1. Insider Trading (Federal Law)
Classic insider trading
Tipping liability
Outsider trading (misappropriation)
Last updated 23 Feb 11

2. Rule 10b-5 Fraud (tort of deceit)
Material misrepresentation
Intentional (defendant aware of truth)
Reliance (plaintiff relies reasonably)
Misrepresentation is cause of loss
Damages
Securities Exchange Act of 1934 Act § 10
It shall be unlawful for any person ...
(b) To use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe

3. Section 10(b) Fraud (tort of deceit)
Material misrepresentation
Intentional (defendant aware of truth)
Reliance (plaintiff relies reasonably)
Misrepresentation is cause of loss
Damages
Securities Exchange Act of 1934 Act § 10
It shall be unlawful for any person ...
(b) To use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe
Fraud (tort of deceit)
Material misrepresentation
Intentional (defendant aware of truth)
Reliance (plaintiff relies reasonably)
Misrepresentation is cause of loss
Damages

4. Classic Insider Trading
Misappropriation (Outsider Trading)
Company shareholders
Outside shareholders
Silence = fraud
(duty of trust/confidence)
Violates duty to source
Tip violates duty *
Knows / reason to know
* improper benefit
INSIDER
10b5-2
Confidentiality agreement
Confidentiality practice
Family member – functional
Tippee
Tippee
Rule 10b5-1: state of mind when trading “on the basis” of material, nonpublic information
“aware” (“conscious knowledge”)
Pre-existing trading plans

5. Classic insider trading …

6. Cady Roberts (SEC 1961) “Classic” Curtiss-Wright
Investors / shareholders
Sell to new investors (sell short)
Gintel (director)
Curtiss-Wright
Non-public, material information
(board votes to cut dividends)

7. Duty to abstain or disclose …

8. Non-public, material info
Chiarella v. US (US 1980)
“Outsider”
shareholders
Pandick
Press
Chiarella
Shareholders
Insider
Acquiror Inc
Non-public, material info
(takeover plans)
Target
Company

9. Chiarella v. US (US 1980)
"... silence in connection with the purchase or sale of securities may operate as fraud actionable under § 10(b) ... But such liability is premised upon a duty to disclose arising from a relationship of trust and confidence between parties to a transaction.”
Justice Lewis Powell

10. Tipping liability …

11. Investors / shareholders
Dirks v. SEC (US 1983)
“Tipping”
Investors / shareholders
Clients dump stock
Secrist
Equity Funding
Non-public, material information
(massive accounting fraud)
Dirks
(analyst)

12. Dirks v. SEC (US 1983)
... a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.
Whether the "tip" was a breach of the insider's fiduciary duty [depends on] whether ... the insider receives a direct or indirect personal benefit that will translate into future earnings.
Justice Lewis Powell

13. Hypothetical “Tipping” Spouse Secrest Investors / shareholders
Sell Stock
Spouse
Secrest
Equity Funding
Non-public, material information
Massive accounting fraud)

14. Martha Stewart …

15. SEC v. Stewart (settled 2006)
“Tipping”
Sells stock
Stock market
Martha
Stewart
(at airport)
Sam
Wachtal
(CEO)
Imclone
Non-public, material information
(FDA likely to disapprove drug)
Faneuil
(ass’t)

16. Outsider Trading … (Misappropriation)

17. US v. O’Hagan (US 1997) “Misappropriation” Shareholders Option
Buy, buy, buy
Shareholders
Option
sellers
Dorsey &
Whitney
O’Hagan
Insider
Grand Met
Non-public, material info
(plan to make tender offer
To Pillsbury shareholders)
Shareholders
Pillsbury

18. Justice Ruth Bader Ginsberg
US v. O’Hagan (US 1997)
The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. …
Under this theory, a fiduciary's undisclosed, self- serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.
Justice Ruth Bader Ginsberg

19. Justice Ruth Bader Ginsberg
US v. O’Hagan (US 1997)
[The "in connection with the purchase or sale of [a] security"] element is satisfied because the fiduciary's fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities. … This is so even though the person or entity defrauded is not the other party to the trade, but is, instead, the source of the nonpublic information.
Justice Ruth Bader Ginsberg

20. US law of insider trading …

21. Classic insider trading:
Fraudulent silence under Section 10(b)
duty of trust or confidence to “abstain or disclose”
Tipping liability:
know or should know that
tipper has breached duty for improper personal benefit
Misappropriation liability:
Fraud on source “in connection with” securities trading
Maintain integrity of securities markets

22. Classic insider trading:
Fraudulent silence under Section 10(b)
duty of trust or confidence to “abstain or disclose”
Tipping liability:
know or should know that
tipper has breached duty for improper personal benefit
Misappropriation liability:
Fraud on source “in connection with” securities trading
Maintain integrity of securities markets

23. Classic insider trading:
Fraudulent silence under Section 10(b)
duty of trust or confidence to “abstain or disclose”
Tipping liability:
know or should know that
tipper has breached duty for improper personal benefit
Misappropriation liability:
Fraud on source “in connection with” securities trading
Maintain integrity of securities markets

24. SEC rulemaking role …

25. Effect of SEC rules
Rule 10b5-1: state of mind when trading “on the basis” of material, nonpublic information
“aware” (“conscious knowledge”)
Pre-existing trading plans
Rule 10b5-2: duty to source in business/personal relations
Agree to maintain confidentiality
Practice of sharing known confidences
Spouse, parent, child, sibling – unless no confidentiality
Regulation FD: no special access for analysts