Insider Trading

Insider trading is the purchase or sale of a security on the basis of material nonpublic information about that security or its issuer, in breach of a duty of trust or confidence. The Securities and Exchange Commission's Rule 10b5-1(a) states the prohibited conduct as being among the "manipulative or deceptive device[s] or contrivance[s]" barred by section 10(b) of the Exchange Act and Rule 10b-5, namely a purchase or sale "on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information."

That final clause is the whole reason an ordinary person can be caught by this. The duty does not have to run to the company; it can run to whoever told you.

There is no statute that defines insider trading, and this is not an inference. The SEC says it in its own regulatory text. Rule 10b5-1(b) provides that "the law of insider trading is otherwise defined by judicial opinions construing Rule 10b-5, and Rule 10b5-1 does not modify the scope of insider trading law in any other respect", and the Preliminary Note to Rule 10b5-2 describes that rule as supplying "a non-exclusive definition" and repeats the same sentence. So the prohibition sits on a three-clause antifraud rule the Commission adopted in 1942, with everything else supplied by courts. That is unusual for a rule carrying criminal liability, and it explains why the answers to specific questions come from cases rather than from a code section.

Two theories, and both are in the rule's own text. The classical theory covers a person who owes a duty to the issuer or its shareholders: a director, an officer, an employee. The misappropriation theory covers a person who owes the duty to whoever was the source of the information, and it is the clause quoted above, "or to any other person who is the source of the material nonpublic information". Rule 10b5-2 is titled for it: "Duties of trust or confidence in misappropriation insider trading cases". The practical difference is that under the misappropriation theory the defendant may have no connection to the company whose shares they traded.

The single most useful paragraph on this page is Rule 10b5-2(b), because it is about families. For the purposes of the misappropriation theory, the rule provides that a duty of trust or confidence exists "in the following circumstances, among others: (1) Whenever a person agrees to maintain information in confidence; (2) Whenever the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality; or (3) Whenever a person receives or obtains material nonpublic information from his or her spouse, parent, child, or sibling."

Paragraph (3) is close to a presumption, and it has an express way out written into the same paragraph: the recipient "may demonstrate that no duty of trust or confidence existed with respect to the information, by establishing that he or she neither knew nor reasonably should have known that the person who was the source of the information expected that the person would keep the information confidential, because of the parties' history, pattern, or practice of sharing and maintaining confidences, and because there was no agreement or understanding to maintain the confidentiality of the information." Both halves are needed, and the burden is on the person who traded.

Awareness, not use. Rule 10b5-1(b) provides that a purchase or sale is on the basis of material nonpublic information "if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale", subject to the affirmative defenses in paragraph (c). So the argument that the information played no part in a decision already made is not available on the face of the rule; what is available is the pre-arranged plan defense described below.

A tippee acquires the tipper's duty, and the test is the tipper's benefit. In Salman v. United States, decided December 6, 2016, the Supreme Court reaffirmed Dirks v. SEC, 463 U.S. 646, holding that a tipper breaches a fiduciary duty by making a gift of confidential information to a trading relative or friend. Quoting Dirks, the Court wrote that "[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend", because in such cases "[t]he tip and trade resemble trading by the insider followed by a gift of the profits to the recipient". Salman itself involved information passed from an investment banker to his brother and on to a brother-in-law, and the Court held the jury could infer the personal benefit from the gift to a trading relative. Personal benefit, Dirks had explained, can often be inferred "from objective facts and circumstances", such as a relationship suggesting a quid pro quo or an intention to benefit the recipient.

Rule 10b5-1 plans are the mechanism insiders actually use, and the cooling-off periods were tightened in December 2022. The rule's affirmative defense protects a purchase or sale made under a contract, instruction or written plan adopted before the person became aware of the information, provided the plan specified the amount, price and date, or supplied a formula, or removed the person's later influence over it. Since the December 2022 amendment (87 FR 80429) the defense carries further conditions:

· The plan must have been entered into in good faith "and not as part of a plan or scheme to evade the prohibitions of this section", and the person must have acted in good faith with respect to it.

