Insider Trading
November 9, 2021
Insider Trading
Insider-trading law has been shaped by competing
premised on the notion that all investors should have equal
institutional forces and theoretical perspectives. While the
access to material information about the securities they
Securities and Exchange Commission (SEC) and federal
trade. Although the defendants in Texas Gulf were insiders,
prosecutors have pushed for broad theories of liability
the court’s opinion did not limit the “disclose or abstain”
rooted in the value of equal access to information, the
rule to a corporation’s officers, directors, and agents.
courts have implemented a narrower framework predicated
Instead, the Second Circuit explained that the requirement
on fiduciary duty and fraud. Congress, however, has not
applied to anyone in possession of material nonpublic
weighed in on this back-and-forth. Despite the attention
information—regardless of their relationship to the
insider trading attracts, legislators have not enacted a
securities issuer.
statutory definition for the offense. Its elements are instead
the product of judicial decisionmaking, with SEC rules
The Supreme Court Alters the Approach
supplementing the core prohibition. Nevertheless, recent
The equal-access gloss on Rule 10b-5 did not last. In 1980,
Congresses have shown increasing interest in insider
the Supreme Court rejected that theory in Chiarella v.
trading, featuring several bills that would codify the
United States. The case involved an employee of a financial
elements of the offense and fill perceived gaps in existing
printer that prepared tender-offer documents for acquirers.
doctrine. This In Focus provides an overview of insider-
Based on information in these documents, the employee
trading law and recent efforts at legislative reform.
identified firms that were being targeted for acquisition and
purchased their shares before the bids were announced. The
The Evolution of Insider-Trading Law
employee thus clearly traded on the basis of material
nonpublic information. Nevertheless, he was not an insider
Origins
of the targeted firms, nor did his employer—which served
The modern insider-trading prohibition is grounded in
the acquirers—have any special relationship with them. In
Section 10(b) of the Securities Exchange Act and SEC Rule
Chiarella, the Court reversed the employee’s insider-
10b-5. Those provisions impose broad prohibitions of fraud
trading conviction based on the absence of such a
in connection with securities transactions, but do not
relationship. According to the Court, a trader’s failure to
explicitly mention insider trading. Nevertheless, the courts
disclose a material fact is fraudulent—and therefore
and regulators have constructed a complex legal regime on
violates Rule 10b-5—only if the trader has a duty to
top of this modest textual foundation.
disclose the fact. There is no such duty, however, absent a
“fiduciary or other similar relation of trust and confidence.”
The story begins in 1961, when the SEC first deployed Rule
While the Court acknowledged that corporate insiders owe
10b-5 to tackle open-market trading on the basis of inside
fiduciary duties to buyers and sellers of their companies’
information. In that year, the Commission settled an
shares, it concluded that the defendant in Chiarella had no
administrative enforcement action against a brokerage-firm
such relationship with the shareholders of the targeted
partner who sold shares of the Curtiss-Wright Corporation
firms. The Court therefore reversed the defendant’s
after learning of an impending dividend cut from one of the
conviction because the trial court’s jury instructions
corporation’s directors. The enforcement action—In re
improperly allowed for a conviction without a finding of
Cady, Roberts & Co.—marked the SEC’s first articulation
the requisite relationship.
of what became known as the “disclose or abstain” rule,
under which persons with special access to a corporation’s
In rejecting the equal-access model from Texas Gulf,
material nonpublic information must either disclose such
Chiarella sets forth the basic contours of what has been
information or abstain from trading the corporation’s
called the “classical” theory of insider-trading liability,
securities.
under which corporate insiders who trade on material
nonpublic information violate Rule 10b-5 by breaching a
While Cady, Roberts represented a notable expansion of
duty to their counterparties (buyers or sellers). The decision
Rule 10b-5, the Second Circuit accepted the SEC’s position
explicitly declined to consider an alternative theory, under
seven years later in SEC v. Texas Gulf Sulphur Co. The
which persons who trade on material nonpublic information
case offers a common insider-trading fact pattern: after a
can violate Rule 10b-5 by breaching a duty to the source of
mining company discovered promising mineral deposits—
the information (in Chiarella, the acquirers that had
but before it announced the discovery—several insiders
retained the defendant’s printing firm). This
bought the company’s shares and options to acquire its
“misappropriation” theory would remain in limbo until
shares. The Second Circuit embraced the SEC’s view that
the Supreme Court embraced it in its 1997 decision in
this conduct violated Rule 10b-5. In doing so, the court
United States v. O’Hagan. In that case, a partner at a law
articulated a broad theory of insider-trading liability
firm representing an acquirer in a takeover bid purchased
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Insider Trading
shares in the targeted firm before the transaction was
SEC Rules
publicly announced. Like the defendant in Chiarella, the
The SEC has responded to the Supreme Court’s fraud-based
lawyer owed no fiduciary duties to his counterparties (the
insider-trading doctrine with a series of rules designed to
target’s shareholders), and therefore could not be liable
patch perceived holes in the case law.
under the classical theory. Nevertheless, the Court
SEC Rule 14e-3 prohibits trading on material nonpublic
concluded that the attorney had violated Rule 10b-5 by
information related to tender offers when (1) the
misappropriating confidential information from the
information is derived from the offering person, issuer of
acquiring company that had retained his law firm. The
the securities sought by the offer, or an insider of the issuer,
Court explained that the attorney’s undisclosed
and (2) the bidder has taken substantial steps to commence
misappropriation of his principal’s information fell squarely
the offer. The SEC adopted the rule six months after the
within Rule 10b-5’s prohibition because it defrauded his
Supreme Court’s Chiarella decision in 1980, at the onset of
principal of the exclusive use of that information.
a decade marked by an explosion in corporate takeovers.
