Insider Trading

Insider Trading

There are two critical issues for securities laws in relation to insider trading: what information constitute insider information not to be used for trading and who is insider which is required to be prohibited for trading.

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In cases related to insider trading, SEC and courts do not establish quatity standard for insider trading, to avoid further fraud.


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Examples of Insiders

Insiders

Insiders who obtain material, nonpublic information because of their corporate position—directors, officers, employees, and controlling shareholders—have the clearest 10b-5 duty not to trade.

Constructive (or temporary) insiders

Outsiders with no relationship to the company in whose securities they trade also have an abstain-or-disclose duty when aware of material, nonpublic information obtained in a relationship or trust or confidence. See O’Hagan. The outsider’s breach of confidence to the information source is deemed a deception that occurs “in connection with” his securities trading.

Outsiders (with duty to source of information)

Constructive insiders who are retained temporarily by the company in whose securities they trade—such as accountants, lawyers, and investment bankers—are viewed as having the same 10b-5 duties as corporate insiders. See Dirks (dictum). Lower courts have also inferred status as constructive insider in family settings where there are expectations of confidentiality.

Tippers

Those with a confidentiality duty (whether an insider or outsider) who knowingly make improper tips are liable as participants in illegal insider trading. See Dirks, Salman. The tip is improper if the tipper expects the tippee will trade and anticipates personal benefits—such as when she sells the tip, gives it to family or friends, or expects the tippee to return the favor. This liability extends to subtippers who know (or should know) a tip is confidential and came from someone who tipped improperly. The tipper or subtipper can be held liable even though she does not trade, so long as a tippee or subtippee down the line eventually does.

Tippees

Those without a confidentiality duty inherit a 10b-5 abstain-or-disclose duty when they trade on improper tips. Dirks, Salman. A tippee is liable for trading after obtaining material, nonpublic information that he knows (or has reason to know) came from a person who breached a confidentiality duty. In addition, subtippees tipped by a tippee assume a duty not to trade if they know (or should know) the information originally came from a breach of duty.

Traders in derivative securities

The 10b-5 duty extends to trading with nonshareholders—such as options traders. O’Hagan (call options). The Insider Trading Sanctions Act of 1984 makes it unlawful to trade in any derivative instruments while in possession of material, nonpublic information if trading in the underlying securities is illegal. Exchange Act §20(d).

Strangers

A stranger with no relationship to the source of material, nonpublic information —whether from an insider or outsider— has no 10b-5 duty to disclose or abstain. Chiarella. Strangers who overhear the information or develop it on their own have no 10b-5 duties.




Influence

Insider trading is an important problem countries with a capital market faces. It not only bar update of effeciency of a capital market, but also cut down confidence of broad public investors to the capital market, raising its cost of financing.



Reasons for Regulation of Insider Trading


Enhance fairness

Insider trading is unfair to those who trade without access to the same information available to insiders and others“in the know”—a fairness rationale. The legislative history of the Exchange Act, for example, is replete with congressional concern about “abuses”in trading by insiders. This fairness notion, however, has not been generally accepted by state corporate law, which has steadfastly refused to infer a duty of candor by corporate insiders to shareholders in anonymous trading markets. See Goodwin v. Agassiz, 186 N.E. 659 (Mass. 1933) (rejecting duty of insiders to shareholders except in face-to-face dealings). Moreover, a fiduciaryfairness rationale cannot explain regulation of outsider trading based on misappropriated information.


Preserve market integrity

Insider trading undermines the integrity of stock trading markets, making investors leery of putting their money into a market in which they can be exploited—a market integrity rationale. A fair and informed securities trading market, essential to raising capital, was the purpose of the Exchange Act. Moreover, market intermediaries (such as stock exchange specialists or over-the-counter market makers) may increase the spread between their bid and ask prices if they fear being victimized by insider traders. Greater spreads increase trading costs and undermine market confidence. Yet a market integrity explanation may overstate the case for insider trading regulation. Many professional participants in the securities markets already trade on superior information; the efficient capital market hypothesis posits that stock prices will reflect this better-informed trading.


Reduce cost of capital

Insider trading leads investors to discount the stock prices of companies (individually or generally) where insider trading is permitted, thus making it more expensive for these companies to raise capital—a cost of capital rationale. In stock markets outside the United States, studies show that cost of equity decreases when the market introduces and enforces insider trading prohibitions. For this reason, most U.S. public companies have insider trading policies that permit insiders to buy or sell company stock only during “trading windows”—usually 7 to 30 days after important company announcements.


Protect property rights

Insider trading exploits confidential information of great value to its holder—a business property rationale. Those who trade on confidential information reap profits without paying for their gain and undermine incentives to engage in commercial activities that depend on confidentiality. Although in the information age a property rationale makes sense, theories of liability, enforcement, and private damages have grown in the United States out of the rhetoric of fiduciary fairness and market integrity.





Enforcement of SEC

For insiders, SEC can implement administrative punishments, or request a court to impose civil punishment, or request DOJ to file criminal charges against them.


Civil Penalties Exchange Act §21A
SEC can seek a judicially imposed civil penalty against those who violate Rule 10b-5 or Rule 14e-3 of up to three times the profits realized or losses avoided by their insider trading.

“Watchdog” Penalties Exchange Act §21A
SEC can seek civil penalties against employers and others who "control" insider traders and tippers. Controlling persons are subject to additional penalties up to $1 million or three times the insider's profits (whichever is greater) if the controlling person knowingly or recklessly disregards the likelihood of insider trading by persons under its control. In addition, Broker-dealers that fail to maintain procedures protecting against such abuses may also be subject to these penalties if their laxity substantially contributed to the insider trading.

“Bounty” Rewards Exchange Act §21A(e)
SEC can pay bounties to anyone who provides information leading to civil penalties. The bounty can be up to 10 percent of the civil penalty collected.

Criminal Sanctions Exchange Act §32(a).

To punish those who engage in “willful” insider trading—that is, insider trading where the defendant knows that it is wrongful—the SEC can (and often does) refer cases to the U.S. Department of Justice for criminal prosecution.