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?
3.11 Customer Protection
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