· A director or officer (as defined in Rule 16a-1(f)) may not trade until the expiration of a cooling-off period consisting of the later of ninety days after adoption, or two business days following disclosure of the issuer's financial results in a Form 10-Q or 10-K for the completed fiscal quarter in which the plan was adopted — "but, in any event, this required cooling-off period is subject to a maximum of 120 days after adoption".

· Anyone who is not the issuer and not a director or officer waits thirty days after adoption.

· A director or officer must include a certification in the plan that, on the date of adoption, they are not aware of material nonpublic information and are adopting the plan in good faith.

· A single-plan limitation applies, with a narrow exception for one later-commencing plan, and any change to the amount, price or timing of the trades is treated as terminating the plan and adopting a new one, which restarts the clock.

Other investors can sue, and the damages are capped by the statute. 15 U.S.C. 78t-1(a) provides that a person who violates the chapter or its rules "by purchasing or selling a security while in possession of material, nonpublic information shall be liable in an action in any court of competent jurisdiction to any person who, contemporaneously with the purchase or sale of securities that is the subject of such violation, has purchased … or sold … securities of the same class." Subsection (b)(1) caps it: "the total amount of damages imposed under subsection (a) shall not exceed the profit gained or loss avoided in the transaction or transactions that are the subject of the violation." And subsection (c) makes a person who violates the chapter by communicating the information jointly and severally liable with the trader, to the same extent, so a tipper's exposure is not limited to their own trading.

Regulation FD, the SEC's rule on selective disclosure by issuers, sits alongside all of this and is a different subject: it governs what a company may tell some investors and not others.

1. Information exists that is material and not public. Materiality is judged by how it would matter to an investor, not by how confidential it felt.

2. Somebody owes a duty of trust or confidence with respect to it: to the issuer and its shareholders, or to whoever was the source.

3. A trade happens while the person is aware of the information. The standard on the face of Rule 10b5-1(b) is awareness, not proven use.

4. If a tippee traded, the question becomes whether the tipper disclosed for a personal benefit, which Dirks allows to be inferred from a gift to a trading relative or friend, and whether the tippee knew of the breach.

5. A pre-arranged plan may supply a defense, but only if it meets Rule 10b5-1(c)'s conditions, including the cooling-off period and, for a director or officer, the certification.

A hypothetical example of the cooling-off arithmetic. A chief financial officer adopts a written selling plan on March 3. Ninety days after adoption is June 1. The company files the Form 10-Q for the quarter in which the plan was adopted on May 8, and two business days after that is May 12. The cooling-off period is the later of the two, so it ends on June 1, and the 120-day maximum, which would fall on July 1, is not reached. No sale under the plan may occur before June 1.

A hypothetical example of the damages cap. An officer sells 5,000 shares at $60 the day before an announcement that takes the price to $38. The loss avoided is 5,000 × ($60 − $38) = 5,000 × $22 = $110,000. Under 15 U.S.C. 78t-1(b)(1) the total damages recoverable by all contemporaneous traders in that class of securities cannot exceed that $110,000, however many of them there are and however much they lost between them. Figures are illustrative.

Insider trading is prohibited conduct, so instead of pros and cons this section sets out what is legitimate and where the line is genuinely uncertain.

What is clearly permitted

• Trading on public information, including public information other people have not bothered to read.
• Trading on your own research, inference or analysis, however good, provided no duty was breached to obtain the inputs.
• Selling or buying company stock under a plan that satisfies Rule 10b5-1(c), including its cooling-off period and, for a director or officer, its certification.
• Holding through an event you happen to know about. The rule reaches purchases and sales, not inaction.

Where it is genuinely uncertain, and why

• Materiality is a judgment, not a threshold, and it is assessed after the fact by people who know what happened next.
• What counts as public is a question of degree: information disclosed to a handful of analysts is not obviously public and not obviously private.
• The family presumption in Rule 10b5-2(b)(3) can be rebutted, but the burden is on the person who traded and the rule requires both of its conditions to be met.
• Because the substance of the law comes from judicial opinions rather than a statute, the answer to an unusual set of facts is genuinely hard to predict, and a modest trade can carry criminal exposure.