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Working Paper
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Defining “Material, Nonpublic:” What Should Constitute

Illegal Insider Information?

Cindy A. Schipani
Stephen M. Ross School of Business
University of Michigan

H. Nejat Seyhun
Stephen M. Ross School of Business
University of Michigan

Ross School of Business Working Paper

Working Paper No. 1287
September 2015

Forthcoming in the ‘Fordham Journal of Corporate and Financial Law'

This work cannot be used without the author's permission.

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 FORTHCOMING: FORDHAM JOURNAL OF

CORPORATE AND FINANCIAL LAW

Defining “Material, Nonpublic:”

What Should Constitute Illegal Insider Information?*

Cindy A. Schipani** and H. Nejat Seyhun***

Abstract

The courts, the SEC, and the U.S. Congress should take up the recent opportunity
presented by the Second Circuit decision in United States v. Newman (773 F.3d 438 (2014)) to
define what material, nonpublic insider trading information means and in this spirit, we offer a
new approach. Our approach is simple, easy to implement and difficult to circumvent by
insiders.

*
Copyright 2015. Cindy A. Schipani and H. Nejat Seyhun. All rights reserved. We thank Alina Charnianuskaya,
Ivana Mrazova, Jacob Styburski, and Julia Xin for excellent research assistantship.
**
Merwin H. Waterman Collegiate Professor of Business Administration and Professor of Business Law, University
of Michigan, Ann Arbor, Michigan.
***
Jerome B. & Eilene M York Professor of Business Administration and Professor of Finance, University of
Michigan, Ann Arbor, Michigan.

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 The statutory penalties for illegal insider trading are almost as severe as first-degree

murder, yet we see insiders make tens of thousands of lucrative transactions every year.

Moreover, the increase in penalties over time has done little to slow down insider trading. 1

What is the explanation for this paradox?

Even though more than 80 years have passed since the Securities and Exchange Act of

1934, which prohibits fraud in the purchase or sale of any security and more than 50 years have

passed since the 1961 decision in In re Cady, Roberts & Co.2 holding trading by insiders on

material, nonpublic information illegal, neither the U.S. Congress nor the U.S. Securities and

Exchange Commission (SEC) has defined what the phrase material, nonpublic information

means. In the absence of any definition, courts typically find insider trades made immediately

prior to disclosure of corporate takeovers, earnings announcements, and dividend announcements

as unlawful.3 Immediately usually means within days or hours of an announcement by the firm.

What is much less clear is whether trading on a takeover or earnings information one month

before the announcement is legal. What is also not clear is the legality of trading on other types

of valuable information such as corporate structuring, new security issues, corporate borrowing

decisions, and personnel changes, etc., all of which can significantly impact stock prices.4 We

argue that it is this ambiguity about what is and is not allowed under the law that enables

corporate insiders to engage in profitable transactions.

1
See Mirela V. Hristova, The Case for Insider-Trading Criminalization and Sentencing Reform, 13 TENN. J. BUS. L.
267, 279-80 (2012). See generally Patrick Augustin, Menachem Brenner & Marti G. Subrahmanyam, Informed
Options Trading Prior to M&A Announcements: Insider Trading?, Working Paper (2015), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2441606.
2
15 U.S.C. § 78j(b); 17 C.F.R. 240.10b-5; 40 S.E.C. 907 (1961).
3
Lisa K. Meulbroek, An Empirical Analysis of Illegal Insider Trading, 47 J. FIN. 1661, 1680 (1992) (noting that
insider trading is associated with immediate price movements and quick price discovery”).
4
See e.g., Karl-Adam Bonnier and Robert F. Bruner, An Analysis of Stock Price Reaction to Management Change in
Distressed Firms, J. OF ACCOUNTING AND ECONOMICS, 95 (1989); Steven Davidoff Solomon, In Corporate
Disclosure, a Murky Definition of Material, N.Y. TIMES, APRIL 5, 2011.

