Insider trading prosecutions have been around for decades and in the simplest terms, are understandable: don’t trade (or tip) if you have confidential information that could affect market pricing. Simple, right? As it turns out, conduct that could be deemed illegal can be more nuanced and therefore, confusing. And presently, the SEC and DOJ seem to have a renewed focus and interest on insider trading.
With the flurry of government filings, there could be uncertainty as to what might be considered violations of securities laws by regulators and prosecutors. Particularly in light of recent cases involving cryptocurrency and Non-Fungible Tokens (NFTs), the average person may understandably be perplexed. This article aims to outline the insider trading laws, bring clarity to what has traditionally been considered “material nonpublic information,” and highlight more recent, albeit unresolved, prosecutions in the digital space.
Back to Basics
Insider trading refers to the practice of trading securities based on “material, non-public information.” Insider trading occurs when a person in possession of “inside Information” (aka, material nonpublic information or “MNPI”) uses this information for one’s own, or another’s, benefit; i.e. buying or selling shares or other securities on the basis of price-sensitive knowledge that is generally not available to others. The misuse of such confidential information may result in other market participants being disadvantaged and thus, it is against the law. In short, it’s illegal for anyone in possession of MNPI to trade in the securities to which that inside information relates, either directly or indirectly (such as asking or advising someone else to trade). And it is illegal to relay the inside information to another person who is likely to trade in securities.
- Overview of the Applicable Laws
The Securities Exchange Act of 1934 (the Exchange Act) includes various prohibitions of securities fraud under Title 15 of the United States Code. Both civil and criminal cases may be brought pursuant to Section 10(b) of the Exchange Act (Section 10(b)) together with U.S. Securities and Exchange Commission (SEC) Rule 10b-5 (Rule 10b-5) in insider trading cases.
In addition, a criminal statute, 18 U.S.C. § 1348 (Section 1348), prohibits securities fraud. Generally, Congress enacted Section 1348 to provide criminal authorities with greater flexibility when pursuing insider trading actions. The language of the statute, however, does not explicitly define or even prohibit insider trading, thus leaving some ambiguity in the law.
Importantly, Section 1348 did not replace the Title 15 provisions, and it applies to only criminal cases (not civil SEC actions). Accordingly, criminal authorities such as the Department of Justice (DOJ) now have the ability to utilize both the traditional Title 15 provisions and Section 1348 when pursuing insider trading charges, while civil authorities like the SEC may use only the traditional Title 15 provisions.
Under the Title 15 securities fraud provisions, insider trading can be enforced under two separate theories of liability: the classical theory and the misappropriation theory. Under either theory, tippers and tippees may be held liable for insider trading. For example, tipper-tippee liability arises when a corporate insider discloses, or “tips,” confidential information to a third party who uses that information to trade in securities. In such cases under Title 15, it is important to note that the tipper (the insider) must receive a “personal benefit” for divulging the confidential information.
- Theories of Liability
Under the classical theory of liability, section 10(b)(5) of the Securities and Exchange Act is violated when a corporate insider trades in the securities of his corporation on the basis of material, non-public information. A corporate insider is an officer, director, or shareholder.
Under the misappropriation theory of liability pursuant to section 10(b) of the Securities Exchange Act, a person commits fraud in connection with a securities transaction when confidential information for securities trading purposes is misappropriated, in breach of a duty owed to the source of the information. United States v. O’Hagan, 521 U.S. 642, 651-52 (1997). The duty must be a fiduciary duty or similar relationship of trust and confidence. United States v. Chestman, 947 F.2d 551, 567 (2nd Cir 1991).
“Material information” for purposes of a Securities Exchange Act violation includes any fact which in reasonable and objective contemplation might affect the value of the corporation’s stock or securities. Securities Exchange Act of 1934, § 10(b), 15 U.S.C.A. § 78j(b). The test is an objective one: whether a reasonable person would attach importance to them in determining a specific course of action in the transaction in question.
