What Constitutes Insider Trading Under SEC Rules??

Federal statutes do not contain a standalone definition of illegal insider trading. Instead, “insider trading” is a term that is used by the U.S. government (and the media) to refer to conduct that triggers liability under the Securities Exchange Act of 1934 and various subsequent rules and regulations.

The vast majority of insider trading cases are anchored to Rule 10b-5, which prohibits fraud and fraudulent conduct “in connection with” purchasing or selling securities. This rule was adopted by the U.S. Securities and Exchange Commission (SEC) in 1942 under Section 10(b) of the Securities Exchange Act of 1934. The Securities Exchange Act of 1934 created the SEC, and the Securities Act of 1933 introduced federal disclosure requirements for all public company offerings. Together, these two laws have served as the bedrock for nine decades of insider trading law and enforcement.

Although Rule 10b-5 is the source of liability in many insider trading cases, it is a general antifraud rule rather than legislation specifically targeting insider trading. As a result, establishing liability under Rule 10b-5 typically requires showing that a defendant breached a fiduciary or confidentiality duty. Mere access to material nonpublic information, whether gained through insider status or some other means, is not enough to establish liability.

Rule 10b-5 liability also requires a showing of “scienter,” which refers to either intentional or reckless conduct. This makes a substantial difference between insider trading cases with and without scienter. It is also a critical distinction that is often overlooked in the media, which frequently refers to all insider trading as “illegal” without clarifying the legal distinctions involved.

As we explain below, Rule 10b-5 and the Securities Exchange Act of 1934 are just two examples of the numerous laws and rules that can expose investors to liability for insider trading. We also outline examples of insider trading that involve and that do not involve scienter.

When is information material, nonpublic, and safe to trade on?

What does it mean for information to be “material”?

In a general sense, material information is information that would influence a reasonable investor’s decision to purchase or sell a particular security. This includes, but is not limited to, information related to:

• Earnings announcements
• Pending mergers and acquisitions
• Impending product events (e.g., FDA approvals)
• Upcoming clinical trial results
• Product launches or product delays
• Other similar events or situations

How is the materiality of contingent events determined?

When the information in question relates to a pending event that is not yet a certainty, the relevant case is Basic Inc. v. Levinson, a U.S. Supreme Court case from 1988. Under Basic Inc. v. Levinson, materiality is determined by “balancing the probability that the event will occur against the anticipated magnitude of the event in light of the totality of the company affect on its shareholders (a corporate transaction’s probability of completion by time of sale x the transaction’s materiality if completed).”

What does it mean for information to be “nonpublic”?

In broad terms, nonpublic information is information that has not yet been disclosed through broad, public communication channels. Once an issuer makes information public, investors no longer face liability for trading in connection with that information, and they no longer need to be mindful of Regulation FD or other regulations that prohibit selective disclosure.

Does the SEC establish a specific waiting period for “nonpublic” information to become “public” information?

No. While the SEC has not adopted any rule establishing a universal waiting period following a public disclosure, public information must generally be broadly disseminated and the relevant investor(s) must have a reasonable opportunity to absorb that information.

What is Regulation FD?

Regulation FD prohibits issuers from selective disclosure. Importantly, this regulation applies regardless of whether the recipient of the nonpublic information trades or not. Under Regulation FD, issuers that intentionally disclose information must disclose that information “simultaneously.” Issuers that unintentionally disclose information must disclose it “promptly.”

Whose breached duty can turn informed trading into fraud?

Corporate employees may legally trade their company’s securities as long as their transactions do not violate any antifraud rule. However, nonemployees can face insider trading liability when they misuse confidential information that is protected by a duty, and in these cases, it is the informed trader’s duty to their information source (rather than to the company’s shareholders) that is at issue.

The concept of “classical insider trading” is well-known to the public, and liability under this theory arises when corporate insiders buy or sell their own company’s securities while breaching a duty of trust or confidence. As the U.S. Supreme Court explained in United States v. O’Hagan (1997), the “misappropriation theory” of insider trading expands upon this. Misappropriation liability arises when informed trading constitutes a breach of the informed trader’s duty to their information source. In other words, misappropriation liability recognizes the possibility of deceiving an information source by using that information improperly.

As a result of O’Hagan, the Securities and Exchange Commission (SEC) adopted Rule 10b5-2, which provides a list of relationships that can give rise to a “duty of trust or confidence.” These examples are nonexclusive, and they include relationships where:

• The parties have a history of sharing confidences.
• An agreement (express or implied) limits disclosure.
• An investor agrees to keep information confidential.
• There is a corporate or other employer-employee relationship.
• The parties are related as spouses, parents, children, or siblings. (Rule 10b5-2(b)(3) presumes a duty in these relationships, but this presumption can be rebutted in some cases).

