Material nonpublic information, tippers and tippees

Two tests, then follow the chain

Information is off limits when it is both material and nonpublic, and a question is usually testing one of those two words. Material means a reasonable investor would consider it important in deciding whether to buy or sell: an unannounced merger, an earnings figure well away from expectations, the loss of a dominant customer, a regulatory decision. Nonpublic means it has not been disseminated to the market at large.

Both tests must be satisfied. A dramatic fact that has already been announced is public, however few people have noticed it, and trading on it is ordinary research. A closely held fact that no reasonable investor would care about is not material. The rumor heard in a bar is usually neither, and acting on a genuine piece of original analysis, however clever, is exactly what the market is for.

Liability follows the information rather than the employment. A person who works at the company is an insider, but so is a lawyer, an accountant, a printer or a consultant who receives the information in confidence. Someone who is given the information and knows, or has reason to know, that it came from a breach of duty is a tippee, and a tippee who trades is liable. So is the tipper, even if the tipper never traded and never made a penny: the tipper’s breach is passing the information on for a personal benefit, and a gift of it to a trading friend or relative counts as one.

Two further points close the common escape routes. Avoiding a loss counts exactly as gaining a profit does: selling before bad news is announced is trading on the information just as buying before good news is. And a person who never trades at all can still be liable as a tipper, which is why the safe response to receiving such information is to stop, tell the firm, and trade nothing.

There is a third element under the two tests, and it is the one that makes the offense a legal wrong rather than an unfair advantage. The SEC’s own formulation is that illegal insider trading means buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material nonpublic information. The duty is what separates the analyst who assembles a conclusion from public scraps, who owes nobody anything, from the lawyer who learns the same fact from a client file. Where no duty is owed to the company, the second route applies instead: misappropriation, taking confidential information from an employer, a family member or a friend and trading on it. That is why the enforcement record reaches so far beyond corporate officers, to employees of law, banking, brokerage and printing firms, to government employees who traded on what their work told them, and to political intelligence consultants who tip or trade on what they obtain from government employees.

The penalties are set in the statute and are worth knowing precisely, because a question can test them directly. The civil penalty for the trader or the tipper may not exceed three times the profit gained or the loss avoided — the treble penalty, and note again that an avoided loss is a base for it. A firm can be reached as a controlling person where it knew or recklessly disregarded that its person was likely to offend and did nothing, or where it recklessly failed to maintain the required policies and procedures; that penalty is capped at the greater of a fixed dollar amount set in the statute or three times the profit gained or loss avoided by the person it controlled. Criminally, a willful violation of the Exchange Act carries a fine of up to five million dollars and imprisonment of up to twenty years for a natural person, and up to twenty-five million dollars for a firm. A defendant cannot be imprisoned for breaching a rule if they prove they had no knowledge of it — a narrow relief that removes the prison term and nothing else.

Duties that arise outside the company

The duty that makes a trade unlawful does not have to be owed to the company whose stock is traded. A government employee who learns of an unannounced agency decision through the job, such as approval of a company’s product, holds it in confidence for the agency. Trading on it is trading on material nonpublic information, and government employees are among the people the SEC has charged.

Family and friends are the other common route. A duty of trust or confidence exists whenever a person agrees to keep information confidential, and a person who learns material nonpublic information from a spouse, parent, child or sibling is presumed to owe that duty unless they can show none existed. Trading on what a relative said in confidence is misappropriation, even if the relative never meant it as a tip.

Exam terms

Material information

Information a reasonable investor would consider important to a decision.

Nonpublic information

Information not yet disseminated to the market at large.

Insider

Anyone who receives the information in confidence, not only an employee.

Tipper

A person who passes on material nonpublic information improperly.

Tippee

A person who receives material nonpublic information knowing, or with reason to know, that it came from a breach of duty.

Dirks v. SEC

The 1983 Supreme Court case on tips. A tipper breaches a duty by passing on material nonpublic information for a personal benefit; a tippee who knows or should know of that breach is liable for trading on it.

Loss avoided

Selling ahead of bad news; treated the same as a profit made.

Breach of duty

The element that makes trading on the information unlawful: a fiduciary duty or other relationship of trust and confidence.

Misappropriation

Taking confidential information from an employer, family member or friend and trading on it, where no duty is owed to the company itself.

Controlling person

A firm that can be penalized for its person’s violation where it ignored the risk or failed to maintain the required procedures.

Treble penalty

The civil maximum: three times the profit gained or the loss avoided.

Worked example

An analyst learns from a friend at a listed company that it will announce a costly acquisition next week, and sells his shares in that company before the news reaches the market.

1. Apply the materiality test. An unannounced, costly acquisition is the kind of information a reasonable investor would want, so it is material.
2. Apply the nonpublic test. The announcement is still a week away and the market has not been told, so the information is nonpublic.
3. Identify the roles. The friend who disclosed it is a tipper and is liable even though the friend traded nothing; the analyst who received it knowing where it came from is a tippee.
4. Notice what the analyst did. Selling to avoid a loss is treated exactly as buying to make a profit, so the absence of a gain is no defense at all.
5. The correct action was to trade nothing, pass the information to no one, and report the conversation to the firm.

Check yourself

Try a question, then read the explanation to review the rule.

Same rule, new context

Related practice

• Insider trading and tippingPractice this