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Difficulty: HardInsider Trading and Misuse of Material Nonpublic Information

A chief research scientist at a publicly traded biotechnology firm informs an old university classmate during a private dinner that the firm's core drug candidate received unexpected regulatory approval earlier that day, prior to any public disclosure. The scientist does not receive any financial payment or tangible benefit and tells the classmate to keep the information confidential. The classmate immediately buys call options on the biotechnology firm's stock and realizes significant profits once the approval is publicly announced. Under federal securities regulations governing insider trading, which of the following statements correctly evaluates the legal liability of both individuals?

  1. A
    Only the classmate is liable because the scientist did not execute any trades or receive direct financial compensation for the information.
  2. Both the scientist and the classmate are liable because disclosing material nonpublic information constitutes a breach of duty by the tipper, and trading on such information creates liability for the tippee.Answer
  3. C
    Neither party is liable because the communication occurred within a private social setting without a formal agreement to share trading profits.
  4. D
    Only the scientist is liable because the classmate is an outside party who holds no direct fiduciary duty to the biotechnology firm or its shareholders.

Answer

Both the scientist (as the tipper) and the classmate (as the tippee) are liable under federal insider trading regulations.
Both the insider (tipper) and the trader (tippee) violate federal securities laws. The insider breaches a duty of trust by revealing material nonpublic information (even without direct financial compensation), and the tippee inherits liability by knowingly executing trades based on that improperly disclosed information.

Step-by-Step Solution

1
Analyze the nature of the information transmitted.
The regulatory drug approval is material (would affect an investor's decision) and nonpublic (not yet released to the general public).
Trading on or disclosing material nonpublic information violates Rule 10b-5 under the Securities Exchange Act of 1934.
2
Evaluate the tipper's (scientist's) liability.
The scientist breached a duty of trust and confidentiality owed to the company by disclosing material nonpublic information to a third party.
Personal benefit for a tipper can include making a gift of confidential information to a friend or acquaintance; monetary gain or personal execution of trades is not required for tipper liability.
3
Evaluate the tippee's (classmate's) liability.
The classmate acted on material nonpublic information obtained from an insider breach.
A tippee inherits the insider's duty and violates insider trading laws when trading securities based on improperly disclosed material nonpublic information.

Key Concept

Tipper and Tippee Liability under Insider Trading Regulations
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Topics

Insider Trading and Misuse of Material Nonpublic Information