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 Over the past 30 years, as public concern about illegal insider trading has increased,

Congress has responded by passing legislation that has repeatedly increased the penalties upon

conviction. In 1984, Congress passed the Insider Trading Sanctions Act (ITSA),5 followed by

the Insider Trading and Securities Fraud Enforcement Act (ITSFEA)6 in 1988 and followed by

the Sarbanes Oxley Act (SOX)7 in 2002, all without defining what constitutes illegal insider

information. Currently, the penalties from insider trading can reach up to 20 years in prison and

up to one million dollars in penalties for each offense.8

Yet, while the penalties have increased over time, the definition of illegal insider

information has become even more ambiguous. To further complicate this matter, through a

strict interpretation of the Supreme Court’s holding in Dirks v. S.E.C,9 the U.S. Court of Appeals

for the Second Circuit recently required a showing of personal benefit to insider-tippers before

attaching liability to tippees.10 In particular, in order to establish tippee liability, the Second

Circuit now requires the government “prove beyond a reasonable doubt that the tippee knew that

an insider disclosed confidential information and that he did so in exchange for a personal

benefit.”11 This ruling significantly raises the bar for establishing liability because this

requirement can easily be avoided by traders who add additional layers between the original

tipper and the eventual tippee. Moreover, the U.S. Solicitor General has requested that the

Supreme Court review the decision; and, if certiorari is granted, the Court may apply the Second

5
Insider Trading Sanctions Act of 1984, Pub. L. No. 98-376, 98 Stat. 1264.
6
Insider Trading and Securities Fraud Enforcement Act of 1988, Pub. L. No. 100- 704, 102 Stat. 4677.
7
Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745.
8
Hristova supra, note 1, at 279-80.
9
See Dirks v. S.E.C., 463 U.S. 646, 662 (1983) (holding that derivative (tippee) liability can only be found where
the insider-tipper “personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain,
there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.”).
In Dirks, the insider-tipper shared personal information with an analyst (the defendant) in order to expose an
insurance scam being perpetrated by the tipper’s company. Id.
10
United States v. Newman, 773 F.3d 438, 442 (2d Cir. 2014).
11
Newman, 773 F.3d at 442.

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Circuit’s personal benefit requirement nationwide.12 We argue that the additional ambiguity

created by the Newman ruling will lead to fewer insider trading prosecutions, increased

frequency and profitability of insider trading, thereby causing detriment to the investing public

and its confidence in public markets.13

Therefore, the courts, the SEC and Congress should reverse course and define insider

trading more precisely. Increasing civil and criminal penalties does not work as a successful

deterrent if there is substantial ambiguity about what is illegal insider trading. This ambiguity

allows insiders to not only trade successfully but also to fend off attempts by the SEC and the

U.S. Justice Department to discipline them after the fact. The evidence we present in this paper

is consistent with our hypothesis. Our evidence shows that insiders have been able to engage in

hundreds of thousands of lucrative transactions over the past 40 years without ever worrying

about sanctions.

We thus urge the courts, the SEC, and Congress to take this opportunity to define the

phrase “material, nonpublic” and in this spirit, we offer an evidentiary presumption. Our

presumption is simple, easy to implement, and difficult to circumvent by insiders. We propose

that the a prima facie case of trading on material, nonpublic information be found upon proof

that: (1) the information giving rise to the trade is of the type that requires an 8-K filing by the

corporation, (2) its announcement must lead to statistically significant abnormal stock returns,

and (3) the insider trading must have occurred within two months prior to the announcement of

the information. Given that corporations file 10-Q and 10-K reports every three months, these

12
U.S. Asks Justices to Review ‘Newman’ Insider Case, SECURITIES LAW DAILY, Aug. 3, 2015,
http://www.bna.com/us-asks-justices-n17179934226/; see also http://www.scotusblog.com/wp-
content/uploads/2015/07/Newman-petition-by-SG-7-29-15.pdf.
13
Beeson, Ed, SEC Loses Insider Trading case on Home Court”, Law360, September 14, 2015. See,
http://www.law360.com/securities/articles/702227?nl_pk=b7cedb18-41f7-4adf-baa2-
177ef5398f80&utm_source=newsletter&utm_medium=email&utm_campaign=securities

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conditions in effect require that all insider trading based on 10-Q/K information to be confined to

approximately one-month window after each earnings announcement.14 If all three conditions

are satisfied, then the burden of proof must shift to the insiders to show that the particular

transaction does not meet the material, nonpublic information requirement. Furthermore, any

tipping by insiders of any information satisfying these three conditions above must again shift

the burden of proof to defendants to show that their tip(s) should be exempted.

There is evidence that information disclosed in 8-K filings provides new and material

information to the public. Recent research shows that 15,419 transactions executed by insiders

during the four-business-days prior to the filing of 8-K reports exhibit statistically significant

abnormal trading profits of 42 basis points.15 This finding indicates that insiders can and do

exploit the new information contained in 8-K reports.

