Insider Trading
When is “tipping” illegal?
When are outsiders “insiders”?
(last updated 9 Oct 06)
Rule 10b-5
Securities Exchange Act of
1934 Act § 10
It shall be unlawful for any
person ...
(b) To use or employ, in
connection with the
purchase or sale of any
security ... any manipulative
or deceptive device or
contrivance in contravention
of such rules and
regulations as the
Commission may prescribe
Fraud (tort of deceit)
• Material misrepresentation
• Intentional (defendant aware
of truth)
• Reliance (plaintiff relies
reasonably)
• Misrepresentation is cause of
loss
• Damages
Rule 10b-5
Securities Exchange Act of
1934 Act § 10
It shall be unlawful for any
person ...
(b) To use or employ, in
connection with the
purchase or sale of any
security ... any manipulative
or deceptive device or
contrivance in contravention
of such rules and
regulations as the
Commission may prescribe
Fraud (tort of deceit)
• Material
misrepresentation
• Intentional (defendant
aware of truth)
• Reliance (plaintiff relies
reasonably)
• Misrepresentation is
cause of loss
• Damages
Chiarella v. US (US 1980)
"... silence in connection with the
purchase or sale of securities
may operate as fraud actionable
under § 10(b) ... But such liability
is premised upon a duty to
disclose arising from a
relationship of trust and
confidence between parties to a
transaction.”
Justice Lewis
Powell
What about tips?
Equity Funding execs who prepared
company financials -- hamming it up
(all went to prison)
Dirks v. SEC (US 1983)
“Tipping”
Investors / shareholders
Clients dump stock
Secrist
Dirks
(analyst)
Did Dirks do
something wrong?
Equity Funding
Non-public, material information
(massive accounting fraud)
Dirks v. SEC (US 1983)
... a tippee assumes a fiduciary duty to the
shareholders of a corporation not to trade
on material nonpublic information only
when the insider has breached his fiduciary
duty to the shareholders by disclosing the
information to the tippee and the tippee
knows or should know that there has been
a breach.
Whether the "tip" was a breach of the
insider's fiduciary duty [depends on]
whether ... the insider receives a direct or
indirect personal benefit that will translate
into future earnings.
Justice Lewis
Powell
Hypotheticals
1. Secrest decides, “To heck with altruism. I’m going to
save myself.” He sells his Equity Funding holdings.
2. Sam, an outside attorney for Equity Funding, consults
on the company’s financial reporting. Realizing how bad
things are, Sam sells his EF holdings.
3. Secrest tells his brother-in-law, “Bob, there are some
bad things happening at Equity Funding. You’d make a
ton by selling short.” Bob does.
4. Secrest calls Dirks today and blurts it all. Has Secrest
violated Reg FD? Does this mean he violated 10b-5?
SEC v. Stewart (filed 2003)
“Tipping”
Stock market
Sells stock
Sells stock
Martha
Stewart
(at airport)
Sam
Wachtal
(CEO)
Imclone
Faneuil
(broker ass’t)
Non-public, material information
(FDA likely to disapprove drug)
Effect of SEC rules
• Rule 10b5-1: state of mind
when trading “on the basis” of
material, nonpublic
information
– “aware” (“conscious
knowledge”)
– Safe harbor for pre-existing
trading plans
Outsider Trading
(Misappropriation)
US v. O’Hagan (US 1997)
“Misappropriation
Shareholders
Option
sellers
Buy, buy, buy
Shareholders
Pillsbury
Dorsey &
Whitney
O’Hagan
Insider
Grand Met
Non-public, material info
(plan to make tender offer
To Pillsbury shareholders)
US v. O’Hagan (US 1997)
The "misappropriation theory" holds that
a person commits fraud "in connection
with" a securities transaction, and
thereby violates § 10(b) and Rule 10b-5,
when he misappropriates confidential
information for securities trading
purposes, in breach of a duty owed to
the source of the information. … Under
this theory, a fiduciary's undisclosed,
self- serving use of a principal's
information to purchase or sell
securities, in breach of a duty of loyalty
and confidentiality, defrauds the
principal of the exclusive use of that
information.
Justice Ruth Bader
Ginsberg
US v. O’Hagan (US 1997)
[The "in connection with the
purchase or sale of [a] security"]
element is satisfied because the
fiduciary's fraud is consummated,
not when the fiduciary gains the
confidential information, but when,
without disclosure to his principal,
he uses the information to purchase
or sell securities. … This is so even
though the person or entity
defrauded is not the other party to
the trade, but is, instead, the source
of the nonpublic information.
Justice Ruth Bader
Ginsberg
Hypotheticals
1.
O’Hagan learns about Grand Met’s plans to acquire Pillsbury. He
figures that the deal will drive down the stock of the competitors of
Pillsbury. He buys put options on the competitors.
2.
Dorsey & Whitney attorneys suspected that O’Hagan was trading
on inside information, particularly when he began driving a
chauffeur-driven Rolls-Royce to work. Is the firm liable?
3.
You are a consultant to the
D&W law firm. Are you an
insider?
4.
You brazenly write an email
to the firm and client Grand Met.
Hey guys –
Thanks for the info,
I’m trading on
Pillsbury.”
ARP
Effect of SEC rules
• Rule 10b5-2: duty to source
in business/personal relations
– Agree to maintain confidentiality
– Practice of sharing known
confidences
– Spouse, parent, child, sibling –
unless no confidentiality
A final review …
“Insider trading”
– Classic insider trading:
• Fraudulent silence under Section 10(b)
• duty of trust or confidence to “abstain or disclose”
– Tipping liability:
• know or should know that
• tipper has breached duty for improper personal
benefit
– Misappropriation liability:
• Fraud on source “in connection with” securities
trading
• Maintain integrity of securities markets
“Insider trading”
– Classic insider trading:
• Fraudulent silence under Section 10(b)
• duty of trust or confidence to “abstain or disclose”
– Tipping liability:
• know or should know that
• tipper has breached duty for improper personal
benefit
– Misappropriation liability:
• Fraud on source “in connection with” securities
trading
• Maintain integrity of securities markets
“Insider trading”
– Classic insider trading:
• Fraudulent silence under Section 10(b)
• duty of trust or confidence to “abstain or disclose”
– Tipping liability:
• know or should know that
• tipper has breached duty for improper personal
benefit
– Misappropriation liability:
• Fraud on source “in connection with” securities
trading
• Maintain integrity of securities markets