classical theory of insider trading

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The classical theory of insider trading is a form of insider trading where a corporate insider—i.e. an employee, director, or officer—commits securities fraud under Rule 10b-5 by trading in securities of their company on the basis of material non-public information. 

The classical theory of insider trading requires that the individual trading on inside information have a fiduciary duty to disclose the information. For example, a corporate director or officer cannot trade in their corporation’s stock based on material non-public information because they have a fiduciary duty to disclose such information. In Chiarella v. U.S., 445 U.S. 222 (1980), the U.S. Supreme Court considered a case where a printer of corporate takeover bids deduced the concealed party names and purchased stock in the target company before the takeover bid became public without disclosing his knowledge of the takeover bid. Once the takeover bid became public, the printer sold the target stock and earned a significant return. The Supreme Court held that the printer did not commit securities fraud because he had no duty to disclose the information of the takeover bid to the seller of the target security. 

Additionally, a corporate insider who tips an outside party inside information may be liable under the classical theory of insider trading if they personally benefited from the tip. In Salman v. U.S., 137 S.Ct. 420 (2016), the Supreme Court considered a case where an investment banker gave investment tips he learned from his deals to his brother, who in turn traded on the information. The Supreme Court upheld the investment banker’s conviction under Rule 10b-5 because he personally benefited from gifting the inside information, which constituted a fiduciary breach. The Court also upheld his brother’s conviction because he assumed his brother’s fiduciary breach and traded on the inside information.  

In U.S. v. O’Hagan, 521 U.S. 642 (1997), however, the Supreme Court abrogated Chiarella’s requirement that the trader possessed a duty to disclose by adopting the misappropriation theory of insider trading

[Last updated in January of 2022 by the Wex Definitions Team]