Of course, this evidentiary presumption does not cover all possible instances of insider

trading and it is not intended to be comprehensive. For instance, insiders may trade on material,

nonpublic information and yet, they may still end up losing money due to unexpected

circumstances. Insiders may also exploit long-lived information beyond two months. Our

objective is to provide a prima-facie presumption of what is always considered material,

nonpublic information, similar to Rule 14e-3 (described below), which has declared takeover-

related information to be always material and nonpublic. We recognize that other types of

trading may still fall in a grey area and will need to be resolved through a fact-finding process.

We expect additional clarity will allow all insiders who want to be on the safe side of the

law to ensure that their transactions do not meet any of the conditions set forth above. Insiders

14
Typically, one week after earnings announcements is also considered a black-out period to allow to markets to
fully digest the earnings information. This in effect confines insider trading to one and four weeks between each
earnings announcement.
15
See Alma Cohen, Robert Jackson & Joshua Mills, “The 8-K Trading Gap,” Columbia University working paper.
available at http://bj1.law.columbia.edu/8kgap.

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already know which events trigger an 8-K filing. By not trading or tipping during the two-month

window preceding an upcoming 8-K filing, insiders can easily ensure that at least two of the

three conditions will not be satisfied. The benefit of this additional clarity should enable courts

to separate routine insider trading from opportunistic trading and increase the confidence in the

public equity markets.

The remainder of the paper is organized as follows. Section I discusses the development

of insider trading law and recent developments in materiality of insider trading information,

including the role of the Newman decision. Section II outlines the numerous criminal and civil

penalties imposed upon the undefined offense of insider trading. Section III describes our

proposal for a new evidentiary presumption and discusses the potential effects of the Newman

decision in establishing liability under insider trading laws. In Section IV, we argue that insiders

exploit the vagueness in the statutes to engage in profitable transactions. Thus, the profitability

of insiders’ transactions is itself a measure of the (in) effectiveness of the insider trading laws.

We also present evidence on time series profitability of historical insider trading to gauge the

deterrence effect of the insider trading laws. Our conclusions follow.

I. The Development of Insider Trading Law

Insider trading is not defined in federal securities laws, thus the courts are left to interpret

whether insider trading is fraudulent and, more specifically to define material, nonpublic insider

information.16 The lack of statutory or regulatory definition in this respect is troublesome and out

of line with many jurisdictions across the Atlantic. 17 In the U.S., the offense is based on

16
See 15 U.S.C. § 78j(b); 17 C.F.R. 240.10b-5.
17
Edward Greene & Olivia Schmid, Duty‐Free Insider Trading?, 2013 COLUM. BUS. L. REV. 369, 424 (2013). In
the European Union (EU) for example, the offense is defined in a statutory directive, the Market Abuse Directive.
The Directive is detailed and the crime is premised on the concept of parity of information without a requirement of
deception or misleading conduct, or breach of a fiduciary duty or any similar relationship of trust and/or confidence.
Id. at 369. The SEC lobbied for a similar parity-of-information approach, but this approach was rejected in
Chiarella v. United States, 445 U.S. 222 (1980), where the Supreme Court found it too broad in scope, since Rule

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interpretations, both judicial and administrative, of the antifraud provisions in Section 10(b) of

the Securities and Exchange Act and Rule 10b-5 of the SEC.18 While state causes of action and

liability for securities fraud had existed long before,19 serious federal involvement did not begin

until 1961, when the SEC argued in In re Cady, Roberts & Co., 20 that federal antifraud

provisions should extend to cover insider trading.21 The crime is either criminal or civil and has

been interpreted by the courts as requiring intent.22

Today, according to the SEC, insider trading “generally occurs when a security is bought or

sold in breach of a fiduciary duty or other relationship of trust and confidence while in

possession of material, nonpublic information.”23 “Inside information” is generally understood to

be “nonpublic information about events or circumstances related to a company’s assets or

earning power known only to corporate management and its confidants, and which can

reasonably be expected to have a material effect on the company’s share price.”24 Not all insider

trading cases involve this type of information, however. Some concern trading by professionals

on nonpublic market information, and others include “tipping” this information to others. The

SEC defines information as being material “if its release could affect the company’s stock price.”

The SEC definitions and rules are generally broader than the limited rulings of the courts.

