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Difficulty: Very hardInsider Trading and Misuse of Material Nonpublic Information

An audit manager at a publicly traded retail corporation learns during a confidential internal review that the company will announce a major restatement of past financial statements. Prior to the public disclosure, the manager tells their sister about the restatement and suggests buying put options. The sister chooses not to trade, but discloses the information to a coworker, knowing the coworker actively trades options. The coworker immediately purchases put options on the retailer's stock and realizes a $50,000 profit after the public announcement. Under federal securities laws regarding insider trading, which of the following statements correctly identifies who may be held liable for insider trading violations?

  1. The audit manager, the sister, and the coworker can all be held liable for insider trading violations.Answer
  2. B
    Only the coworker who actually executed the options trade can be held liable, because tipper liability requires executing a trade or receiving direct monetary compensation.
  3. C
    Only the audit manager and the coworker are liable; the sister is completely exempt from liability because she neither traded nor received financial compensation.
  4. D
    Neither party can be held liable under insider trading regulations because equity derivative contracts such as put options are exempt from federal insider trading laws.

Answer

The audit manager, the sister, and the coworker can all be held liable for insider trading violations.
Under the Insider Trading Sanctions Act and SEC rules, liability for insider trading applies to the original tipper who breaches a duty of trust, intermediate tippers who knowingly pass along material nonpublic information, and tippees who trade on the information. The audit manager breached a duty to the firm, the sister acted as an intermediate tipper by passing the inside news to a third party, and the coworker traded on the inside information knowing its confidential nature. Thus, all three parties are subject to insider trading liability.

Step-by-Step Solution

1
Analyze the original tipper's actions and duty.
The audit manager owed a fiduciary duty of trust and confidentiality to the company and breached it by disclosing material nonpublic information to a family member.
Disclosing confidential financial information to a relative constitutes a breach of duty and establishes primary tipper liability.
2
Evaluate the intermediate tipper's actions.
The sister received material nonpublic information from an insider and passed it along to a coworker who she knew traded options.
An intermediate individual who knowingly conveys inside information that leads to a trade can be held liable as a tipper, even if they did not trade or receive monetary gain themselves.
3
Evaluate the trading tippee's actions and liability.
The coworker knew or had reason to know that the information was nonpublic and originated from a corporate insider breach, yet executed option trades based on it.
A tippee who trades while in possession of material nonpublic information knowing it was improperly disclosed incurs full insider trading liability.

Key Concept

Tipper and Tippee Liability under Insider Trading Regulations
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Topics

Insider Trading and Misuse of Material Nonpublic Information