In addition to Rule 10b5-2, the Supreme Court also formally adopted the misappropriation theory of insider trading in 1997, when it affirmed the convictions of a law firm employee who used information about a confidential acquisition to purchase stock in the target company. This decision underscored the Supreme Court’s endorsement of a broad and continuing expansion of federal insider trading liability to reach informed trades that do not fit squarely within the classical insider trading scenario.

When does receiving or sharing a tip create liability?

When does a tipper face liability?

A tipper may face liability regardless of whether it personally executes any trades. A tipper’s liability depends on its own breach of a fiduciary or confidentiality duty, rather than the fact that it gave information to someone who then executed an insider trade. It also depends on the tipper’s scienter (i.e., its knowledge that its disclosure would facilitate securities transactions). As the Supreme Court explained, “No liability can attach to a tipper that violates no antifraud rule.” (See Dirks v. SEC, 463 U.S. 646 (1983)).

When does a tippee face liability?

Liability attaches for a tippee who receives or shares information in breach of a fiduciary or confidentiality duty if three requirements are met:

• The tipper receives a personal benefit in exchange for disclosure.
• The tippee knows that the tipper breached its duty of trust or confidence.
• The tippee knowingly uses the nonpublic information to buy or sell securities.

These are three of four requirements (or four of five, depending on how they are grouped) for tippee liability. These requirements are essentially the elements of a Rule 10b-5 claim.

How is the “personal benefit” of a tipper determined?

The personal benefit element is established through either direct or circumstantial evidence. As a result, a close relationship between a tipper and tippee is a factor to consider; however, by itself, a close relationship is not sufficient to establish a personal benefit (and to satisfy the Dirks personal-benefit requirement).

What if a tippee receives information from someone who received a tip from someone else?

This is referred to as “remote tippee” liability. An informed trader who receives a tip from someone else who received the tip from the original insider (or some other information source) remains potentially liable if there is evidence that the trader had knowledge of the original breach.

When did the Supreme Court address the personal-benefit requirement for tipper liability?

The Supreme Court addressed this requirement in Dirks v. SEC (1983), and again in Salman v. United States (2016). In Salman, the Court confirmed that “giving a gift of confidential business information to a trading relative or friend is functionally the same as trading on the information himself.”

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Does tender-offer trading require a fiduciary-duty breach?

In a general sense, mere possession of undisclosed, material information is not enough to establish insider-trading liability. Similarly, simply having an informational advantage does not satisfy the governing antifraud elements of liability. Instead, informed trading becomes “illegal insider trading” in certain circumstances, most notably when:

• The conduct involves a merger or acquisition and Rule 14e-3 imposes liability for tender-offer trading in connection with the acquisition;
• The conduct involves a breach of a fiduciary or confidentiality duty (or use of material information that was obtained from someone who breached a fiduciary or confidentiality duty); and
• The conduct involves scienter (which includes, but is not limited to, insider status or membership of a protected class of “insiders”).

Insider trading involving a tender offer is unique because it can fall within Rule 14e-3, which can establish liability without proving the breach of a fiduciary or confidentiality duty. The rule prohibits anyone from purchasing or selling a security in connection with a “tender offer” that has not yet been public. This can make Rule 14e-3 more applicable in SEC cases that do not meet other elements for insider-trading liability. Rule 14e-3 takes effect once “substantial steps” have been taken toward completing a tender offer, and it applies to all informed persons who know (or have reason to know) that the nonpublic information they possess:

• Is material;
• Came from the tender offer’s offeror, target, or agent; and
• Has not been disclosed to the public.

How can insiders trade legally without violating SEC rules?

Insiders often have the ability to trade in compliance with the Securities Exchange Act of 1934. In addition to the general restrictions on informed trading and the reporting and recovery rules related to Section 16 trades, public company insiders must also comply with the SEC’s specific rules governing trading plans under Rule 10b5-1. In 2022, the SEC announced significant updates to these rules.

1. Insider Trading under Rule 10b5-1 Trading Plans

Rule 10b5-1 is an affirmative defense against liability for insider trading. While the rule contains a comprehensive list of requirements to obtain this defense, the three most important ones (which were significantly tightened by the SEC’s most recent 2022 amendments) are:

• Cooling-Off Period. Directors and officers must wait 90 days after adopting or modifying their qualifying trading plans before they can execute trades (unless the insider can demonstrate that the trades would have been executed anyway). This cooling-off period is capped at 120 days, and persons other than directors and officers are subject to a 30-day cooling-off period instead.
• Representation as to Material Nonpublic Information. Before adopting, modifying, or amending qualifying trading plans, directors and officers must represent that they do not possess material nonpublic information at the time of adoption.
• Single-Plan Limitation. Generally, Rule 10b5-1 bars insiders from using multiple overlapping trading plans, except for single-trade plans.