A. Lack of Statutory Clarity

10b-5 is based on fraud. The parity-of-information approach is focused on the information, not how the person
obtains it from his or her source, and does not involve criminal intent. The U.S. has not adopted this approach and
continues to suffer from lack of clear definitions of insider trading.
18
15 U.S.C. § 78j(b); 17 C.F.R. 240.10b-5.
19
Robert B. Thompson, Insider Trading, Investor Harm, and Executive Compensation, 50 CASE W. RES. L. REV.
291, 293 (1999).
20
Id.
21
Securities Exchange Act of 1934 Release No. 8-3925, 40 S.E.C. 907 (Nov. 8, 1961); see Thompson, supra note
17, at 293.
22
See, e.g., Chiarella, 445 U.S. 222.
23
SEC Enforcement Actions: Insider Trading Cases, U.S. Securities and Exchange Commission, available at
http://www.sec.gov/spotlight/insidertrading/cases.shtml.
24
Roberta S. Karmel, The Law on Insider Trading Lacks Needed Definition, Brooklyn Law School Legal Studies,
Research Paper No. 413, at 2 (May 2015), available at http://ssrn.com/abstract=2607693 (citing SEC v. Texas Gulf
Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968)).

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 Section 10(b) of the 1934 Securities Exchange Act (the “Exchange Act”) provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce or of the mails, or of any facility of any national
securities exchange—
...
(b) To use or employ, in connection with the purchase or sale of any security registered
on a national securities exchange or any security not so registered, or any securities-based
swap agreement any manipulative or deceptive device or contrivance in contravention of
such rules and regulations as the Commission may prescribe as necessary or appropriate
in the public interest or for the protection of investors.25

SEC Rule 10(b)(5) similarly states:

It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of any national
securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the circumstances under
which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate
as a fraud or deceit upon any person, in connection with the purchase or sale of any
security.26

It is notable that neither the statute nor the regulatory rule even utilize the phrase “insider

trading” let alone define it. Instead, insider trading has been considered fraud, covered by the

above statute and rule, through court interpretation.27

Historically, the SEC and the U.S. government did not agree on the definition of insider

trading. The SEC resisted defining insider trading in fear that a definition would enable more

fraud.28 Therefore, it has passed rules to clarify the borders of what the crime constitutes based

25
15 U.S.C. § 78j(b).
26
17 C.F.R. 240.10b-5.
27
Securities Exchange Act of 1934 Release No. 8-3925, 40 S.E.C. 907 (Nov. 8, 1961) (the first decision to hold that
section 10(b) of the 1934 Exchange Act and SEC rule 10(b)(5) apply to insider trading); Chiarella, 445 U.S. 222
(the first Supreme Court case to hold that section 10(b) and rule 10(b)(5) cover insider trading).
28
See e.g., Jed S. Rakoff, Keynote Address at the PLI Securities Regulation Institute: Is the S.E.C. Becoming a Law
Unto Itself? (noting that the S.E.C. “has repeatedly resisted any effort by Congress to statutorily define insider
trading, preferring to leave the concept sufficiently flexible as to be able to adjust to new developments”) Nov. 5,

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on the court decisions on the matter throughout the years. When the U.S. Senate29 and the U.S.

House of Representatives30 attempted to define insider trading with proposed bills in 1987, the

SEC proposed its own bill.31 These bills, however, adopted different approaches. Whereas the

Senate and SEC gave contemporaneous traders the ability to recover damages, the House put

forward a criminal statute.32

The Senate bill would have considered “information … [to have been] used or obtained

wrongfully only if it has been obtained by, or its use would constitute, directly or indirectly,

theft, conversion, misappropriation or a breach of any fiduciary, contractual, employment,

personal or other relationship of trust and confidence.”33 The SEC, on the other hand, wanted to

outlaw trading while in possession of material, nonpublic information only if this information

“has been obtained by, or its communication would constitute, directly or indirectly (A) theft,

bribery, misrepresentation, espionage (through electronic or other means) or (B) conversion,

misappropriation, or any other breach of any personal or other relationship of trust and

confidence, or breach of any contractual or employment relationship.” 34 This change from

“possession” to “use” resulted in no action being taken until the ITSFEA 35 which, while

increasing sanctions for the crime, was not any more helpful in defining insider trading.36

