Insider Trading occurs when actual insiders, constructive insiders, certain outsiders, and tippers/tippees trade on the basis of material, non-public information. Below, I discuss the definition of each category of trader that can be implicated with a 10b-5 violation of insider trading.
Actual Insider: This is the most basic and straightforward category of insiders–this refers to members of the Board of Directors, the officers and members of management positions, controlling shareholders, and even employees that are privy to material non-public information resulting from their position as a corporate insider.
Although this may seem surprising, the Supreme Court did not address insider trading it handled the case of Vincent Chiarella–a markup man at a financial printing shop that was able to decode the target company in a takeover bid (it is common for corporations to use codenames like “Pinewood” or “Spruce” to maintain secrecy during takeover preparations and submit the true names of the companies involved at the last minute). After he would figure out the company involved, he would borrow money and then purchase the stock in the company be taken over. He would sell immediately after the takeover announcement.
In determining whether Chiarella was liable, the Supreme Court formally described the classical theory of liability for insider trading, saying that an actual insider is prohibited from trading on that material non-public information because he has a fiduciary duty to shareholders to keep the information confidential. This is the signature departure from state laws on insider trading, which assert that actual insiders have fiduciary duties to the corporation but not the shareholders specifically.
Constructive Insider: At the Supreme Court level, a “constructive” insider refers to members of the professional class that have access to materially non-public information as a result of their professional relationship with insiders. This usually refers to lawyers and accountants, and sometimes includes consultants and investment bankers hired to perform M&A work.
Where is all the good stuff? In the footnotes. In one of the three Supreme Court cases that addresses insider trading, the Dirks v. SEC case mentioned this in footnote 14: “Under certain circumstances, such as when corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they 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…For such a duty to be imposed, however, the corporation must expect the outsider to keep the disclosed nonpublic information confidential, and the relationship at least must imply such a duty.”
Outsiders Facing Liability: Unlike insider trading violations for actual and constructive insiders, the insider trading violation for outsiders occurs on a theory of misappropriation. For outsiders to be implicated in an insider trading case, the lie arises when an outsider feigns fidelity to the source of the information. The deception is pretending to be faithful to someone when you are not, in fact, going to be faithful to them.
In 2000, the SEC adopted Rule 10b5-2 that provides a non-exhaustive list of three situations when a person has a duty of trust or confidence that could subject them to insider trading liability under a misappropriation theory.
The three situations are: (1) When a person agrees to maintain information in confidence; (2) the person communicating the material non-public information has a history or practice of doing such so that the recipient knows or should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality; (3) a person receives material non-public information from a spouse, parent, child, or sibling (this can be rebutted).
You should keep in mind that Rule 10b5-2 has never been litigated. It is possible that it is not actually valid because it contradicts a 1991 Second Circuit ruling in United States v. Chestman which the Supreme Court may adopt as persuasive instead of Rule 10b5-2. Fiduciary duties are almost always the province of state law, and it is not clear to me that the SEC has the authority to promulgate Rule 10b5-2. But until it is litigated, this rule is something you should know about as far outsider trading is concerned.
Tipper/ Tippee: For people that give out stock tips (tipper), an insider trading violation will occur if there is a fiduciary duty of confidentiality as an actual insider, constructive insider, or outsider facing liability and the tipper passes on the material non-public information to a tippee. It does not matter if the original person receiving the tip trades–what counts is whether someone along the tipping chain does so (e.g. sub-tippers and sub-tippees keep the chain alive). After breaching a duty of confidentiality to pass along material non-public information, a tipper must also receive a financial or material benefit from the breach. The Supreme Court has never defined this gain beyond the declaration in Dirks that “absent some personal gain, there has been no breach of duty to shareholders.”
If you receive a stock tip, you may be liable for insider trading if two elements are satisfied: (1) If the tipper breached a fiduciary duty and received a financial or material benefit from the breach; and (2) the tippee knew or should have known that the fiduciary duty was breached and the tipper received a personal benefit. If both of these prongs are satisfied, then you inherit a duty to either publicly disclose your knowledge or abstain from trading. You are put in the position of the insider, inheriting (and potentially violating) the same duties as the actual insider, constructive insider, or outsider facing liability.
Notice: This article, which I believe may be of interest to readers, is for general information and entertainment purposes only. It only reflects my best understanding of the topic at hand and should not be relied upon as legal or investment advice.
Sources Consulted:
Chiarella v. United States, 445 U.S. 222, 235-237 (1980), accessible online here: https://supreme.justia.com/cases/federal/us/445/222/case.html
Dirks v. SEC, 463 U.S. 646, 655, n. 14 (1983), accessible online here: https://supreme.justia.com/cases/federal/us/463/646/case.html
United States v. O’Hagan, 521 U.S. 642, 652-53 (1997), accessible online here: https://www.law.cornell.edu/supremecourt/text/521/642
17 CFR 240.10b5-2, accessible online here: https://www.law.cornell.edu/cfr/text/17/240.10b5-2
United States v. Chestman, 947 F.2d 551 (2d Cir. 1991), cert. denied 503 U.S. 1004 (1992), accessible online here: https://law.resource.org/pub/us/case/reporter/F2/947/947.F2d.551.89-1276.309.html
Originally posted 2016-03-13 18:42:42.
