Throughout the history of the U.S. stock market, individuals have used insider access to information to gain an unfair advantage over other investors. The use of material non-public information (“MNPI”) in financial trading by corporate insiders has long been a significant concern of the U.S. government and investors. For such insiders, being accused of insider trading can have devastating consequences, especially due to the public nature of these cases in the media. Even if the charges are dropped or if a trial results in an acquittal, the simple fact of being accused can result in damage to one’s reputation and loss of employment. There are several well-known insider trading cases, including those involving Martha Stewart, Enron, Michael Milikin.
The Securities and Exchange Commission (SEC) has implemented several regulations to protect the market and investors from the effects of insider trading. Additionally, the SEC has aggressively investigated and sought civil sanctions for violations of these rules. When regulators believe tougher sanctions are appropriate, the Department of Justice (DOJ) can prosecute criminal violations of insider trading laws, which can result in fines and jail time upon conviction.
What is considered insider trading?
Federal securities law lacks a comprehensive definition of “insider trading,” which is a concept that includes both legal and illegal activity. Rather, the definition of unlawful insider trading has principally evolved pursuant to judicial and administrative decisions interpreting Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5.
Section 10(b) is primarily an anti-fraud provision and the primary source of law on insider trading. It prohibits the use of “manipulative and deceptive devices” in connection with the sale of securities on any national securities exchange and authorizes the SEC to create rules and regulations to enforce the prohibition. To regulate such fraudulent “devices,” the SEC promulgated Rule 10b-5, but neither Section 10(b) nor Rule 10b-5 define what constitutes unlawful insider trading. In the year 2000, the SEC implemented Rule 10b5-1, which clarified the contours of prohibited insider trading by offering a non-exclusive definition.[i]
According to the SEC, unlawful insider trading is, generally, defined as:
(1) trading in a security or a derivative;
(2) while aware of MNPI pertaining to the security traded;
(3) in breach of a fiduciary duty or other relationship of trust and confidence.
Pursuant to that definition, unlawful insider trading occurs when a company insider or a “misappropriator,” in breach of a duty of confidence, takes advantage of access to MNPI to gain profits or avoid losses on the stock market. Under the classical theory of insider trading, a corporate executive or other “insider” breaches a fiduciary duty when they trade in company stock based on the company’s MNPI. Insider trading liability also extends beyond insiders under the “misappropriation theory.” For example, when an insider gives MNPI to an “outsider” who then acts on the inside “tip” by trading the company’s stock, both acts can violate insider trading laws.
SEC Rule 10b5-2 clarifies when a “duty of trust or confidence” exists under the misappropriation theory. Generally, such a duty exists by an agreement to receive information in confidence. It also exists when there is a pattern of information sharing between communicators and receivers of information (e.g., a tipper and tippee) which indicates an expectation of confidentiality. Additionally, a duty of trust or confidence exists, as a rebuttable presumption, when individuals receive MNPI from direct family members.
Not every disclosure of MNPI that benefits a trader will lead to legal liability under the Exchange Act. In cases involving tips to outsiders, “tippers” can be held liable only if they receive a personal benefit from giving the tip. “Tippees” can be held liable only if (1) the “tipper” breached a duty by disclosing MNPI and by receiving a personal benefit and (2) the tippee knew or had reason to believe the tipper disclosed MNPI in breach of a duty for personal benefit. Notwithstanding, a personal benefit may not be required under criminal statutes. The government has recently prosecuted insider trading under statutes criminalizing wire and securities fraud found in Title 18 of the U.S. Code. And in United States v. Blaszczak, a Second Circuit panel affirmed an insider trading conviction in a “tipping” case and found that a “personal benefit” was not required under the relevant criminal provisions. 947 F.3d 19 (2d Cir. 2019), vacated and remanded, 141 S. Ct. 1040 (2021). However, because the Supreme Court vacated the decision (on unrelated grounds), it does not hold precedential value.
Regulatory & Enforcement Mechanisms
Insider trading can be hard to prosecute. Direct evidence is rare. Typically, there are no “smoking guns”, and prosecutors frequently have to rely on circumstantial evidence. For that reason, in addition to general prohibition of trading on trading based on MNPI, securities statutes and regulations attempt to prophylactically police insider trading through several different methods. For example, securities law provisions require disclosure of securities holdings and transactions effectuated by executive officers, directors, and any holder of 10% or more of common stock or other registered equity securities, and further require disgorgement of certain “short swing” profits. Additionally, several SEC regulations are intended to prevent insiders and favored outsiders from using information asymmetries to their advantage vis-à-vis the market at large. These include rules requiring periodic reporting of material company information and Regulation FD, which is designed to prevent selective disclosure of company information to market professionals and certain shareholders.
In terms of civil and criminal enforcement, the SEC has resisted legislative efforts to statutorily define insider trading in favor of the existing, more flexible, approach capable of application to market developments and new business and technological practices. This vagueness has resulted in the evolution of insider trading law on a case-by-case basis as federal appellate courts have accepted or rejected liability theories advanced by the SEC and DOJ. Many market participants find such “regulation through enforcement” frustrating. Notwithstanding, eschewing precise delineations distinguishing legal from illegal activity arguably allows the SEC and courts to respond more ably to evolving market practices and innovative schemes. It may also more effectively discourage trading that too closely borders unlawful insider trading.
Conclusion – Continuing Development
Insider trading law has become more defined over the past several decades, but its evolution will crawl forward as courts test novel legal theories against new fact patterns. This dynamic is presently being demonstrated in SEC v. Panuwat, a case currently pending in the U.S. District Court for the Northern District of California. In response to a motion to dismiss, the Court accepted the SEC’s theory predicated on “shadow trading” by holding that the SEC had adequately pleaded the elements of an insider trading claim.
The SEC’s “shadow trading” theory is viewed as novel because the allegedly fraudulent trading involved call options in the stock of a competitor, which the defendant purchased after learning about a pending corporate acquisition by his employer. In contrast, insider trading cases have traditionally involved trading in the securities of the company about which an insider holds MNPI. Regardless of whether the prosecution results in a conviction that is sustained on appeal, the SEC’s use of the shadow trading theory highlights the flexible and changing nature of insider trading jurisprudence and enforcement.
[i] Rules 10b5-1 was implemented simultaneously with Rule 10b5-2. Each settled only discrete questions disagreed upon by appellate courts and were implemented as part of an effort to clarify prohibitions against insider trading and the circumstances under which trades based on MNPI can lead to legal liability. Other than the discrete questions settled, neither rule otherwise modified the law of insider trading.
