Insider Trading
(Federal Law)
• Classic insider trading
• Tipping liability
• Outsider trading
(misappropriation)
Last updated 31 Mar 11
Classic Insider
Trading
Misappropriation
(Outsider Trading)
Company
shareholders
Outside
shareholders
Silence = fraud
Violates duty
(duty of trust/confidence)
to source
(1) Tip violates duty *
(2) Knows / reason to know
* improper benefit
INSIDER
10b5-2
• Confidentiality agreement
• Confidentiality practice
• Family member – functional
Tippee
Rule 10b5-1: state of mind when trading “on the Tippee
basis” of material, nonpublic information
• “aware” (“conscious knowledge”)
• Pre-existing trading plans
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
Fraud (tort
of deceit)
• Intentional
aware
• Material(defendant
misrepresentation
of• truth)
Intentional (defendant
aware(plaintiff
of truth) relies
• Reliance
• Reliance (plaintiff relies
reasonably)
reasonably)
• Misrepresentation
is cause of
• Misrepresentation is cause
loss
of loss
• Damages
•
Damages
Classic insider trading …
Cady Roberts (SEC 1961)
“Classic”
Investors / shareholders
Sell to new investors
(sell short)
Gintel (director)
Curtiss-Wright
Non-public, material information
(board votes to cut dividends)
Duty to abstain or disclose …
Chiarella v. US (US 1980)
“Outsider”
shareholders
Pandick
Press
Chiarella
Shareholders
Insider
Acquiror Inc
Target
Company
Non-public, material info
(takeover plans)
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
Tipping liability …
Dirks v. SEC (US 1983)
“Tipping”
Investors / shareholders
Clients dump stock
Secrist
Dirks
(analyst)
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
Hypothetical
“Tipping”
Investors / shareholders
Sell Stock
Spouse
Secrest
Equity Funding
Non-public, material information
Massive accounting fraud)
Martha Stewart …
SEC v. Stewart (settled 2006)
“Tipping”
Stock market
Sells stock
Martha
Stewart
(at airport)
Sam
Wachtal
(CEO)
Imclone
Faneuil
(ass’t)
Non-public, material information
(FDA likely to disapprove drug)
Outsider Trading …
(Misappropriation)
US v. O’Hagan (US 1997)
“Misappropriation”
Shareholders
Option
sellers
Dorsey &
Whitney
Buy, buy, buy
O’Hagan
Insider
Shareholders
Pillsbury
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
US law of 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
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
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
SEC rulemaking role …
Effect of SEC rules
• Rule 10b5-1: state of mind when
trading “on the basis” of material,
nonpublic information
– “aware” (“conscious knowledge”)
– Pre-existing trading plans
• 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
• Regulation FD: no special access
for analysts