Insider trading is the trading of a company’s securities by individuals with access to confidential or material 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). 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.
Courts impose liability for insider trading with Rule 10b-5 under the classical theory of insider trading and, since U.S. v. O’Hagan, 521 U.S. 642 (1997), under the misappropriation theory of insider trading.
Under the classical theory of insider trading, insiders who “tip” friends about material non-public information which may influence the company’s publicly traded stock price may be liable. 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 has the same duty as the insider imputed onto them. In other words, a friend may not make a trade based upon that privileged information. Failure to abide by the duty constitutes insider trading and creates grounds for liability. 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, 463 U.S. 646 (1983)was a pivotal U.S. Supreme Court decision regarding this type of insider trading. InDirks, 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. Dirksalso 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.
The emergence of the misappropriation theory of insider trading in O’Hagan has paved the way for passage of17 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. Under Rule 10b5-1, however, a defendant can assert an affirmative preplanned trade defense.
[Last updated in February of 2022 by the Wex Definitions Team]