“Tippee” Liability
SEC Rule 10b5-1 defines the circumstances in which a
Rule 10b-5 is not limited to corporate insiders and persons
purchase or sale of securities constitutes trading “on the
who directly misappropriate nonpublic information. Rather,
basis of” material nonpublic information. The rule adopts a
much of the ambiguity in insider-trading law involves the
broad conception of this standard, defining “on the basis of”
circumstances in which defendants can be liable for trading
to include mere awareness of such information. Rule 10b5-
on the basis of a “tip” from such persons. The Supreme
1 also sets forth affirmative defenses for insiders who trade
Court’s decision in Dirks v. SEC remains the seminal case
pursuant to a preexisting contract, instruction, or written
on “tippee” liability. In Dirks, a former insider at a financial
plan. In response to allegations that corporate executives
conglomerate had leaked information about corporate fraud
regularly abuse Rule 10b5-1 trading plans, SEC Chair Gary
to a securities analyst. The analyst then passed the
Gensler and some Members of Congress have expressed
information to clients, who ultimately traded on it. The
interest in revisiting the rule.
Court rejected the SEC’s argument that the analyst had
violated Rule 10b-5 by relaying the information, reasoning
SEC Rule 10b5-2 provides a nonexclusive list of the
circumstances in which a person has a “duty of trust or
that tippees are liable for insider trading only if they know
confidence” for purposes of the misappropriation theory of
or should know that their tippers violated a fiduciary duty
or similar obligation by disclosing the information. For
insider-trading liability. The rule departs from a strict
such a violation to occur, the Court explained, the tipper
fiduciary model, providing that such a duty exists whenever
must seek to personally benefit from the disclosure.
(1) a person agrees to maintain information in confidence;
Because the tipper in Dirks was motivated by a desire to
(2) two people have a pattern or practice of sharing
expose corporate fraud rather than by the prospect of
confidences, such that the recipient of the information
pecuniary or reputational benefits, the Court concluded that
should know that the other person has an expectation of
there had been no breach of a duty—and therefore no
confidentiality; or (3) someone receives information from a
violation of Rule 10b-5 by the tippee.
spouse, parent, child, or sibling, provided that the defendant
does not affirmatively demonstrate the absence of an
Dirks’s “personal benefit” requirement has bedeviled the
expectation of confidentiality.
courts. In Dirks itself, the Supreme Court explained that the
standard could be satisfied with evidence suggesting a quid
Proposed Legislation
pro quo, or a “gift” of nonpublic information to “a trading
Recent Congresses have featured several pieces of insider-
relative or friend.” In the latter circumstance, the Court
trading legislation. H.R. 2655, the Insider Trading
reasoned, a tip resembles trading by the insider or
Prohibition Act (ITPA) (117th Cong.)—which the House
misappropriator himself, followed by a gift of the profits to
has passed—would retain the current fraud-based regime
the tippee. Later decisions have complicated this inquiry. In
but broaden it in certain respects. Among other things, the
2014, the Second Circuit adopted a restrictive view of the
bill would fill an oft-criticized gap in the law by prohibiting
“personal benefit” test in United States v. Newman, where it
trading on the basis of information that is obtained by
held that tippee liability requires proof of a “meaningfully
various illegal methods, even where there is no breach of a
close personal relationship that generates an exchange that
fiduciary duty or similar obligation. In the 114th Congress,
is objective, consequential, and represents at least a
H.R. 1173, the Ban Insider Trading Act (BITA), would
potential gain of a pecuniary or similarly valuable nature.”
have adopted a similar change and expressly dispensed with
This language stands in some tension with Dirks’s
the personal-benefit requirement for tippee liability. S. 702,
recognition that a tipper can personally benefit from a gift
the Stop Illegal Insider Trading Act (114th Cong.),
of information to a relative or friend. The Supreme Court
would have gone further than either the ITPA or the BITA
partially clarified the law in its 2016 decision in Salman v.
and replaced the current fraud-based regime with an equal-
United States, where it rejected Newman’s conclusion that
access model prohibiting any trading on the basis of
the personal-benefit test requires a tipper and tippee to have
material nonpublic information. Finally, S. 2211 and H.R.
exchanged something of “pecuniary or similarly valuable
1528, the Promoting Transparent Standards for
nature.” Even so, the status and scope of Newman’s
Corporate Insiders Act (117th Cong.), would direct the
“meaningfully close personal relationship” requirement
SEC to study possible revisions to Rule 10b5-1.
remain unsettled.
Jay B. Sykes, Legislative Attorney
IF11966
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Insider Trading
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