- Tipper-Tippee Situations
In situations involving alleged tipper-tippees, insider trading liability may arise under either theory of liability. This can happen when an insider provides alleged MNPI to an “outsider” (someone not within the company or privy to MNPI), who then may trade in securities based on that confidential information.
Because tippers owe a fiduciary duty either to their company’s shareholders (classical theory) or to the source of the inside information (misappropriation theory), tippers may be liable for breaching this fiduciary duty when they share MNPI with a tippee. (A tipper is liable for insider trading when: “(1) the tipper had a duty to keep material non-public information confidential; (2) the tipper breached that duty by intentionally or recklessly relaying the information to a tippee who could use the information in connection with securities trading; and (3) the tipper received a personal benefit from the tip.” SEC v. Obus, 693 F.3d 276, 289 (2d Cir. 2012).
As such, if the person receiving the tip(s) trades on that MNPI, they too may be liable for insider trading. In sum, tippees may be liable if (1) they trade on received MNPI, (2) the tippers breached a fiduciary duty by sharing the MNPI, and (3) the tippees know or should have known the tippers breached a fiduciary duty. Dirks v. SEC, 463 U.S. 646, 660 (1983).
Notably, if a tippee receives MNPI and shares the MNPI with someone else—referred to as a remote tippee—the remote tippee may be held to these same standards (but that remote tippee must or should know that a fiduciary duty was breached).
The broadest elements of insider trading are the following:
- Defendant actually received information
- The information was material
- The information was nonpublic
- The information directly influenced the defendant’s trade.
Specifically, as discussed above, several statutes may be invoked to charge insider trading.
- Insider trading under Section 1348
Securities Fraud under Section 1348 of Title 18 (adopted in 2002 as part of the Sarbanes-Oxley Act) makes it a crime to “knowingly execute[ ], or attempt[ ] to execute, a scheme or artifice . . . to defraud any person in connection with . . . any security.” In enacting Section 1348, Congress sought to lessen the burden on criminal prosecutors to prove securities fraud by eliminating historically specific Title 18 requirements, such as “the element that the mails or wires were used to further the scheme to defraud.”
In the Ninth Circuit, an individual is liable under Section 1348 if the government can prove that a person: (1) knowingly executed or attempted to execute a scheme or plan to defraud or a scheme or plan for obtaining money or property by means of false or fraudulent pretenses, representations, or promises; (2) the statements made or facts omitted as part of the scheme were material; (3) defendant acted with the intent to defraud; and (4) the scheme was in connection with the purchase or sale of securities. United States v. Hussain, 972 F.3d. 1138, 1146 (9th Cir. 2020).
Further, the government must prove that the defendant acted intentionally, deliberately, and voluntarily, rather than by mistake, accident, or carelessness. As with the wire fraud statute, the government must show that the defendant acted with the intent to deprive another person of something of value.
One question that remains open for Section 1348 prosecutions is whether a personal benefit is one of the elements of the offense. Ultimately, the Second Circuit held the personal benefit requirement does not apply to insider trading cases brought under Section 1348. In United States v. Blaszczak, 947 F.2d 19 (2nd Cir. 2019), the government was required to prove that the defendants acted with the intent to deprive a federal agency of something of value (material, non-public information, MNPI) by trading on the agency’s information or converting it to their own use. The case went up to the Supreme Court, which remanded the case back to the Second Circuit for a different reason (see below). The case was ultimately dismissed by the DOJ and thus, nationally, the question remains open as to whether a personal benefit to the tipper is required in fraud prosecutions under Title 18, as is required under Title 15 prosecutions. The Ninth Circuit has not addressed this issue to date.
- Insider Trading Under 15 U.S.C. §§ 78j(b), 78ff; 17 C.F.R. § 240.10b-5
For Title 15, prosecutions, the Ninth Circuit (Model Instruction No. 15.47: Securities Fraud) has outlined the following elements that the government must prove beyond a reasonable doubt:
(1) the defendant willfully [used a device or scheme to defraud someone] [made an untrue statement of a material fact] [failed to disclose a material fact that resulted in making the defendant’s statements misleading] [engaged in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person];
(2) the defendant’s [acts were undertaken] [statement was made] [failure to disclose was done] in connection with the [purchase] [sale] of [specify security];
(3) the defendant directly or indirectly used the [specify instrument or facility] in
connection with [these acts] [making this statement] [this failure to disclose]; and
(4) the defendant acted knowingly.
