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Difficulty: Very hardInsider Trading and Misuse of Material Nonpublic Information

A structural engineering consultant retained by a publicly traded utility firm learns during a confidential safety audit that a key regional power facility faces an immediate, unannounced regulatory shutdown. The consultant does not execute any securities transactions, but discloses this material nonpublic information to a close personal friend. The friend immediately buys put options on the utility firm's stock prior to the public press release, generating significant profits. Under federal securities laws, which of the following statements correctly describes the potential insider trading liability of the consultant and the friend?

  1. Both the consultant and the friend can be held liable under insider trading regulations, even though the consultant did not personally execute any trades.Answer
  2. B
    Only the friend can be held liable, because tipper liability strictly requires the individual conveying the information to execute a trade directly.
  3. C
    The friend is completely exempt from liability because non-employees who do not owe a direct fiduciary duty to the issuer cannot be prosecuted for insider trading.
  4. D
    Neither party can be held liable because information acquired by independent contractors during external safety audits is exempt from insider trading rules.

Answer

Both the consultant (tipper) and the friend (tippee) can be held liable for insider trading violations, even though the consultant did not execute any securities transactions personally.
Under federal securities laws and SEC Rule 10b-5, a person who possesses material nonpublic information and breaches a duty of trust by passing it to another acts as a tipper and can be held liable even if they do not execute any trades. The recipient who trades on that information while knowing (or having reason to know) it was nonpublic and improperly disclosed acts as a tippee and is also liable.

Step-by-Step Solution

1
Analyze the status of the consultant's information.
The engineering consultant acquired material nonpublic information while under a duty of confidentiality as a temporary insider for the utility firm.
Independent contractors working with confidential corporate data inherit a fiduciary-like duty of trust and confidence.
2
Evaluate the consultant's action of sharing the information.
By conveying material nonpublic information to a friend, the consultant committed a tipper violation.
A tipper is liable for breaching a duty of trust by passing confidential information, regardless of whether the tipper personally trades or receives monetary compensation.
3
Evaluate the friend's trading action.
By trading options based on information known to be material and nonpublic, the friend committed a tippee violation.
A tippee who knows or should know that information was disclosed in breach of a duty inherits liability upon executing a trade.

Key Concept

Tipper and Tippee Liability under Insider Trading Regulations
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Topics

Insider Trading and Misuse of Material Nonpublic Information