Insider trading continues to dominate the headlines in the financial press. Even after a number of recent “blockbuster” enforcement actions, convictions and settlements in the last three years, the SEC’s acting head of enforcement is reported to have said that there is a lot more to come in insider trading enforcement.
Given that insider trading has been, and by all indications will continue to be, a top enforcement priority for the SEC, it is more important than ever for financial professionals to understand the elements of insider trading liability.
This article will provide a brief summary of the key elements of prohibited insider trading.
Definition of Insider Trading
Insider trading is, in short, the purchase or sale of securities on the basis of material, non-public information in breach of a duty arising out of a fiduciary relationship or other relationship of trust and confidence. There are two primary theories of insider trading liability: the “classical” theory and “misappropriation” theory, which are discussed below under “Breach of Duty.”
On the Basis Of
Liability for insider trading requires that a trader purchase or sell securities “on the basis of” material non-public information. “On the basis of” sounds like it means that the trader’s decision to purchase or sell securities was influenced by material, non-public information. However, this is not how the “on the basis of” requirement is applied by the SEC in practice. Pursuant to the SEC’s Rule 10b5-1, a purchase or sale of a security is “on the basis of” material non-public information if the trader was aware of the material non-public information when he made the purchase or sale.
Also, as set forth in the definition above, in order to be liable for insider trading the information being traded on must be non-public. The dividing line between what is “non-public” and “public” is not exact.
Information is most likely to be considered public when it has been disclosed in a manner sufficient to ensure availability to the investing public, for example, through a major news wire service, and sufficient time has passed since its dissemination for investors to have absorbed the information. Information that has not been widely disseminated, such as government records that are publicly available and information obtained through Freedom of Information Act requests may also be deemed public. However, under certain circumstances, hard-to-find information, although publicly available, may be considered non-public by the SEC and courts.
There is also no bright line between information that is material and not material. In general, for information to be material there must be a substantial likelihood that a reasonable investor would consider it important in deciding whether or not to purchase or sell a security. Said slightly differently, there must be a substantial likelihood that the information would be viewed by a reasonable investor as significantly altering the total mix of information available about the security. Material, non-public information includes both confidential information originating from within a company, so called “corporate information,” and information that originates from outside of a company but is price sensitive with respect to a company’s securities, so called “market information.”
Breach of Duty
The statutory basis for insider trading is Section 10(b) of the Securities Exchange Act of 1934 and the SEC’s Rule 10b-5, which make it unlawful for any person to engage in any act, practice or course of business that would operate as a fraud or deceit upon any other person in connection with the purchase or sale of a security. The breach of duty requirement reflects that insider trading is a deceit or fraud on the source of the information.
Under the classical theory of insider trading, which applies to insiders of a corporation, an insider breaches his or her duty of trust and confidence to the corporation and its shareholders when the insider trades on material, non-public information learned by reason of his or her position with the corporation.
The misappropriation theory of insider trading is a complement to the classical theory that applies to market participants other than corporate insiders. Under the misappropriation theory, a person engages in illegal insider trading when he or she trades while in possession of material, non-public information in breach of a duty owed to the source of information. For purposes of the misappropriation theory, such a duty may arise as a result of a fiduciary relationship, such as an attorney-client relationship, or a result of an agreement, such as an agreement to maintain information in confidence, and under other circumstances as well.
Tipper and Tippee Liability
Under both the classical and misappropriation theories of insider trading, tippers and tippees of material, non-public information may face liability for insider trading. The standards for liability under both theories generally overlap.
Tipper liability requires that (1) the tipper had a duty to keep material non-public information confidential, and the tipper knew that the information was non-public and material, or acted with reckless disregard of the nature of the information; (2) the tipper breached that duty by intentionally or recklessly relaying the information to a tippee who could use the information in connection with securities trading; and (3) the tipper received a personal benefit from the tip.
Tippee liability requires that (1) the tipper breached a duty by tipping confidential information; (2) the tippee knew or had reason to know that the tippee improperly obtained the information (i.e., that the information was obtained through the tipper’s breach); and (3) the tippee, while in knowing possession of the material non-public information, used the information by trading or by tipping for a personal benefit.
The “personal benefit” requirement referred to above for tipper liability is broadly construed and is not limited to pecuniary benefit. If the tipper and tippee are friends, relatives or business associates, the existence of a personal benefit will almost always be found.
Also, a tippee need not know definitively that the tipper disclosed the material, non-public information in breach of a duty. Insider trading liability will attach if the tippee should have known of the tipper’s breach. Whether a tippee should have known of the tipper’s breach is a fact specific inquiry, but an important factor may be the sophistication of the tippee. Financial professionals may be viewed as being particularly sophisticated.
Insider Trading in the Context of Tender Offers
The SEC’s Rule 14e-3 governs insider trading in the context of tender offers. Rule 14e-3 provides that if a bidder has taken a substantial step to commence a tender offer, no other person who possess material, non-public information relating to the tender offer that was acquired, directly or indirectly, from the bidder, the target company, or any insider or other person act on behalf of the bidder or the target company, can buy or sell the target company’s securities, unless the material, non-public information is publicly disclosed. Rule 14e-3 also prohibits “tipping” of material, non-public information regarding a tender offer to third parties. Note that there is no requirement under Rule 14e-3 that trader be in breach of a duty of trust and confidence for liability to attach.
Foreign Insider Trading Laws
It is also important to appreciate that there are differences between the regulation of insider trading in the United States and foreign jurisdictions. In Canada, Europe, Australia, Japan and other foreign jurisdictions laws prohibiting insider trading differ substantially from insider trading laws in the U.S. and in some cases extend to conduct that would not be considered wrongful under U.S. laws. For example, in some foreign jurisdictions a breach of a duty of trust and confidence is not required to establish insider trading liability.
In light of the SEC’s enforcement efforts, investors, financial firms and issuers of securities need to be aware of insider trading laws, properly train and educate employees concerning insider trading compliance, develop policies and procedures that anticipate insider trading compliance concerns and when necessary consult experienced legal counsel.
Greg Kramer is a partner in the corporate and securities practice areas of Kleinberg, Kaplan, Wolff & Cohen, P.C. He has extensive experience advising clients in connection with trading and compliance issues such as evaluating potential trading restrictions, insider trading issues and advising on compliance with short sale rules, Regulation M and Rule 144. Kleinberg, Kaplan, Wolff & Cohen is a leading New York law firm representing clients in transactional, regulatory, trusts and estates, tax, real estate, litigation and securities matters. For more information, please visit www.kkwc.com..
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author.