The instruction notes, however:
A jury can infer the tipper personally benefitted “where the tipper receives something of value in exchange for the tip or ‘makes a gift of confidential information to a trading relative or friend.’” Salman v. United States, 137 S. Ct. 420, 423 (2016) (quoting Dirks, 463 U.S. at 664). But if the tipper did not personally benefit from tipping the undisclosed inside information, then the tippee is not liable under Rule 10b-5(b). See, e.g., Dirks, 463 U.S. at 649-50 (finding no tippee liability because tipper was whistleblower who did not personally benefit from tipping material, undisclosed inside information).
In Salman, the defendant argued that he couldn’t be held liable as a tippee because the tipper, who was his brother-in-law, did not personally receive money or property in exchange for the tip. The Supreme Court disagreed, noting that a relative can make a “gift” of confidential information to a trading relative. However, the facts in the case showed that the brother-in-law shared the inside information to “benefit” the tippee and with the expectation that he would trade on it. He testified that he tipped information to “help him” and to “fulfill whatever needs he had.”
Thus, as it stands, Salman is good law and it holds that when a tipper gives inside information to a “trading relative or friend,” the jury can infer that the tipper meant to provide the equivalent of a cash gift. In such situations, the tipper “benefits personally because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.” Salman, at 428. (The Supreme Court has presumed that gifts involve personal gain.)
- Insider Trading Under the Wire Fraud Statute
A final alternative for the government to charge insider trading is through the wire fraud statute – Section 1343 of Title 18. However, a violation of Section 1343 requires a “scheme or artifice to defraud” to obtain money or property by means of false or fraudulent pretenses, representations or promises. The Ninth Circuit requires that a defendant have acted with the intent to “deceive and cheat” a victim. United States v. Miller, 953 F.3d 1095 (9th Cir. 2020).
However, after Kelly v. United States, 140 S.Ct. 1565 (2020) (“Bridgegate”), the Supreme Court held that the wire fraud statute only prohibits deceptive schemes to defraud a victim of money or property and in Kelly, depriving the government of the use of the bridge lanes did not qualify.
As a result, in the Blaszczak case mentioned above, wherein a defendant was convicted of wire fraud after he obtained confidential information from a current Medicare Services employee about future rule changes, then passed the information to a hedge fund that traded on it, when the case returned to the Second Circuit, the DOJ conceded that under Kelly, Blaszczak’s insider trading could not be charged as wire fraud and the conviction should be dismissed.
Key Definitions
- Definition of Fiduciary Duty
A fiduciary duty cannot be imposed unilaterally by entrusting a person with confidential information. United States v. Chestman, 947 F.2d 551, 567 (2nd Cir 1991). “Reposing confidential information in another, then, does not by itself create a fiduciary relationship.” Id. Common law associations that are considered fiduciary include: attorney and client, executor and heir, guardian and ward, principal and agent, trustee and trust beneficiary, and senior corporate official and shareholder.
A “similar relationship of trust and confidence,” therefore, must be the functional equivalent of a fiduciary relationship. In Chestman, it was held that the tipper had no fiduciary duty or equivalent to the person who gave him the insider information because the information received was between spouses and was unprompted and served no purpose. Qualifying relationships are marked by the fact that the party in whom confidence is reposed has entered into a relationship in which he or she acts to serve the interests of the party entrusting him or her with such information. Id. at 568-69.
Thus, a duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information. Chiarella v. United States, 445 U.S. 222, 235 (1980).
However, courts have held that the relationship of employment creates a fiduciary relationship, or a similar relationship of trust and confidence, which is the functional equivalent of a fiduciary relationship, such as to invoke the misappropriation theory of imposing liability for trading under Section 10(b). United States v. Newman, 664 F.2d 12 (2nd Cir. 1981).
