Regulation Of Insider Trading Outline

Regulation of Insider Trading

1. Theory

   1. Insider Trading harms investors

   2. Insider Trading distorts company disclosures

   3. Insider Trading is theft of company information

   4. Insider Trading hams market and increases firms' cost of capital

   5. Insider Trading signals information to stock markets

   6. Insider Trading compensates management

2. Overview of Federal Regulation of Insider Trading

   1. Traditional Theory: § 10(b) and Rule 10b-5 make it unlawful for a director, senior executive, or other employee of a corporation to use material, non-public information to purchase or sell that corporation's stock unless such a person has a pre-established plan for such trading. In the Matter of Cady, Roberts & Co.

      1. Disclose or Abstain Rule: "a corporate insider must abstain from trading in the shares of his corporation unless he has first disclosed all material information known to him." Chiarella v. United States (citing In the Matter of Cady, Roberts & Co)

      2. Materiality: The test for materiality is that "there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of the information made available."

         • Where the misstatement or omission relates to contingent or speculative information or events, the test has been expanded so that materiality "will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity."

      3. Knowledge: A person "trades on the basis" of material nonpublic information if the trader is "aware" of the material nonpublic information when making the purchase or sale. Rule 10b5-1(b).

         • In its release, the SEC explained that "aware" is a commonly used English word, implying "conscious knowledge."

      4. A person other than a corporate insider may be treated as an insider for purposes of Rule 10b-5 where confidential information is disclosed legitimately to such a person in connection with his work for the corporation (e.g. an underwriter, attorney, or accountant). Dirks v. SEC

   2. Misappropriation Theory: Rule 10b-5 may also prohibit trading by a person who is an outsider. Under the misappropriation theory such a person may be deemed to have violated Rule 10b-5 because he has misappropriated material, non-public information from its source in a breach of a fiduciary duty owing to the source rather than to the person with whom he trades. United States v. O'Hagen; see also Chiarella v. United States (reversing conviction because the misappropriation theory was not in the jury instructions and thus was not an issue on appeal)

      1. Rule 10b5-2 clarifies how misrepresentation theory applies to non-business relationships

         • Under the rule, a person receiving material nonpublic information under any of the following circumstances owes a duty of trust or confidence, and thus can be liable under the misappropriation theory if he trades on the basis of such information:

           • The recipient agreed to maintain the information in confidence. Rule 10b5-2(b)(1).

           • The persons involved in the communication have a history, pattern or practice of sharing confidences (both business and...

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