Illegal insider trading is generally defined as purchasing or selling securities while in the possession of material, non-public information in violation of a duty not to trade.  The following is an overview of the (i) “traditional” or "classical" theory of insider trading, and the (ii) “misappropriation” theory.

A.  The “traditional” or "classical" theory of insider trading.

The statutory authority for the traditional or classical theory of insider trading liability is grounded in Section 10(b) of the Exchange Act  and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5.

Section 10(b) of the Exchange Act provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . . [t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.15 U.S.C. § 78j(b).

Rule 10b-5 provides that:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device,  scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage 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.

“Traditional” or "classical" insider trading occurs when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information."  SEC v. Talbot, 530 F.3d 1085, 2008 U.S. App. LEXIS 13726 at *11  (9th Cir. 2008).  The courts have found that such trading qualifies as a "deceptive device" under § 10(b) because a relationship of trust and confidence exists between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation. The relationship of trust and confidence between the trader and the shareholders of the corporation in which he trades gives rise to a duty to disclose or to abstain from trading because of the necessity of preventing “a corporate insider from . . . taking unfair advantage of . . . uninformed . . . stockholders.”  Id. at 11-12. 

Under this theory of insider trading, it is illegal for corporate insider, e.g. officers, directors, employees and any beneficial owners of more than ten percent of a class of the company's equity securities, to buy or sell stock in their own companies while in possession of material, nonpublic information about that security, unless otherwise permitted, e.g. under a Rule 10b5-1 trading plan.

B.  The Misappropriation Theory of insider trading.

However, liability under the classical theory does not address trading by a corporate outsider who owes no fiduciary duty to the corporation in whose shares he seeks to trade.  As an example, the employee of a printer who traded in the securities of the targets of the printer’s clients’ takeover attempts would not qualify as an insider and thus would owe no fiduciary duty to the target entities in whose stock he traded, a requirement for liability under the classical theory of insider trading.  See Chiarella v. United States, 445 U.S. 222, 228 (1980). 

In response to this, the Supreme Court in United States v. O'Hagan, 521 U.S. 642 (1997) recognized the misappropriation theory, which reaches trading by corporate outsiders as opposed to corporate insiders.  Under this theory, a person violates § 10(b) and Rule 10b-5 when he knowingly misappropriates confidential, material, and nonpublic information for securities trading purposes, in breach of a duty arising from a relationship of trust and confidence owed to the source of the information.  SEC v. Talbot, 2008 U.S. App. LEXIS 13726 at *15.  Under this theory, a fiduciary’s undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.  United States v. O'Hagan, 521 U.S. at 652.  "In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information." Id.

Under this theory of insider trading, it is illegal for anyone to buy or sell a security where he or she is in possession of material, nonpublic information about the security, where that information was received from a source to which there is some relationship of trust and confidence. 

C.  Tippee Liability.

So when is it okay to trade on nonpublic information?  The Supreme Court has held that as a general rule, there is no general duty between all participants in market transactions to forgo actions based on material, nonpublic information.   Mere possession of nonpublic information does not give rise to a duty to disclose or abstain; only a specific relationship does that.  Dirks v. Securities and Exchange Commission, 463 U.S. 646, 1983 U.S. LEXIS 102, at * 22 (1983).  The Supreme Court has explicitly stated that there can be no duty to disclose where the person who has traded on inside information "was not [the corporation's] agent, . . . was not a fiduciary, [or] was not a person in whom the sellers [of the securities] had placed their trust and confidence."  Dirks v. SEC, at *19.

However, the Supreme Court has also recognized that there must be a ban on tippee trading, lest insiders be able to give undisclosed corporate information to an outsider for the same improper purpose of exploiting the information for their own personal gain.  In Dirks, the Court reasoned that the transactions of those who knowingly participate with the fiduciary in such a breach must be "as forbidden" as transactions "on behalf of the trustee himself,” citing 15 U. S. C. § 78t(b) (making it unlawful to do indirectly "by means of any other person" any act made unlawful by the federal securities laws).  Accordingly, the Court held that in determining whether a tippee is under an obligation to disclose or abstain, a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when (i) the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach, and (ii) that the insider personally benefits, directly or indirectly, from his disclosure.  Id, at *29, 33. 

Under this theory of insider trading, it is illegal for anyone to buy or sell a security where he or she is in possession of material, nonpublic information about the security, where that information was received from an insider in breach of his fiduciary duty to shareholders, and the tippee knows or should know that there has been a breach, and where the insider personally benefits, directly or indirectly (need not be financial), from the disclosure.

Allen M. Lee  Mr. Lee’s practice focuses on business, corporate and intellectual property matters, including the creation, protection and exploitation of intellectual property assets.  He counsels clients on business formation, general corporate matters, trademark, copyright, trade secret, patent, licensing, internet and domain name issues, among other things.  For more information contact: Allen M. Lee, a Professional Law Corporation, Tel: (650) 254-0758, Fax: (650) 967-1851, Email: allen@allenmlee.com, Internet: www.allenmlee.com.