- Definition of “Insider”
An insider is traditionally defined as an officer, director, or employee of a company, but it can also refer to a company’s business associates in certain circumstances, such as attorneys, accountants, consultants, banks, and the employees of such organizations. People who have direct access to inside information, such as a person who receives a “tip” from an officer or director, are also considered “insiders” and may be subject to prosecution for insider trading.
The definition of insider is transaction-specific; that is, an individual may be an insider with respect to each material nonpublic item of which he/she is aware. Additionally, people who are not considered to be insiders may nonetheless be charged with insider trading if they receive tips from insiders, or if they are the ones who tip the information (tipper and tippee). Indeed, anyone who has knowledge of MNPI may be considered an “insider” for purposes of the federal securities laws prohibiting insider trading.
For example, the SEC has brought insider trading cases against:
- friends, business associates, family members, and other “tippees” of such officers, directors and employees, who traded the securities after receiving such information;
- employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;
- government employees who learned of such information because of their employment by the government;
- employees of financial printers who learned of the information during the course of their employment; and
- other persons who misappropriated, and took advantage, of confidential information from their employers.
- Definition of “Material”
In general, information is considered to be “material” if it would be important to a reasonable investor in deciding whether to buy, sell, or hold a Company’s securities or that would, if disclosed, be likely to affect the market price of the Company’s securities. Information would be considered material if there is a substantial likelihood that its disclosure would be viewed by a reasonable investor as having significantly altered the “total mix” of information available and if, together with all other available information about the Company, it would be likely to cause a revaluation of the securities by reasonable investors.
Courts tend to believe that if a “reasonable investor” would find the information important enough to alter the total picture in some way, then the information is material. Therefore, any information, that, upon disclosure, would likely to result in a substantial change in the price of the Company’s stock, is deemed MNPI. The information can be positive or negative.
For example, information is non-public if it has not been previously disclosed to the general public and is otherwise not available to the general public, or that the public has not had a reasonable opportunity to understand it. Information could be considered nonpublic until it has been widely disseminated to the public through SEC filings, major newswire services, national news services and financial news services and there has been sufficient time for the market to digest that information.
In the simplest terms, corporate insiders are not allowed to give investors or potential investors market-moving tips about their companies. At the same time, companies must disclose critical news, like quarterly earnings, to everyone at the same time.
However, it should be noted that some “inside” data acquisition is appropriate: for example, it is usually legal to obtain intelligence such as tracking the flights of corporate jets to see if an executive is heading to the offices of a possible merger partner, or getting information through reporters and bloggers. Because much of this type of intelligence is akin to “reading tea leaves,” and anyone so inclined could do this kind of research, it would not be considered illegal conduct.
The SEC itself has articulated that it will not adopt a “bright line” rule as to materiality. For example, the SEC has stated that in some instances, some new products or contracts may clearly be material to an issuer, but that does not mean that all product developments or contracts will be material. Each situation will be assessed on a case-by-case basis.
List of Examples of Material InformationIllustrations of material information, by broad terms, may include information about:
- earnings’ estimates or any earnings guidance;
- financial performance, especially quarterly and year-end earnings;
- significant changes in financial performance outlook or liquidity of the Company as a whole or of a reporting segment of the Company’s business;
- company projections that significantly differ from external expectations;
- changes in previously released earnings’ estimates;
- significant new products or technological breakthroughs;
- a proposed merger, acquisition or tender offer;
- new major contracts, orders, suppliers, customers or finance sources, or the loss thereof;
- high level management changes;
- significant litigation developments;
- significant joint ventures;
- extraordinary borrowings or purchases;
- sales of substantial assets;
- stock splits or offerings or other changes in capitalization;
- financial liquidity problems;
- a take-over bid, issuer bid or insider bid;
- imminent or potential changes in the Company’s credit rating by a rating agency;
- voluntary calls of debt or preferred stock of the Company;
- the contents of forthcoming publications that may affect the market price of securities;
- a significant cybersecurity incident experienced by the company that has not yet been made public;
- approvals or denials of requests for regulatory approval by government agencies of products, patents or trademarks;
- significant changes or developments in supplies or inventory, including significant product defects, recalls or product returns;
- the borrowing of a significant amount of funds;
- a large customer cancelling future orders for a product;
- a major labor dispute or a dispute with a major contractor or supplier; and
- bankruptcies and receiverships.
