealers keep records of customers, and which customers own which accounts. Automated surveillance can flag all “buys” preceding a favorable announcement, and all “sells” preceding a negative announcement.
Regulators closely examine trading sequences in the days and weeks leading up to a major announcement. Size and timing of trades are two factors that are considered.[25] For example, a hedge fund that dumps tens of thousands of shares before a negative announcement may be investigated for avoiding losses based on inside information. Even seemingly small trades may raise eyebrows, as someone who has never before traded a particular stock, but who acquires 100 shares in a pharma company hours before a major announcement may be investigated for trading on inside information.
Regulators may examine the investor’s trading history across all securities, contacts the investor may have with those “in the know,” communications in the days and hours leading up to the trade and other sources of information. Where a violation is found, the trader may be required to return the trading profits to the government or the company (this is called “disgorgement”) and pay penalties and fines. In extreme situations, the insider may be prosecuted and may be subject to prison time, as insider trading is a felony.
Short Swing Profit Rule
It is assumed that high-level executives, directors and investors may have access to inside information. For this reason, the 1934 Securities Exchange Act codified what is known as the “short swing profit rule” in Section 16.[26]
The rule requires people who own 10% or more of a company’s shares to report when they make trades in their company. If they buy and sell the company’s stock in any six-month period, they must disgorge the profits to the company.[27] “Profits” are determined by matching the actual purchase price against the highest sale price during any six-month period.[28] The purpose of this rule is to prevent insider trading even when knowledge of insider information cannot be proven by making it much more difficult for insiders to use their insider information to profit.
Rule 10b5-1 Plans
Many high-level insiders are compensated through stocks and options since they can be valuable compensation that doesn’t require the company to pay large sums of cash. If insiders could never monetize the stocks or options by selling, this compensation would be close to worthless.
Therefore, the SEC has developed rules that permit insiders to trade their company shares under certain circumstances. These rules are set forth in SEC Rule 10b5-1 and are commonly referred to as “10b5-1 Plans.”
First, the insider cannot have access to material nonpublic information regarding the company when she enters the plan, which means all important information must have been disclosed to investors before the plan is put in place. Second, the plan must specify, at the outset, the number of securities to be sold at particular times, the sale prices and the timing of sales. Alternatively, the transactions can be made pursuant to a specified algorithm or formula. Third, the insider cannot change the plan terms. Finally, these plans are administered through brokers, and the brokers cannot have any communications with the insiders regarding the company or the timing and price of transactions. The insider must relinquish control of the timing and manner of trades to a third-party who does not have access to material nonpublic information and who must follow a rigid plan for transactions in the stock.
10b5-1 Plans do not prevent accusations or charges of insider trading. They do, however, provide those accused of insider trading with an “affirmative defense” that the stock transactions were made pursuant to a predetermined plan and are unrelated to any material nonpublic information.
Conclusion
Thank you for participating on our video-course on Securities Law and Regulation. We hope that you now have a better understanding of the world in which ownership of publicly traded companies is regulated and restricted. We hope that you will take advantage of our other business law courses and welcome any feedback or questions that you may have. Best of luck!
[1] L. Hilton Foster, “Insider Trading Investigations”, U.S. Securities Exchange Commission, 1, 2, https://www.sec.gov/about/offices/oia/oia_enforce/foster.pdf (last visited October 26, 2018); “Year-by-Year SEC Enforcement Statistics,” U.S. Securities Exchange Commission, https://www.sec.gov/news/newsroom/images/enfstats.pdf (last visited Oct. 26, 2018).
[2] In re Cady, Roberts & Co., 40 S.E.C. 907, 911 (1961).
[3] Chiarella v. U.S., 445 U.S. 222, 227 (1980).
[4] “Insider Trading,” Investor.gov, https://www.investor.gov/additional-resources/general-resources/glossary/insider-trading(last visited October 26, 2018).
[5] Chiarella, 445 U.S. at 233.
[6] Id. at 665-66.
[7] 15U.S.C. 78j(b).
[8] 17 C.F.R. 240.10b5-1.
[9] See United States v. Martoma, 894 F.3d 64 (2d Cir. 2017)
[10] TSCIndustries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
[11] U.S. v. Rajaratnam, 719 F.3d 139, 158-59 (2d Cir. 2013).
[12] Chiarella, 445 U.S. at 231-33.
[13] Ernst& Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976).
[14] S.E.C.v. McNulty, 137 F.3d 732, 741 (2d Cir. 1998).
[15] Dirks, 463 U.S. at 655 n. 14.
[16] UnitedStates v. O’Hagan, 521 U.S. 642, 652 (1997).
[17] Dirks, 463 U.S. at 652-53.
[18] 17 C.F.R. 240.10b5-2.
[19] “Summary of Case Against Martha Stewart,” Associated Press, Washington Post, (Mar. 5, 2004) http://www.washingtonpost.com/wp-dyn/articles/A33838-2004Mar5.html
[20] Salman v. U.S., 137 S. Ct. 420, 427 (2016).
[21] Dirks, 463 U.S. at 664.
[22] Id.
[23] L. Hilton Foster, “Insider Trading Investigations”, U.S. Securities Exchange Commission, 1, 2, https://www.sec.gov/about/offices/oia/oia_enforce/foster.pdf (last visited October 26, 2018)
[24] Id. at 3-4.
[25] Id. at 6.
[26] 15 U.S.C. 78p.
[27] 15 U.S.C. 78p(b).
[28] Gund v. First Fla. Banks, Inc., 726 F.2d 682, 688 (11th Cir. 1984).