The Rule 10b5-1 affirmative defense also requires insiders to adopt and operate their trading plans in “good faith,” a broad requirement that is subject to extensive debate. Ultimately, this Requirement depends on a case-by-case evaluation of all circumstances involved.

2. Section 16 Reporting and Recovery Rules

Section 16 of the Securities Exchange Act of 1934 also contains general restrictions on insiders trading in their company’s securities. These restrictions do not depend on the insider’s possession of material nonpublic information. There are two main aspects:

• Reporting Obligations under Section 16(a). Under Section 16(a) of the Securities Exchange Act of 1934, issuers’ insiders must generally disclose their trades within two business days (and they generally must do so by filing Form 4).
• Short-Swing Profit Recovery under Section 16(b). Under Section 16(b) of the Securities Exchange Act of 1934, if a public company insider buys and sells (or sells and buys) shares within a six-month window, this generates “short-swing profits.” When insiders do this, the issuers’ shares may recover those profits from the insider. The recovery of short-swing profits is an automatic entitled right, that does not depend on anything beyond the actual fact of the short-swing profit, as established by the timing of the insider’s transactions.

Can options, bonds, or “shadow trades” count as insider trading?

As explained above, insider trading involves the purchase or sale of “securities” by a person who knows that material information about a security is not yet public. For purposes of insider trading, “securities” covers a very broad range of financial instruments, including bonds as well as company shares. In securities litigation, this can lead to liability for “shadow trading,” which refers to the use of confidential information about one company to trade in securities of another company.

Can Rule 10b-5 Reach Insider Trading Executed Through Options?

Yes. Due to its broad language, Rule 10b-5 applies to insider trading executed through options, short sales, or even the exchange of a security for cash in certain circumstances. This has been affirmed in numerous SEC enforcement actions and private securities litigation.

Do SEC Rules Enforce Liability for Shadow Trading?

While the SEC does not appear to have adopted any explicit rules allowing for shadow trading enforcement, recent cases suggest that it will pursue these allegations under its general antifraud authority. Shadow-trading cases are often challenging because they rely on establishing the materiality of undisclosed information by showing the information may lead to market movements in companies and industries related to the information source.

A jury recently confirmed the SEC’s ability to reach shadow traders in its 2024 decision in SEC v. Panuwat. Matthew Panuwat, an executive at Medivation, learned in a confidential meeting that Pfizer was about to announce its acquisition of Medivation. Panuwat immediately purchased Incyte options, with a justification that focused partly on the economic relationship between Medivation and Incyte. The jury found Panuwat liable for insider trading by trading Incyte options, thereby giving rise to a possibility of future shadow trading liability for executive insiders who possess nonpublic information about their companies.

How do civil and criminal insider-trading cases differ?

An SEC civil insider-trading investigation can proceed alongside a DOJ criminal insider-trading investigation. While both are conducted by federal law enforcement agencies, they each follow their own distinct procedures.

For example, while the SEC is the primary enforcement body for the securities laws, rules, and regulations, it also brings civil enforcement actions (though it can refer these matters to DOJ if warrant). On the other hand, the DOJ prosecutes federal crimes, including criminal securities offenses, and it does not bring civil insider trading enforcement actions.

Another high-level difference between civil insider trading and criminal insider trading lies in how the governing antifraud rules address scienter. In civil Rule 10b-5 insider trading cases, recklessness (as opposed to willfulness) typically satisfies the scienter requirement. Conversely, criminal insider trading under the Securities Exchange Act of 1934 requires a showing of willfulness. The word “willfulness” implies that the insider not only possessed material nonpublic information but that he also intended to violate the Exchange Act.

In 2002, the Sarbanes-Oxley Act of 2002 created a standalone criminal securities-fraud offense under 18 U.S.C. § 1348, which does not contain a willfulness requirement. However, the statute still requires scienter in some form (i.e., knowingly or willfully).

There is also a substantial difference between the standard of proof and the standard of liability applied in civil versus criminal insider trading cases. In civil cases under Rule 10b-5, the SEC generally needs to establish its claims by a preponderance of the evidence. In criminal cases, the DOJ must establish its charges beyond a reasonable doubt.

Finally, the Securities Exchange Act of 1934 also provides for civil monetary penalties. Section 21A of the Exchange Act authorizes the SEC to seek civil insider-trading penalties against both insiders and the companies that insiders work for. The penalties can be as high as triple the profit obtained or the loss avoided through the illegal transactions.

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Nothing here is legal advice, and the details of your case matter. Todd Spodek and Spodek Law Group take federal criminal and white collar cases nationwide, from offices in New York, Brooklyn, Queens and Los Angeles. You can reach the firm at 212-300-5196.