Insider Trading (Federal Law)

Insider trading regulation in the US

• Classic insider trading: – Fraudulent silence under Section 10(b)– duty of trust or confidence to “abstain or disclose”– When can insider trade? Rule 10b5-1

• 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– When is there fiduciary relationship? See Rule 10b5-2

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

The framework …

(imputing a duty not to trade)

Chiarella v. US (US 1980)

“Good news”

Insider

Acquiror Inc

Non-public, material info(takeover plans)

Shareholders

shareholders

Target Company

Pandick Press

Chiarella

Justice Powell:

"... 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.”

.... duty to disclose ... guarantees that corporate insiders, who have an obligation to place the shareholder's welfare before their own, will not benefit personally through fraudulent use of material, nonpublic information.

Expanding the framework …

(tipping and trading on tips)

Dirks v. SEC (US 1983)

“Bad news”

Clients dump stock

What theory?

Equity Funding

Non-public, material information(massive accounting fraud)

Investors / shareholders

Dirks (and clients)

Secrist

Tipping liabilityJustice Powell:

... 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.

Applying the framework …

(was there a tip?)

SEC v. Stewart (2003 …)

“Bad news”

Sells stock

Imclone

Non-public, material information(FDA plans to deny drug application)

Stock market

Martha Stewart

(at airport)

SamWachtal(CEO)

Faneuil(ass’t)

Further expanding the framework …

(misappropriation of confidential info)

US v. O’Hagan (US 1997)

“Misappropriation”

Buy, buy, buyInsider

Grand Met

Non-public, material info(plan to make tender offerTo Pillsbury shareholders)

Shareholders

Shareholders

Pillsbury

Dorsey &Whitney

O’Hagan

Option sellers

Misappropriation Theory

Justice Ginsberg:

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. See Brief for United States 14. 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.

Misappropriation Theory

Justice Ginsberg:

[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. The securities transaction and the breach of duty thus coincide. 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.

Clarifying the framework …

(the SEC steps into the fray)

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