Insider Trading | Brian JM Quinn | November 15, 2013

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Insider Trading

Original Creator: Brian JM Quinn Current Version: Brian JM Quinn Show/Hide

Anyone familiar with the law of agency will very quickly understand why insider trading is so troublesome. When an insider uses the information of the corporation for their own benefit, the agent violates their duty of loyalty to the corporation.

Over the years, the jurisprudence of insider trading has evolved to meet the changing landscape of the marketplace. In the following cases we start with classical insider trading theory and then progress to more modern evolutions including liability for insider trading under Federal misappropriation theory.

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  1. 1 Show/Hide More State-based liability
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

    State-based insider trading liability takes the form a derivative action by stockholders against insiders. In such an action, the basic claim is that directors (or “insiders”) used confidential information of the corporation for their own benefit and not for the benefit of the corporatoion. As a derivative action based, state-based insider trading liability is prosecuted by stockholders and not by state regulators or the SEC. Oracle as well as the Beam v Martha Stewart case from earlier in the semester are examples of stockholders bringing derivative suits against board members who have allegedly engaged in insider trading in the stock of the corporation.

    Consistent with other derivative actions, in state-based insider trading cases, the remedy, if any, is paid to the corporation in the form of disgorgement of profits. Because the state-based action is derivative, neither stockholders nor any governmental entity is entitled to receive any of the profits disgorged as a remedy. Those illicit profits are paid back to the corporation and are not paid as fines to the SEC or any other regulator. In addition, state-based insider trading liability is civil and not criminal.

  2. 2 Show/Hide More Federal-based liability
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
    In additional to state-based liability, traders trading on the basis of inside information may also be liable under the federal securities laws. Federal insider trading liability carries with it potentially both civil and criminal liability. Like state-based liability, federal liability for insider trading is derived from the common law. There is no federal statute that explicitly prohibits insider trading. Rather, courts have interpreted Section 10b of the Securities Act of 1934, the Act’s anti-fraud provision, as prohibiting insider trading.
    1. 2.2 Show/Hide More SEC v Texas Gulf Sulphur
      Original Creator: Brian JM Quinn
      The following case, Texas Gulf Sulphur is an early federal insider trading case.  In TGS, the court starts from the position that insiders, as fiduciaries, have an obligation not to use the corporation’s information for their personal benefit. As fiduciaries, insiders have an obligation to “disclose” the confidential inside information, or “abstain from trading” while in possession of the corporation’s material, confidential inside information.  Questions arise as to what information is material and when is information no longer confidential such that an insider may freely trade on it.
    2. 2.3 Show/Hide More Tipper/Tippee Liability
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      What about liability for insider trading in situations where the trading doesn't involve an insider? The knottiest of these problems involve situations where insiders have tipped outsiders who then trade.

      Tipping is a direct challenge to the classical insider trading doctrine and requires some development of the law. Because the recipient of inside information does not have a fiduciary duty to the shareholders or the corporation, classical insider trading theory does not extend to recipients of inside information. Courts have responded to these situations by finding ways to extend liability to recipients of inside information, “tippees”. Because courts built tippee liability for insider trading on an ediface of fiduciary duty, the reach of liability can at times be limited.

      1. 2.3.1 Show/Hide More Dirks v. SEC
        Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
        Tipper/Tippee liability
      2. 2.3.2 Show/Hide More SEC. v. Switzer
        Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
        Not all tippees will be subject to liability for trading on a corporation’s materail, confidential inside information. In the case that follows, the court tests the limits of liabilty for tippees.
      3. 2.3.4 Show/Hide More U.S. v. Chestman
        Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
        There are many situations in which it might be unreasonable for the court to seek evidence of a breach of fiduciary duty. For example, where a spouse learns inside information and trades on it. The courts and SEC have adapted in response to those situations.
    3. 2.4 Show/Hide More Misappropriation Theory
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      Classical insider trading theory generates liability for insiders, temporary insiders, and tippees in the event any of them trade in the stock of the corporation to which they own a fiduciary duty while in possession of material inside information.

      However, this classical theory has an obvious limitation. Under the classical theory of insider trading, there is no liability if the insider uses the material inside information of the corporation to trade in the stock of ANOTHER corporation and not the corporation to which the insider has a fiduciary duty.

      The following cases lay out the courts' response to the limitations of the classical insider trading theory while holding on to its fiduciary duty core.

      1. 2.4.2 Show/Hide More U.S. v. O'Hagan
        Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      2. 2.4.3 Show/Hide More SEC v. Dorozhko
        Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
        Like tipper/tippee liability, there are limits to use of misappropriation theory. In Dorozhko, the Second Circuit extends misappropriation theory in a novel way. Dorozhko involves a Ukrainian hacker who steals inside information and then trades on it. The lack of a fiduciary relationship to the source of the information should mean there is no liability under misappropriation theory. However, here the court agrees with the SEC's theory and extends liability but in a novel way, suggesting that fiduciary relationships are not actually required in order to establish liability under 10b-5.
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December 12, 2013

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