B. Defining Insider Trading through Case Law

2014; The Muddle of Insider Trading Regulation, N.Y. TIMES, Nov. 24, 1991, available at
http://www.nytimes.com/1991/11/24/business/l-the-muddle-of-insider-trading-regulation-101791.html.
29
S. 1380, 100th Cong. (1987).
30
H.R. 1238, 100th Cong. (1987).
31
Insider Trading Act of 1987, 19 Sec. Reg. & L. Rep. (BNA) 1284 (1987).
32
S. 1380, 100th Cong. (1987); H.R. 1238, 100th Cong. (1987); Insider Trading Act of 1987, 19 Sec. Reg. & L. Rep.
(BNA) 1284 (1987).
33
S. 1380, at 2.
34
Accompanying Letter, and Analysis by Ad hoc Legislation Committee, 19 Sec. Reg. & L. Rep. (BNA) 1817
(1987).
35
Insider Trading and Securities Fraud Enforcement Act of 1988, Pub. L. No. 100-704, 102 Stat. 4677 (1988)
(codified in subsections of 15 U.S.C. § 78 & 80b-4a).
36
Karmel, supra note 22, at 9.

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 In large part due to the lack of statutory clarity, the courts find it necessary to shape the

boundaries of what constitutes illegal insider information through case law. In re Cady, Roberts

& Co,37 the first insider trading case under Rule 10b-5, a broker-dealer’s liability derived from

the conduct of one of its principals, a director of a corporation that decided to make a dividend

cut.38 The SEC found the director had violated Rule 10b-5 when, soon after leaving the board

meeting, he sold securities in customer accounts of the broker-dealer, including those in which

he had a beneficial interest.39 The SEC emphasized the existence of a relationship, which gave

the director access to inside information only intended for a corporate purpose and the unfairness

of allowing him to take advantage of this information by trading without disclosure.40

In SEC v. Texas Gulf Sulphur Co., 41 the Second Circuit adopted this view when it

affirmed an injunction against an issuer, its officers and employees, disallowing them from

trading and tipping others to trade stocks and options based on insider information concerning a

large copper strike by the issuer in Canada. The court rooted its decision in the theory that

investors trading on impersonal exchanges should have similar access to material information.42

In this case and those following, the SEC would argue that in the public securities markets Rule

10b-5 requires a parity of information among traders.43

In In re Investors Management Co., investment advisers and mutual fund managers sold

stock in a company because of a selective disclosure from the underwriter of the company’s

debentures of a reduction in its earnings. 44 The SEC held that anyone who obtains insider

information, “which he has reason to know emanates from a corporate source and which places

37
40 S.E.C. 907 (1961).
38
Id. at 909.
39
Id.
40
Id. at 911-13.
41
SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968).
42
Id. at 849.
43
Karmel, supra note 22, at 3.
44
In re Investors Management Co., 44 S.E.C. 633, 636-37 (1971).

10

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him in a position superior to other investors, acquires a relationship with respect to that

information giving rise to a legal duty under Rule 10b-5.”45 Commissioner Smith’s concurring

opinion further stated that the tippee “must know that the information was given to him in breach

of a duty by a person having a special relationship to the issuer” and the information must also

have substantially contributed to the trading at hand. 46 The case exemplifies the two main

questions in the debate: first, whether possession of insider information is enough for a violation

or if it also has to be traded or used and, second, must the tippee trading on the information know

that it was given in breach of a duty by someone with a special relationship with the company in

question in which he or she cannot disclose this information?47 This concurring opinion would

resonate in a later ruling of the Court.

Almost a decade later in Chiarella v. United States,48 the Supreme Court rejected this

parity of information theory stating that not every case of financial unfairness is in violation of

Rule 10b-5. 49 In this case, the Court reversed the conviction of an employee of a printing

company who, upon learning of upcoming tender offers for a few target companies, purchased

shares in those companies in order to sell them at a profit after the tender offer was announced.50

Because the names of the companies were not well disguised, the employee was able to ascertain

their names on his own and, thus, was not tipped. Noting this, the Court held that “silence in

connection with a purchase or sale constitutes fraud only if liability is premised on a duty to

disclose arising from a relationship of trust and confidence.”51

45
Karmel, supra note 22, at 3 (citing Chiarella, 445 U.S. at 240).
46
Id.
47
Karmel, supra note 22, at 3.
48
445 U.S. 222 (1980).
49
Id. at 231-32.
50
Id. at 222.
51
Id. at 230.

