Key Takeaways
- Insider trading is trading securities based on material nonpublic information (MNPI) in violation of a duty of trust or confidence
- Material information is information a reasonable investor would consider important when making an investment decision, such as pending mergers or earnings surprises
- Information remains nonpublic until it has been released through official channels, widely disseminated, and the market has had time to absorb it
- SEC Rule 10b5-1 trading plans provide an affirmative defense if established when the insider has no MNPI, with a 90-day cooling-off period for directors/officers
- Penalties for insider trading include disgorgement of all profits, civil fines up to 3x the profit gained, criminal fines up to $5 million, and imprisonment up to 20 years
Insider Trading
Insider trading is one of the most serious securities violations. Understanding what constitutes insider trading and how to avoid it is essential for the SIE exam and a career in the securities industry.
What is Insider Trading?
Insider trading is the purchase or sale of a security based on material nonpublic information (MNPI) in violation of a duty of trust or confidence.
Key Elements
| Element | Description |
|---|---|
| Material Information | Information a reasonable investor would consider important |
| Nonpublic Information | Information not publicly available |
| Duty of Trust | Obligation owed to source of information |
| Trading on Basis of | Being aware of MNPI when trading |
Material Nonpublic Information (MNPI)
What Makes Information "Material"?
Information is material if a reasonable investor would consider it important when making an investment decision.
Examples of Material Information
| Positive MNPI | Negative MNPI |
|---|---|
| Earnings significantly better than expected | Earnings significantly worse than expected |
| Pending merger or acquisition | Loss of major customer |
| FDA drug approval | Pending SEC investigation |
| Major contract win | Product recall |
| Stock split or dividend increase | Executive departure |
What Makes Information "Nonpublic"?
Information is nonpublic if it has not been:
- Released through official channels
- Widely disseminated to the investing public
- Available long enough for the market to absorb it
Key Point: Even after an announcement, information may remain "nonpublic" until it's widely disseminated and the market has had time to react.
Who Can Commit Insider Trading?
Traditional Insiders
| Insider Type | Examples |
|---|---|
| Corporate Insiders | Officers, directors, employees |
| Temporary Insiders | Attorneys, accountants, consultants |
| Controlling Shareholders | Large shareholders with inside access |
Tippees
A tippee is someone who receives material nonpublic information from an insider.
| Condition | Liability |
|---|---|
| Tipper breached duty for personal benefit | Tippee can be liable |
| Tippee knew or should have known information was inside | Tippee can be liable |
| Information received innocently | May still be prohibited from trading |
Misappropriation Theory
Even non-insiders can violate insider trading laws if they:
- Steal information
- Misappropriate information from their employer
- Trade on information obtained through deception
SEC Rule 10b-5
SEC Rule 10b-5 is the primary antifraud rule prohibiting insider trading.
What Rule 10b-5 Prohibits
It is unlawful to:
- Use any device to defraud
- Make untrue statements of material fact
- Omit material facts that make statements misleading
- Engage in fraudulent practices
"On the Basis Of" Standard
A trade is made "on the basis of" MNPI if the person was aware of the information when trading.
Note: You don't need to prove the information caused the trade—awareness is sufficient.
Rule 10b5-1: Trading Plans
Rule 10b5-1 provides an affirmative defense for insiders who trade pursuant to a pre-established trading plan.
10b5-1 Plan Requirements
| Requirement | Description |
|---|---|
| Adopted when "clean" | No MNPI at time of plan adoption |
| Written plan | Must be documented |
| Specifies terms | Price, amount, date predetermined |
| Cooling-off period | Cannot trade immediately after adoption |
| Good faith | Cannot alter plan based on MNPI |
Cooling-Off Period (2023 Amendments)
| Who | Minimum Cooling-Off |
|---|---|
| Directors and officers | 90 days (up to 120) |
| Other insiders | 30 days |
Additional Requirements
- Cannot have overlapping plans
- Directors/officers must certify no MNPI at adoption
- Cannot adopt plan during blackout periods
Information Barriers (Chinese Walls)
Information barriers prevent the flow of MNPI between departments.
Purpose
| Function | Description |
|---|---|
| Prevent conflicts | Keep research separate from investment banking |
| Maintain integrity | Ensure recommendations aren't influenced by deals |
| Compliance | Satisfy regulatory requirements |
Common Barriers
- Physical separation of departments
- Separate computer systems
- Restricted access to information
- Different reporting lines
- Watch lists and restricted lists
Watch Lists and Restricted Lists
Watch List
- Securities monitored for potential MNPI
- Internal surveillance tool
- Not disclosed to employees
- Triggers enhanced review of trades
Restricted List
- Securities where trading is prohibited
- Disclosed to relevant employees
- Firm may not trade or recommend
- Used when firm has MNPI
Penalties for Insider Trading
Civil Penalties
| Penalty | Maximum |
|---|---|
| Disgorgement | Return of all profits |
| Civil fines | Up to 3x the profit gained or loss avoided |
| Injunctions | Court orders to cease violations |
Criminal Penalties
| Penalty | Maximum |
|---|---|
| Fines (individuals) | Up to $5 million |
| Fines (entities) | Up to $25 million |
| Imprisonment | Up to 20 years |
Administrative Actions
- Industry bars
- Suspension from industry
- Censure
- Additional fines
Obligations When Aware of MNPI
If you become aware of MNPI, you must:
- Abstain from trading in that security
- Not tip others about the information
- Report to compliance department
- Wait until information is public and absorbed
Warning: You must refrain from trading even if it means suffering a loss or missing a profit opportunity.
Front Running vs. Insider Trading
| Front Running | Insider Trading | |
|---|---|---|
| Information Source | Customer order | Corporate information |
| Who Violates | Broker-dealer | Anyone with MNPI |
| What's Used | Knowledge of pending order | Material nonpublic info |
Both are prohibited but arise from different sources.
Case Examples
Typical Insider Trading Scenario
- Executive learns of pending merger (MNPI)
- Executive buys stock before announcement
- Stock price rises on merger news
- Executive sells at profit
- Result: Violation of Section 10(b) and Rule 10b-5
Tippee Scenario
- Corporate officer tells friend about earnings miss
- Friend sells stock before announcement
- Stock drops on earnings news
- Result: Both tipper and tippee liable
Key Takeaways
- MNPI = information a reasonable investor would consider important that isn't public
- Trading while aware of MNPI violates Rule 10b-5
- Both insiders and tippees can be liable
- 10b5-1 plans provide a defense if properly established
- Information barriers prevent MNPI from spreading
- Penalties include disgorgement, fines, and imprisonment
- When in doubt, don't trade—report to compliance
Which of the following BEST describes "material" information for purposes of insider trading rules?
A corporate executive learns that their company will announce better-than-expected earnings tomorrow. The executive immediately buys shares. This is an example of:
What is the purpose of a Rule 10b5-1 trading plan?