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Difficulty: Very hardInsider Trading and Misuse of Material Nonpublic Information

An IT systems administrator at an enterprise software firm discovers confidential database backup files containing unannounced acquisition terms for a medical device manufacturer. During a personal family dinner, the administrator discloses the pending acquisition details to his brother, explicitly instructing him not to trade on the news. The brother nevertheless purchases call options on the target company and tells a coworker, who subsequently buys shares of common stock. Which of the following statements regarding tipper and tippee liability under federal insider trading regulations are correct in this scenario? (Select all that apply.)

  1. The IT administrator can be held liable as a tipper even though he did not personally execute any securities transactions in the target company.Answer
  2. The brother can be held liable as a tippee because he traded while knowing, or having reason to know, that the information was material, nonpublic, and passed in breach of a duty.Answer
  3. C
    The brother's coworker is completely exempt from tippee liability because she received the information secondhand and maintained no direct relationship with the software firm.
  4. D
    The IT administrator is fully absolved of tipper liability because he explicitly instructed his brother not to trade prior to the public announcement.

Answer

The correct statements are that the IT administrator can be held liable as a tipper despite not executing trades, and the brother can be held liable as a tippee for trading on material nonpublic information obtained in breach of a duty.
Under the Insider Trading Sanctions Act and SEC Rule 10b-5, tipper liability is established when an individual improperly communicates material nonpublic information in breach of a fiduciary or confidentiality duty, even if that individual never trades or receives direct financial gain. Tippee liability attaches when a person trades on such information knowing (or having reason to know) it was disclosed in breach of a duty. Thus, both the statement establishing tipper liability for the non-trading IT administrator and the statement establishing tippee liability for the brother who bought options are accurate.

Step-by-Step Solution

1
Evaluate tipper liability for the IT administrator
The administrator breached a duty of confidentiality by disclosing unannounced acquisition terms. Under federal insider trading rules, a tipper is liable for communicating material nonpublic information in breach of a duty, regardless of whether the tipper personally executed trades.
Personal execution of trades is not a required element for tipper liability.
2
Evaluate tippee liability for the brother
The brother received material nonpublic information, knew or had reason to know it was confidential and disclosed in breach of duty, and acted upon it by purchasing call options.
Trading while in possession of material nonpublic information derived from a breach of duty fulfills the legal elements of tippee liability.
3
Evaluate the distractors regarding remote tippees and verbal warnings
Remote (secondhand) tippees remain subject to insider trading rules if they knew or had reason to know the information originated from an improper breach. Additionally, providing a verbal warning not to trade does not shield the tipper from legal liability for the unauthorized leak.
Neither lack of direct contact with the insider source nor explicit warnings against trading provide an automatic exemption from liability.

Key Concept

Tipper and Tippee Legal Liability Elements under Federal Securities Laws
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Topics

Insider Trading and Misuse of Material Nonpublic Information