Insider trading

Insider trading occurs when someone trades a security while in possession of material, non-public information (MNPI) — information that hasn't been released to the public and that a reasonable investor would consider important, like an unannounced merger, earnings surprise, or FDA decision. Despite the name, you don't have to be a corporate insider to commit it — but simply possessing MNPI isn't enough. Liability generally requires that the trading or tipping breach a fiduciary duty or a duty of trust or confidence, whether owed to the company's shareholders (the classical theory) or to the source of the information (the misappropriation theory). One notable exception: under Rule 14e-3, trading on MNPI about a tender offer is prohibited without any showing of a duty breach.

Liability reaches both sides of a tip. The tipper — the person who shares the information in breach of a duty — and the tippee — the person who receives and trades on it — can both be prosecuted, even if the tipper never traded a single share. The tippee is liable only if they knew or had reason to know the information was disclosed improperly. For example, an executive who tells a friend about an upcoming acquisition, and the friend who understands the tip was improper and buys stock ahead of the announcement, have both broken the law.

The punishment is severe and often the focus of exam questions. Civil penalties can reach three times the profit gained or loss avoided (treble damages), sought by the SEC under the Insider Trading and Securities Fraud Enforcement Act of 1988. Criminal penalties add fines of up to $5 million and up to 20 years in prison for individuals, while firms face fines up to $25 million. Violators also face industry bars and disgorgement of profits.

Insider trading appears on virtually every securities licensing exam as a prohibited activity. The SIE and Series 6 exams test the definition, tipper/tippee liability, and penalty amounts, while the Series 63 exam treats insider trading among the criminal violations of state securities law.