Insider trading

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Insider trading is the trading of a company’s stocks or other securities by individuals with access to confidential or non-public information about the company.  Taking advantage of this privileged access is considered a breach of the individual’s fiduciary duty.

A company is required to report trading by corporate officers, directors, or other company members with significant access to privileged information to the Securities and Exchange Commission (SEC) or be publicly disclosed.  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 friends do not satisfy 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.  In other words, a friend must not make a trade based upon that privileged information.  Failure to abide by the duty constitutes insider trading and creates grounds for 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 17 CFR 240.10b5-1, 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 SEC actively monitors trading, looking for suspicious activity.  See United States v. O’Hagan, 521 U.S. 642 (1997).  Under §10b5-1, however, a defendant can assert an affirmative preplanned trade defense.

The U.S. Supreme Court expounded on 10(b) in a pair of cases.  In 2007, Tellabs, Inc. v. Makor Issues & Rights, LTD determined the requisite specificity when alleging fraud.  With Congress requiring sufficient 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, 443 F. 3d 987 (2008).

For more information, see Securities.

See also White-collar crime.