Insider Trading: Theories of Liability, Common Defenses and Recent Cases

• Citation: Vol. 20 No. 2
• Publication year: 2014
• Author: By Angela Machala

Insider Trading: Theories of Liability, Common Defenses and Recent Cases

By Angela Machala

Angela Machala is a partner at Scheper Kim & Harris LLP. Her practice focuses on the representation of companies and corporate executives in regulatory and white collar criminal investigations, as well as state and federal civil litigation. She has spoken as a panelist at both the ABA White Collar Crime National Institute and the NACDL West Coast White Collar Seminar on topics related to criminal investigations and effective negotiations with the government.

Insider trading cases brought by the SEC and the Department of Justice often get extensive coverage in the press, perhaps because such cases appeal to the investing public's basic sense of fairness. After all, any semblance of a level playing field for investors is undermined if corporate insiders (and their family and friends) can trade with impunity based on information unavailable to other investors. In the parlance of the SEC and DOJ, insider trading laws are necessary to guard against loss of investor confidence in the integrity of the securities markets.

In 2013, insider trading cases dominated headlines more than ever before, from the SEC's high-profile loss to Mark Cuban, the owner of the Dallas Mavericks, to the indictment and guilty plea of SAC Capital Advisors. Below is a primer on the two most common theories of insider trading liability, as well as some common defenses to each theory, followed by a discussion of recent insider trading cases.

Criminal and civil insider trading law derives from Section 10(b) of the Securities Exchange Act (the "Exchange Act"), which prohibits "any manipulative or deceptive device or contrivance" used "in connection with the purchase or sale of any security."¹ Rule 10b5-1 under the Exchange Act prohibits "the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information." Section 32 of the Exchange Act makes it a crime to willfully violate any provision of the Exchange Act (or rule enacted thereunder), so both the DOJ and SEC can pursue insider trading violations.²

1. THEORIES OF LIABILITY

There are two general theories of insider trading liability under Section 10(b): the "classical theory" and the "misappropriation" theory. Under either theory, someone must have violated a duty of trust or confidence in order for there to be liability.

A. "CLASSICAL" THEORY

The "classical" theory of insider trading applies when a corporate insider, such as an officer, director, or controlling stockholder, makes a trade in the securities of the company on the basis of material, nonpublic information obtained by reason of the insider's position. The archetypal scenario is a company executive who learns about his employer's impending earnings announcement and trades in the company's securities in order to make a profit (or avoid losses) prior to the announcement being made. Such insiders are "forbidden by their fiduciary relationship from personally using undisclosed corporate information to their advantage."³ The fiduciary duty a corporate insider owes to the corporation's shareholders requires him or her to either abstain from trading on the non-public information or disclose it.⁴

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The classical theory of insider trading liability applies to both "temporary" insiders and "tippers-tippees." Temporary insiders are people who are generally outsiders to the company but who "have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes."⁵ For instance...