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Corporations • Federal Securities Laws
CORP#066
Legal Definition
A person commits insider trading where they (1) purchase or sell stock with (2) knowledge of material, nonpublic information and (3) without disclosing that information, and (4) breach a duty of trust and confidence owed to either (a) the issuer, (b) the shareholders of the issuer, or (c) another person who is the source of the non-public information.
Plain English Explanation
Information is powerful. With the right information at the right time, a person can confidently predict whether a company's stock will increase in value or decrease in value. To make things fair (or at least try to), the law draws a line in the sand when it comes to which information is legal and which information is illegal to use in buying or selling stock. In short, legal information is information that is public. A good way to determine whether or not information is public is if a person with enough money and resources could figure it out without having to bribe someone inside of the company to tell them. Press releases from a company are obviously public information, but these days some companies use fleets of high tech satellites with cameras that allow investors to count the number of cars in a parking lot outside of a company's retail locations to estimate their sales. This kind of information is obviously only available to a small, wealthy, powerful group of investors, and yet it is completely legal because the information gathered is, technically, publicly available to be captured by those who want it badly enough (and have a ton of money).
In contrast, illegal information is the kind of information that is only available from within the company itself. Maybe it is a report printed on a piece of paper inside of a filing cabinet in an office building, or maybe it is a piece of information that was heard during a private meeting and exists within the brains of privileged employees. Either way, because this information has not yet left the privacy and security of the company to enter the public realm, it is illegal to use that insider information to buy or sell shares.
Why? Imagine if in a private meeting between the CFO and CEO, the CFO mentions that her projections were way off and it looks like there will be massive layoffs. This information likely signals that the company's stock is going to be worth less in the future. The moment it becomes publicly known (through a press release or the news), there will be a massive race of people trying to sell their shares, which drives the price down. With this in mind, it isn't fair to let some people start the race early because they so-happen to have access to inside knowledge of a company. To allow that would basically give everyone in Wall Street an unchecked advantage to know ahead of time what to buy and sell, and when.
And yes, for what it's worth, I realize that Wall Street has plenty of questionably-ethical ways of collecting data, but for the sake of your law school exams, it's best not to get lost down that rabbit hole.
With all of that in mind, let's break down the elements that you must establish to show someone committed insider trading under Rule 10b-5:
(1) The first element is that someone must have actually bought or sold stock. Seems obvious, but don't get suckered into questions that involve all the elements but, in the end, the actor doesn't actually pull the trigger and buy or sell anything.
(2) Next, you need to make sure that the stock transaction was based on important non-public knowledge that would likely affect the value of the stock if all parties were aware of it.
(3) Next, look to see if the person with insider knowledge disclosed it to whoever they sold to. This is unlikely, since most stocks are not sold at arm's length. In other words, if a person with insider information goes to buy or sell shares from someone, but before the transaction they tell the person, "Hey, heads up, but I'm buying this stock because of insider information that I want you to be aware of before you agree to transact with me," then it gives a chance for the other party to decide if they are being ripped off. Obviously, though, this doesn't work if you buy or sell via a stock exchange or trading app since you never have a chance to talk to the other party.
(4) The last element is that the person accused of committing insider trading must have violated the trust owed to either (a) the company that issued the stock; (b) the shareholders of the company; or (c) the person who is the original source of the information.
This card was long. Let's summarize what we learned here as simply as possible: Under Rule 10b-5, it is illegal to buy or sell stock based on super valuable, non-public information about a company when you have a special relationship of trust with either the corporation itself, the source of the information, or the shareholders of the corporation.
In contrast, illegal information is the kind of information that is only available from within the company itself. Maybe it is a report printed on a piece of paper inside of a filing cabinet in an office building, or maybe it is a piece of information that was heard during a private meeting and exists within the brains of privileged employees. Either way, because this information has not yet left the privacy and security of the company to enter the public realm, it is illegal to use that insider information to buy or sell shares.
Why? Imagine if in a private meeting between the CFO and CEO, the CFO mentions that her projections were way off and it looks like there will be massive layoffs. This information likely signals that the company's stock is going to be worth less in the future. The moment it becomes publicly known (through a press release or the news), there will be a massive race of people trying to sell their shares, which drives the price down. With this in mind, it isn't fair to let some people start the race early because they so-happen to have access to inside knowledge of a company. To allow that would basically give everyone in Wall Street an unchecked advantage to know ahead of time what to buy and sell, and when.
And yes, for what it's worth, I realize that Wall Street has plenty of questionably-ethical ways of collecting data, but for the sake of your law school exams, it's best not to get lost down that rabbit hole.
With all of that in mind, let's break down the elements that you must establish to show someone committed insider trading under Rule 10b-5:
(1) The first element is that someone must have actually bought or sold stock. Seems obvious, but don't get suckered into questions that involve all the elements but, in the end, the actor doesn't actually pull the trigger and buy or sell anything.
(2) Next, you need to make sure that the stock transaction was based on important non-public knowledge that would likely affect the value of the stock if all parties were aware of it.
(3) Next, look to see if the person with insider knowledge disclosed it to whoever they sold to. This is unlikely, since most stocks are not sold at arm's length. In other words, if a person with insider information goes to buy or sell shares from someone, but before the transaction they tell the person, "Hey, heads up, but I'm buying this stock because of insider information that I want you to be aware of before you agree to transact with me," then it gives a chance for the other party to decide if they are being ripped off. Obviously, though, this doesn't work if you buy or sell via a stock exchange or trading app since you never have a chance to talk to the other party.
(4) The last element is that the person accused of committing insider trading must have violated the trust owed to either (a) the company that issued the stock; (b) the shareholders of the company; or (c) the person who is the original source of the information.
This card was long. Let's summarize what we learned here as simply as possible: Under Rule 10b-5, it is illegal to buy or sell stock based on super valuable, non-public information about a company when you have a special relationship of trust with either the corporation itself, the source of the information, or the shareholders of the corporation.