11

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 Apart from its majority opinion, the case also generated an important dissent from Chief

Justice Burger, which shaped the development of insider trading law. In his dissent, he stated that

a rule, that does not require parties to an arm’s length business transaction to disclose, in the

absence of a confidential or fiduciary relation,

permits a businessman to capitalize on his experience and skill in securing and

evaluating relevant information; it provides incentive for hard work, careful
analysis, and astute forecasting. But the policies that underlie the rule also should
limit its scope. In particular, the rule should give way when an informational
advantage is obtained, not by superior experience, foresight, or industry, but by
some unlawful means.52

In the 5-4 decision, the majority of the Justices presumably supported the misappropriation

doctrine.53

Sidestepping this limited understanding of insider trading violations, the SEC passed

Rule 14e-3.54 Rule 14-e-3 creates a “disclose or abstain” from trading requirement for anyone

who (1) possesses material information concerning a tender offer and (2) knows or has reason to

know the information is nonpublic and derived from the offeror or target company. The SEC

regards this as a prophylactic rule and argues that neither scienter nor breach-of-duty is required

to trigger a violation. 55 This rule proved to be useful in its prosecutions involving advance

knowledge of tender offers, and both the SEC and the DOJ prosecuted a number of cases under

this rule, on the basis of misappropriation theory.56

52
Id. at 239-40.
53
Karmel, supra note 22, at 4 (citing Chiarella, 445 U.S. 222).
54
17 C.F.R. §240.14e-3 (2014).
55
Karmel, supra note 22, at 4 n. 33 (citing Tender Offers, Exchange Act Release No. 17120, 45 Fed. Reg. 60,410
(Sept. 4, 1980)).
56
Karmel, supra note 22, at 4; see SEC v. Jacobs, No. 13-CV-1289 (N.D. Ohio June 11, 2013) (denying defendants’
motion for judgment as a matter of law where downstream tippees allegedly traded on information concerning a
planned tender offer); Steginsky v. Xcelera Inc., Nos. 13-cv-1327, 13- cv-1892 (2d Cir. Jan. 27, 2014) (reversing the
trial court’s dismissal of insider trading charges where defendants allegedly traded on information concerning a
planned tender offer).

12

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 Explicitly rejecting the equal access or parity of information theory, the Supreme Court in

Dirks v. SEC, overturned the SEC’s sanctions against Dirks finding that a tippee’s liability is

derivative.57 Dirks, an insurance company analyst, received information from a former officer of

a company and began an independent investigation resulting in a finding that the company was

engaging in large scale fraud. 58 After Dirks told his clients and potential clients about his

findings, many sold their shares of the company. The Court rejected SEC’s argument that when

tippees come into knowledge of material information they know is confidential, they must

publicly disclose it or abstain from trading.59 Instead, in order for a tippee to be held liable for

trading on material, nonpublic information, the tipper must have breached her duty “before the

tippee inherits the duty to disclose or abstain.”60 As the Dirks Court explained, because there are

many legitimate reasons why an insider might disclose material nonpublic information,61 the test

for insider breach “is whether the insider personally will benefit, directly or indirectly, from his

disclosure.”62 According to Dirks, personal benefit may be satisfied in many ways, e.g., by proof

of pecuniary benefits, reputational benefits that will promote future earnings, the benefit

associated with "mak[ing] a gift of confidential information to a trading relative or friend," or

even the mere existence of a relationship between the insider and tippee that suggests a quid pro

quo arrangement;63 and the federal courts have typically imposed little burden on prosecutors in

57
Dirks, 463 U.S. at 647.
58
Id. at 646.
59
Id. at 647.
60
Id.
61
In Dirks, for example, the insider-tipper was acting as a whistleblower and disclosed information to the defendant
in order to expose an insurance scam occurring at his company.
62
Id. at 662.
63
Id.

13

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proving this element. 64 Absent some personal gain, there has been no breach of duty to

stockholders. And absent a breach by the insider, there is no derivative breach.65

Hence, a tippee is not liable unless the use of the information breaches a fiduciary duty

that she owed to either her clients or organization and the insider realized a personal benefit. The

ruling thus endorsed Commissioner Smith’s aforementioned opinion in Investors Management.66

Following the ruling, the SEC attempted to distinguish the case of SEC v. Stevens67 from

Dirks. In Stevens, a CEO made a number of unsolicited calls to some securities analysts to tell

them the soon-to-be announced quarterly results would be lower than expected. 68 The SEC

argued that through his selective disclosure the CEO attempted to benefit from enhancing his

reputation and managerial status. 69 Following a settlement in the case, the SEC adopted