The specificity of the information is also important. While there is no definitive test as to specificity, some examples of information that is immaterial include:
- information from an insider about a company’s mere intention to pursue a merger at some time in the future, prior to any contact with the potential suitors and absent any evidence of an interested suitor; or
- a forecast that future sales revenue (time unspecified) would not be as good as in the past (versus a statement that 2nd quarter earnings would be down); or
- a compilation of information pieced together and given materiality by an analyst.
According to the SEC’s Regulation FD (“Fair Disclosure”):
an issuer is not prohibited from disclosing a non-material piece of information to an analyst, even if, unbeknownst to the issuer, that piece helps the analyst complete a “mosaic” of information that, taken together is material. Similarly, since materiality is an objective test keyed to the reasonable investor, Regulation FD will not be implicated where an issuer discloses immaterial information whose significance is discerned by the analyst. Analysts can provide a valuable service in sifting through and extracting information that would not be significant to the ordinary investor to reach material conclusions. We do not intend, by Regulation FD, to discourage this sort of activity. The focus of Regulation FD is on whether the issuer discloses material nonpublic information, not on whether an analyst, through some combination of persistence, knowledge, and insight, regards as material information whose significance is not apparent to the reasonable investor.
See 17 C.F.R. § 243.100, 65 Fed. Reg. 51716, 51722 (Regulation FD requires an issuer to make public material information disclosed to security market professionals or holders of the issuer’s securities who are reasonably likely to trade on the basis of that information.)
Expanded Use of Insider Trading Laws in Current Prosecutions
In July 2022, the Southern District of New York indicted three individuals in the first ever cryptocurrency insider trading case. Wire fraud charges were brought against a former product manager at Coinbase, his brother and a friend. The charges allege that the manager shared confidential information about pending announcements of new crypto assets that Coinbase would add to its exchange. The brother and friend allegedly purchased and sold at least 25 crypto assets for a profit of $1.1 million using Etherium blockchain wallets at least 14 times before Coinbase made its announcements.
At the same time, the SEC brought civil charges against the trio, asserting for the first time that trading crypto assets constitutes securities fraud. In an arguably controversial move, the SEC alleged that several of the traded crypto assets are securities. Yet Coinbase itself disputes that its instruments are securities (we previously wrote about the Ripple litigation.
Additionally, this year the DOJ charged a former Ozone Networks, Inc., or OpenSea, employee with wire fraud and money laundering “in connection with a scheme to commit insider trading in Non-Fungible Tokens, or ‘NFTs,’ by using confidential information about what NFTs were going to be featured on OpenSea’s homepage for his personal financial gain.” This is the first ever prosecution involving digital assets. The defendant has already filed a motion to dismiss the charges, arguing that prosecutors’ theory that he misappropriated his own ideas about what should go on Open Sea’s homepage would “criminalize run-of the-mill civil employment disputes. He further disputes that NFTs can be classified as securities or commodities.
It remains to be seen whether such charges stick.
CONCLUSION
The pattern that emerges from historical and present cases is this: always err on the side of caution. Unsure of whether to trade: don’t do it or consult with an attorney or the company’s legal department. Read employment agreements carefully. While one is certainly permitted to discuss one’s work with friends or family, be cautious about disclosing market-moving information, particularly to those who might trade. On the flip side, if you’ve intentionally or accidentally been exposed to what could be considered MNPI (see list above), proceed with caution before trading. Once again, consult with an attorney or even a financial planner (though without further disseminating the MNPI). In short, if you don’t think you should have heard what you heard: forget you heard it.