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Question

Difficulty: MediumInsider Trading and Misuse of Material Nonpublic Information

An independent accounting contractor working on a confidential audit for a publicly traded company discovers undisclosed financial distress and tells a friend during dinner. The friend subsequently purchases put options on the company's stock before the public earnings release. Which of the following statements regarding regulatory liability under insider trading rules are CORRECT?

  1. The independent accounting contractor can be held liable as a tipper for breaching a duty of trust and confidentiality by passing material nonpublic information.Answer
  2. The friend can be held liable as a tippee because trading was conducted while knowingly in possession of material nonpublic information obtained from an insider source.Answer
  3. C
    The friend is exempt from tippee liability because an independent accounting contractor is an external service provider rather than a direct corporate officer of the company.
  4. D
    Insider trading regulations apply only when equity shares are directly purchased or sold, excluding derivatives such as put or call options.

Answer

Under federal insider trading rules, both the contractor who passed the information (tipper) and the friend who traded on it (tippee) are liable. External contractors are considered temporary insiders, and insider trading rules cover option transactions as well as direct stock trades.
The correct statements establish that tippers are liable for communicating material nonpublic information in breach of confidentiality and tippees are liable for trading on such information. Contractors act as temporary insiders, and insider trading prohibitions apply broadly to all securities transactions, including options.

Step-by-Step Solution

1
Determine the status of the information and the source
The financial audit data is material nonpublic information, and the accounting contractor holds a duty of trust as a temporary insider.
Contractors given access to confidential corporate files inherit fiduciary duties regarding nonpublic data.
2
Evaluate tipper liability
The contractor committed a violation by communicating material nonpublic information to an unauthorized third party.
Communicating confidential data in breach of duty creates tipper liability.
3
Evaluate tippee liability and instrument coverage
The friend inherits liability upon trading on the tip, and options transactions fall fully under insider trading prohibitions.
Tippees who know or should know the information source is bound by confidentiality are subject to prosecution when trading any related securities, including options.

Key Concept

Tipper and Tippee Liability for Misuse of Material Nonpublic Information
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Topics

Insider Trading and Misuse of Material Nonpublic Information