Regulation FD, which imposed a duty on public companies that disclose insider information to

analysts or others in the industry to simultaneously disclose it publicly.70

The courts and the SEC also do not agree on the interpretation of situations involving the

tipping of family members by insiders. For example, in United States v. Chestman,71 a husband

tipped a stockbroker based on information he had received from his wife, who had received it

64
Second Circuit Redefines “personal benefit” in Insider Trading Case, LATHAM & WATKINS CLIENT ALERT
COMMENTARY 1175, http://www.lw.com/thoughtLeadership/lw-personal-benefit-decision-insider-trading (2014);
see, e.g., S.E.C. v. Yun, 327 F.3d 1263, Fed. Sec. L. Rep. (CCH) ¶ 92408 (11th Cir. 2003) (finding sufficient
evidence to support a “reputational” benefit where the tipper and tippee had worked together for several years and
split commissions on various real estate deals, indicating that disclosure was made in order to strengthen a beneficial
relationship); S.E.C. v. Sargent, 329 F.3d 34 (1st Cir. 2003) (finding evidence of personal benefit when the tipper
allegedly passed on the information in order to "effect a reconciliation with his friend and to maintain a useful
networking contact").
65
Dirks, 463 U.S. at 647.
66
Karmel, supra note 22, at 5. See generally, Investors Mgmt. Co., 44 S.E.C. 633.
67
SEC v. Stevens, 559 U.S. 460 (2010).
68
Litigation Release No. 12813, 48 SEC Docket no. 9 at 739 (Mar. 19, 1991).
69
Id.
70
17 C.F.R. § 243.100 (2014). Regulation FD cannot lead to private damages suits or criminal prosecution as it is
not promulgated under Section 10(b) or 14 of the Securities Exchange Act. Regulation FD provides in pertinent
part, that “[w]henever an issuer, or any person acting on its behalf, discloses any material nonpublic information
regarding that issuer or its securities to [a broker, dealer, investment adviser, investment company, or holder of the
issuer's securities], the issuer shall make public disclosure of that information: (1) [s]imultaneously, in the case of an
intentional disclosure; and (2) [p]romptly, in the case of a non-intentional disclosure.”
71
United States v. Chestman, 947 F.2d 551 (2d Cir. 1991) (en banc).

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through a line of family members, starting with a family member who was a corporate insider.72

The stockbroker was prosecuted in the matter, but the Second Circuit overturned the conviction

under Section 10(b),73 arguing that a family relationship is not a sufficient basis to establish the

fiduciary relationship necessary based on Chiarella74 and Dirks.75 Following this holding, the

SEC passed Rule 10b5-2, which establishes that “(3) whenever a person receives or obtains

material nonpublic information from his or her spouse, parent, child or sibling: provided

however, that the person receiving or obtaining the information may demonstrate that no duty of

trust or confidence existed with respect to the information” he or she has a duty of trust and

confidence under the misappropriation theory.76

The causal connection between a trader’s possession of insider information and her

trading is unclear in the case law, and the circuits currently disagree on its proper interpretation.

For example, the Second Circuit held in United States v. Teicher that “knowing possession” is

sufficient to establish insider trading liability.77 Yet, in SEC v. Adler, the Eleventh Circuit found

that “use” is required.78 In United States v. Smith, the Ninth Circuit required a proof of “use” in a

criminal case, since criminal intent cannot be based on a legal presumption.79 The SEC again

answered the question by passing Rule 10b5-1, which establishes that trading “on the basis” of

insider information means the trader “was aware of” the information when the trade was made.80

The next Supreme Court case to deal with insider trading was United States v. O’Hagan,

in which the Court reinstated a criminal conviction under Rule 10b-5 and 14e-3 of a lawyer who

72
Id. at 555.
73
He was convicted under Rule 14e-3, however. Id. at 571.
74
Chiarella, 445 U.S. 222 (1980).
75
Dirks, 947 F.2d at 568.
76
17 C.F.R. §240.10b5-2.
77
United States v. Teicher, 987 F.2d 112, 119 (2d Cir. 1993).
78
SEC v. Adler, 137 F.3d 1325, 1336 (11th Cir. 1998).
79
United States v. Smith, 155 F.3d 1051, 1069 (9th Cir. 1998).
80
17 C.F.R. §240.10b5-1.

