Insider Trading and Front-Running
Insider trading and front-running involve the misuse of confidential information for personal gain. Both practices are serious violations that undermine market fairness and integrity.
What Is Insider Trading?
Insider trading is buying or selling securities while in possession of material nonpublic information (MNPI) about the security or issuer.
Key Terms
| Term | Definition |
|---|---|
| Material | Information a reasonable investor would consider important in making an investment decision |
| Nonpublic | Information not yet available to the general public |
| Insider | Anyone who possesses MNPI, not just corporate insiders |
Exam Tip: "Insider" is broader than it sounds. You don't have to be a corporate officer or director to be guilty of insider trading—anyone who trades on MNPI can be liable.
Who Can Be an Insider?
| Category | Examples |
|---|---|
| Traditional insiders | Officers, directors, significant shareholders |
| Temporary insiders | Lawyers, accountants, investment bankers working for the company |
| Tippees | Anyone who receives MNPI from an insider |
| Misappropriators | Anyone who steals or misuses confidential information |
The Tipper-Tippee Relationship
Tipper: The person who discloses MNPI to another
Tippee: The person who receives MNPI from a tipper
Liability for Tippees
A tippee is liable for insider trading if:
- The tipper breached a duty by disclosing the information
- The tipper received a personal benefit (direct or indirect) from the disclosure
- The tippee knew or should have known that the information was confidential
Chain of Tippees
Liability can extend through multiple tippees. If A tells B who tells C who tells D, all may be liable if each knew (or should have known) the information was MNPI.
Examples of MNPI
| MNPI | Why It's Material |
|---|---|
| Upcoming earnings announcements | Would affect stock price |
| Merger or acquisition plans | Would significantly change company value |
| New product breakthroughs | Could dramatically affect future earnings |
| Impending regulatory action | Could impact operations or liability |
| CEO resignation or major management change | Leadership affects company direction |
| Significant contract wins or losses | Directly impacts revenue |
When Information Becomes Public
Information is generally considered public when it has been:
- Filed with the SEC (10-K, 10-Q, 8-K filings)
- Issued in a press release from the company
- Widely disseminated through news media
- Made available through legitimate disclosure channels
Key Point: Even after announcement, information needs time to be "absorbed" by the market. Trading immediately after announcement (but before dissemination) may still be problematic.
Front-Running
Front-running is trading ahead of a customer's order when you know the customer's order will likely move the market price.
How Front-Running Works
- Agent receives large order from customer (e.g., buy 100,000 shares)
- Agent buys shares for own account first
- Agent executes customer's large order, which drives up price
- Agent sells own shares at higher price for profit
Why Front-Running Is Prohibited
- Violates duty to customer (customer's interest should come first)
- Uses confidential customer information for personal gain
- Harms customer by raising the price they pay (or lowering the price they receive)
- Constitutes breach of fiduciary duty
Information Barriers (Chinese Walls)
Information barriers (historically called "Chinese walls") are policies and procedures that prevent the flow of MNPI between different departments within a financial firm.
Purpose of Information Barriers
| Department | Potential MNPI |
|---|---|
| Investment banking | Merger plans, IPOs |
| Research | Upcoming recommendations |
| Trading | Large customer orders |
| Asset management | Trading intentions |
Common Barrier Components
- Physical separation of departments
- Restricted access to sensitive information
- Compliance monitoring of trading activity
- Restricted lists and watch lists
- Required pre-approval for personal trading
Penalties for Insider Trading
Civil Penalties
- Disgorgement: Return all profits or avoided losses
- Civil fines: Up to 3× the profit gained or loss avoided
- Injunctions: Court orders prohibiting future violations
Criminal Penalties
- Imprisonment: Up to 20 years for individuals
- Criminal fines: Up to $5 million for individuals; up to $25 million for entities
Administrative Penalties
- Suspension or revocation of registration
- Industry bars
- Cease and desist orders
Controlling Person Liability
Controlling persons (employers, supervisors) can be liable for insider trading by those under their control if they:
- Knew or recklessly disregarded the violation
- Failed to establish adequate policies and procedures
- Failed to properly supervise
Key Takeaways
- Insider trading is buying/selling securities based on material nonpublic information
- "Insider" includes anyone with MNPI, not just corporate officers
- Tippees can be liable if they knew the information was confidential
- Front-running is trading ahead of customer orders to profit from anticipated price movement
- Information barriers (Chinese walls) prevent improper flow of MNPI within firms
- Penalties include disgorgement, fines up to 3× profits, and imprisonment up to 20 years
- Controlling persons can be liable for violations by those they supervise
A corporate attorney learns that her client company will be acquired at a significant premium. She tells her brother, who buys shares before the announcement. Who may be liable for insider trading?
An agent receives a large customer order to buy 50,000 shares of XYZ stock. Before executing the customer order, the agent buys 1,000 shares for his personal account. This practice is called:
What is the purpose of information barriers (Chinese walls) within a securities firm?
What is the maximum criminal fine for an individual convicted of insider trading?
5.1 State Administrator Powers
Chapter 5: Administrative Provisions