insider trading: an overview
Insider trading refers to the trading of a company’s stocks or other securities by individuals with access to confidential or non-public information. Taking advantage of this privileged access is considered a breach of the individual’s fiduciary duty.
The United States requires that a company report trading by corporate officers, directors, or other company members with significant access to privileged information to the Securities and Exchange Commission or be publicly disclosed. United States federal law defines an “insider” as a company’s officers, directors, or someone in control of at least 10% of a company’s equity securities. Congress has criminalized these insiders’ use of non-public information under the theory that the use fraudulently violates a fiduciary duty with which the company has charged the insider. From an economic public policy perspective, scholars consider insider trading socially undesirable because it increases the cost of capital for securities traders and therefore depresses economic growth. The Insider Trading Sanction Act of 1984 and the Insider Trading and Securities Exchange Act of 1988 provide for insider trading penalties to surpass three times the profits gained from the trade.
Problems also exist with regard to insiders “tipping” friends about non-public information that may influence the company’s publicly-traded stock price. Because the friends do meet the definition of an insider, a problem arose regarding how to prosecute these individuals. Today, a friend who receives such a tip becomes imputed with the same duty as the insider – that is not to make a trade based upon that privileged information. Failure to abide by the duty constitutes insider trading and creates grounds for a prosecution. The person receiving the tip, however, must have known or should have known that the information was company property to be convicted.
Dirks v. SEC proved a pivotal U.S. Supreme Court decision regarding this type of insider trading. In Dirks the Court held that a prosecutor could charge tip recipients with insider trading liability if the recipient had reason to believe that the information’s disclosure violated another’s fiduciary duty and if the recipient personally gained from acting upon the information. 463 U.S. 646 (1983). Dirks also created the constructive insider rule, which treats individuals working with a corporation on a professional basis as insiders if they come into contact with non-public information. Id.
The recent emergence of the misappropriation theory of insider trading has paved the way for passage of §10(b)-5, which permits criminal liability for an individual who trades on any stock based upon the misappropriated information. Previously, the prosecutor could only charge the insider if the stock of the insider’s company had been traded. While proof of insider trading can be difficult, the Securities and Exchange Commission actively monitors trading, looking for suspicious activity. See United States v. O’Hagan, 521 U.S. 642 (1997). Under §10(b)-5, however, a defendant can assert an affirmative preplanned trade defense.
The U.S. Supreme Court recently expounded on 10(b) in a pair of cases. In 2007 Tellabs, Inc. v. Makor Issues & Rights, LTD (06-484) determined the requisite specificity when alleging fraud. With Congress requiring enough facts from which "to draw a strong inference that the defendant acted with the required state of mind," the Supreme Court determined that a "strong inference" means a showing of "cogent and compelling evidence." In the 2007-2008 term, the Supreme Court determined that 10(b) does not provide non-government plaintiffs with a private cause of action against aiders and abettors in securities fraud cases, either explicitly or implicitly. See Stoneridge v. Scientific-Atlanta (06-43) (2008).
For more information, see Securities.
See also White-collar crime.
menu of sources
U.S. Constitution and Federal Statutes
- U.S. Code:
- CRS Annotated Constitution
- Title 17 C.F.R., Chapt. II - Securities and Exchange Commission
Federal Judicial Decisions
- U.S. Supreme Court:
- U.S. Circuit Courts of Appeals: Recent Securities Decisions
State Judicial Decisions
- N.Y. Court of Appeals:
- Appellate Decisions from Other States
Key Internet Sources
- Corporate Information from SEC Filings (EDGAR)
- Financial Industry Regulatory Authority (FINRA)
- Business and Corporations Law (Nolo)
- Stock Valuation:
- Federal Agencies:
UsefulOffnet (or Subscription - $) Sources
- Good Starting Point in Print: Thomas Lee Hazen, Hornbook on the Law of Securities Regulation, West Group, 5th ed. (2007)
- LII Downloads