Federal regulation of insider trading occurs through three main sources: Section 16 of the Securities Exchange Act of 1934, Securities and Exchange Commission (SEC) Rule 10b-5, and SEC Rule 14e-3. The SEC rules are enforced by both the SEC and private plaintiffs, while violations of the Securities Exchange Act are crimes that can be prosecuted by the Justice Department. Section 16 of the Securities Exchange Act of 1934 provides the most straightforward regulation of insider trading. This section requires statutorily defined insiders – officers, directors, and shareholders who own 10 percent or more of a firm’s equity class -to report their registered equity holdings and transactions to the SEC. Under Section 16, insiders must disgorge to the issuer any profit received from the liquidation of shares that have been held less than six months.
The two SEC rules provide more complex regulation of insider trading. Rule 10b-5 states, in part, that “it is unlawful . . . to engage in any act . . . which operates as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” However, this Rule does not specifically define insider trading. Thus, definitions of insider trading comes from legal and SEC interpretations of Rule 10b-5.
In addressing insider trading cases, the courts have adopted two major theories of liability for illegal insider trading: the classical theory and the misappropriation theory. The “classical theory,” which has been adopted by the Supreme Court, states that a person violates Rule 10b-5 if he buys or sells securities based on material non-public information while he is an insider in the corporation whose shares he trades, thus breaking a fiduciary duty to shareholders. The classical theory is also cal led the “fiduciary breach theory,” because it concentrates on those who trade securities of a firm in breach of a duty to the shareholders of that firm. This theory is sometimes referred to as the “abstain or disclose theory,” because insiders must abstain from trading on material information about their firm until that information has been disclosed.
The classical theory also states that people who trade on material non-public information provided to them by insiders are also in violation of Rule 10b-5. An example of a violation of Rule 10b-5 under the classical theory is the purchase of stock in a firm by its CEO just before the firm announces it is increasing its dividend. Since advance knowledge of a dividend increase is material information and the CEO is an insider, such trading is illegal. The second major theory of insider trading under Rule 10b -5 is the “misappropriation theory,” which has not been adopted by the Supreme Court but has been adopted by most lower federal courts. The misappropriation theory was developed by the SEC to address insider trading by non-insiders. Although many people consider trading on non-public information undesirable, non-insiders who do so are not liable under the classical theory. However, under the misappropriation theory, Rule 10b-5 is violated when a person misappropriates material non-public information and breaches a duty of trust by using that information in a securities transaction, whether or not he owes a duty to the shareholders whose stock he trades. Thus, those receiving “tips” are liable, even if the provider of the tip is not an insider.
SEC Rule 14e-3 allows for prosecution of inside trading by non-insiders. This rule makes it illegal to trade around a tender offer if the trader possesses material non-public information obtained from either the bidder or the target. Thus, in the case of a tender offer, Rule 14e-3 prohibits inside trading even when no breach of duty occurs.
The penalties for violations of insider trading laws can be severe. Money damages can be up to three times the profit made on the trade, while fines can be up to a million dollars. Further criminal violations of these laws can result in jail time.
