Introduction
Insider trading refers to the buying or selling of a publicly-traded company's stock by someone who has non-public, material information about that stock. While insider trading can be legal under certain circumstances, it is illegal when the material information is still non-public. This guide will explore the nuances of insider trading, including the legal and illegal aspects, as well as the concept of tipper/tippee liability.
Legal Framework
Securities Exchange Act of 1934
The primary legislation governing insider trading in the United States is the Securities Exchange Act of 1934. Section 10(b) of the Act, along with SEC Rule 10b-5, prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.
Insider Trading Sanctions Act of 1984
This Act increased the penalties for insider trading and allowed the SEC to seek civil penalties against violators. It also provided for the imposition of treble damages, which means that violators could be required to pay up to three times the profit gained or loss avoided as a result of the insider trading.
Insider Trading and Securities Fraud Enforcement Act of 1988
This Act further strengthened the penalties for insider trading and required companies to establish and enforce policies to prevent insider trading.
Illegal Insider Trading
Definition
Illegal insider trading occurs when a person buys or sells a security while in possession of material, non-public information about the security. Material information is any information that could affect an investor's decision to buy or sell the security.
Key Cases
United States v. O'Hagan
In this landmark case, the Supreme Court held that a person commits fraud "in connection with" a securities transaction, and thereby violates Section 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.
Dirks v. SEC
The Supreme Court ruled that a tippee (a person who receives insider information) is only liable if the tipper (the person who provides the information) has breached a fiduciary duty and the tippee knows or should know about the breach.
Penalties
Penalties for illegal insider trading can include both civil and criminal sanctions. Civil penalties can include fines and disgorgement of profits, while criminal penalties can include imprisonment.
Legal Insider Trading
Definition
Legal insider trading occurs when corporate insiders—officers, directors, and employees—buy or sell stock in their own companies in compliance with the rules set forth by the SEC. These transactions must be reported to the SEC, usually within two business days.
Reporting Requirements
Corporate insiders must file a Form 4 with the SEC to report their trades. This form must be filed electronically and is available to the public.
Safe Harbor Provisions
Rule 10b5-1 provides a defense against insider trading liability. It allows insiders to set up a trading plan for selling stocks they own. As long as the plan is established when the insider is not in possession of material non-public information, the trades can occur regardless of subsequent information.
Tipper/Tippee Liability
Definition
Tipper/tippee liability arises when an insider (the tipper) provides material non-public information to another person (the tippee), who then trades on the information. Both the tipper and the tippee can be held liable for insider trading.
Key Cases
Salman v. United States
The Supreme Court held that a tippee is liable if the tipper breaches a fiduciary duty by making a gift of confidential information to a trading relative or friend.
United States v. Newman
The Second Circuit held that a tippee is only liable if they knew the information was disclosed in breach of a fiduciary duty and that the tipper received a personal benefit.
Elements of Liability
To establish tipper/tippee liability, the following elements must be proven:
- The tipper had a fiduciary duty to the company.
- The tipper breached that duty by disclosing the information.
- The tippee knew or should have known about the breach.
- The tipper received a personal benefit from the disclosure.
Preventive Measures
Corporate Policies
Companies can implement policies to prevent insider trading, such as blackout periods during which insiders are prohibited from trading the company's stock.
Training and Education
Regular training and education programs can help employees understand the rules and regulations surrounding insider trading and the importance of compliance.
Monitoring and Enforcement
Companies should monitor trading activity and enforce their insider trading policies to ensure compliance. This can include regular audits and the use of trading windows.
Conclusion
Insider trading is a complex area of securities law that involves both legal and illegal activities. Understanding the legal framework, key cases, and preventive measures can help individuals and companies navigate this challenging area. By adhering to the rules and regulations, corporate insiders can engage in legal insider trading while avoiding the severe penalties associated with illegal activities.
