January 25, 2024
“Insider trading” is one of those commonplace legal terms that every adult has heard numerous times in their lives and probably has a vaguely accurate sense of what it means, but few (even among lawyers) can define it under the law. Most people understand that insider trading involves using non-public information to buy or sell securities in the market at an advantage over others, but that definition does not get us to what can be a very fine line between legal activity that can earn profits and illegal activity that can earn a lengthy prison sentence (up to 35 years in some cases).
A considerable reason for this confusion about the definition of illegal insider trading is that there is not actually one specific law prohibiting insider trading, nor is the term “insider trading” even used in the primary statutes that prosecutors use to enforce federal restrictions against insider trading (another reason is that federal courts have spent decades continuing to define insider trading, and continue to do so to this day).
Instead, insider trading might be better understood as a general legal theory to describe a number of statutes and case law approaches used to prosecute insider trading, several of which are described below.
Rule 10b-5 and the “Classical Theory” of Insider Trading
Although trading in securities has been the subject of regulation throughout our nation’s history, much of our modern securities laws and regulations emanate from the Securities Act of 1933 and Securities Exchange Act of 1934, passed in the years following the great stock market crash of 1929. Pursuant to the authority granted by the Securities Exchange Act of 1934, the Securities and Exchange Commission (SEC) issued SEC Rule 10b-5, which prohibits, among other things, engaging in “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security.” While SEC Rule 10b-5 does not, on its face, explicitly prohibit insider trading, subsequent court decisions have made clear that insider trading is indeed prohibited by the rule.
Under the so-called “classical theory” of insider trading, a corporate insider (e.g. a company president, officer, manager, or director) violates the law when they trade securities in their own company based on material information not available to the public (e.g., the announcement of an acquisition of the company which will likely raise the price of shares, or government approval of a product of the company), as doing so is a breach of a duty owed to both the company and its shareholders, who are presumably when they sell prices at an artificially low price (or buy shares at an artificially high price if the non-public information portends badly for the share price) to their own disadvantage and the advantage of the insider.
The “Tipping Theory” of Insider Trading
This type of insider trading liability extends beyond corporate insiders to those who receive “tips” in the form of this private information from insiders. For example, if a company president tells his best friend that the company is going to be acquired, and the best friend buys shares in the company based on this information, there may be insider trading liability for both the “tipper” and the “tippee” depending on whether the tipper received any benefit for providing the tip, and/or intended to provide a benefit to the tippee. If there was no benefit to the tipper or no intent to provide a benefit to the tippee, then that person may avoid insider trading liability, but what does and does not qualify as such a benefit has been the subject of decades of case law before the Supreme Court and Courts of Appeal, and the law continues to evolve on this topic.
The “Misappropriation Theory” of Insider Trading
While the tipping theory of insider trading can be considered an extension of the classical theory of insider trading in that both are based on the concept of a corporate insider using non-public information for their own benefit at the expense of the company’s shareholders (with the tippee basically standing in the shoes of the corporate insider), the “misappropriation theory” of insider trading applies to corporate “outsiders” who nonetheless gain access to inside, non-public information about a corporation and use it to their own benefit.
The genesis of the misappropriation theory is the 1997 U.S. Supreme Court case U.S. v. O’Hagan, in which federal prosecutors charged a law firm partner who was hired by an acquiring company to represent the company in the purchase of a target company. The partner purchased stock in the target company prior to the announcement of the merger. Unlike in the classical theory scenario, where the inside information is provided by an insider at the company whose shares are at issue, in this situation the shares at issue are of a company to which the defendant owed no duty to the company or its shareholders. However, the court ruled that the partner could nonetheless be charged with insider trading as he misappropriated inside information entrusted to him to the detriment of the target company’s shareholders.
As with tipper liability cases, how far the misappropriation theory of insider trading extends continues to evolve as courts are presented with new scenarios.
Insider Trading Enforced Pursuant to 18 U.S. Code § 1348
In recent years, federal prosecutors have increasingly relied on 18 U.S. Code § 1348 (in addition to SEC Rule 10b-5) in prosecuting insider trading cases, whether based on the classical theory, tipper theory, or misappropriation theory. Section 1348 was enacted as part of the Sarbanes-Oxley Act of 2002 (passed in the wake of numerous high-level corporate scandals, including Enron), and mirrors prior insider trading enforcement law, while at the same time providing prosecutors with an arguably more straightforward and stringent approach to insider trading than the prior approach based on decades of complex case law.
Some commenters have asserted that Section 1348 insider trading charges are easier to prosecute than those pursued under SEC Rule 10b-5, as the elements provide a lower standard. It should also be noted that SEC Rule 10b-5 imposes a maximum sentence of 25 years in prison, while Section 1348 provides a maximum sentence of 35 years in prison.
Speak with an Experienced White Collar Crimes Lawyer
The time to seek experienced counsel from a skilled white collar defense attorney is at the first signs of a potential government investigation, enforcement action or prosecution. Often, the first steps in responding to a potential government proceeding are the most critical in setting the course for an ultimate outcome that defends one’s interests, reputation, and, in some cases, freedom. Contact our office to speak with an experienced white collar defense attorney regarding your situation today.