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traded in the securities of a target company when the bidder was a client of the defendant’s law

firm.81 The holding further advanced the Court’s agreement with the misappropriation theory and

found that SEC can regulate non-deceptive activities “as a reasonably designed means of

preventing manipulative acts” under § 14(e).82

Following many victories for the SEC and the DOJ, both have prosecuted insider trading

robustly. The SEC alone has prosecuted almost 600 defendants in civil insider trading cases over

the past five years.83

C. The Ambiguity of Defining “Material, Nonpublic” in the Case Law

There is no clear answer to what constitutes “material, nonpublic information” in the case

law. In general, “material” information is information that fits into one or more of the following

categories: (1) there is a substantial likelihood that a reasonable investor would consider the

information as important in making his or her investment decisions,84 (2) the disclosure of such

information would be “viewed by the reasonable investor as having significantly altered the

‘total mix’ of information made available,” 85 or (3) the disclosure of that information is

“reasonably certain to have a substantial effect on the market price of the security.”86

The SEC defines information as “nonpublic” when investors “may not lawfully acquire

[it] without the consent of the source,” or when the information may be lawfully disseminated

81
United States v. O’Hagan, 521 U.S. 642, 647‐48 (1997).
82
Id. at 666-673.
83
Oversight of the SEC’s Division of Enforcement: Testimony Before the Subcommittee on Capital Markets and
Government Sponsored Enterprises of the H. Comm. On Capital Markets and Government Sponsored Enterprises
(2015) (testimony of Andrew Ceresney, Director Division of Enforcement), available at
http://www.sec.gov/news/testimony/031915‐test.html#.VQ2lt_nF_Tq.
84
Joint Market Practices Forum, Statements of Principles and Recommendations Regarding the Handling of
Material Nonpublic Information by Credit Market Participation, ISDA (Oct. 2003).
85
Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988) (quoting TSC Industries, Inc. v. Northway, Inc., 426 U.S.
438, 448-448-49 (1976)).
86
Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 166 (2nd Cir. 1980).

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but has not been made available to investors generally. 87 According to the SEC, insiders must

wait a “reasonable” amount of time after disclosure before trading. What constitutes a

“reasonable” amount of time depends on the circumstances of the disclosure.88

The courts, in contrast, have focused more on the “material” portion of the test. The basic

test for materiality was established in List v. Fashion Park, Inc.,89 in which the court held that the

materiality of the information rests on “whether a reasonable man would attach importance [to

the information] in determining his choice of action in the transaction in question.” This includes

any information that “in reasonable and objective contemplation might affect the value of the

corporation’s stock or securities.”90 Material information also encompasses “those facts which

affect the probable future of the company and those which may affect the desire of investors to

buy, sell, or hold the company’s securities.”91

The determination of materiality is fact-specific; hence, depending on the circumstances,

the same information may be material or non-material. 92 In practice, certain factors seem to

easily satisfy the materiality test. For example, the Chartered Financial Analyst (CFA) guidelines

generally include the following information as material: dividend increase, decrease, or

omission; quarterly earnings of sales considerably different from consensus; gain or loss of a

major client; changes in management; important development within the industry; government

reports of economic trends; large acquisition or divestiture; and when an offer is made to tender

87
Victor Brudney, Insiders, Outsiders, and Informational Advantages under the Federal Securities Laws, 93 HARV.
L. REV. 322 (Dec. 1979).
88
Selective Disclosure and Insider Trading, 65 Fed. Reg. 51716, 51721, Release Nos. 33-7881, 34-43154, IC-24599
(Aug. 24, 2000)(adopting release for Regulation FD and Rules 10b5-1 and 10b5-2).
89
List v. Fashion Park, Inc., 340 F.2d 457, 462 (2nd Cir. 1974).
90
Id. at 462 (quoting Kohler v. Kohler Co., 319 F.2d 634, 642, 7 A.L.3d 486 (7 th Cir. 1963); see also Kronfeld v.
Trans World Airlines, Inc, 832 F.2d 726, 731 (2nd Cir. 1987).
91
Texas Gulf Sulphur Co., 401 F.2d at 849).
92
Basic, 485 U.S. at 236.

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shares. 93 Courts often cite the market price impact of the information and the source of the

information in support of a finding of materiality. A court is more likely to find the information

material when the source of the information is reliable.94

On numerous occasions, the courts have found that confidential information about tender

offers can be material, nonpublic information. In Chestman, the Second Circuit Court stated

“[o]ne violates Rule 14e-3(a) if he trades on the basis of material nonpublic information

concerning a pending tender offer that he knows or has reason to know has been acquired

‘directly or indirectly’ from an insider of the offeror or issuer, or someone working on their

behalf.” 95 As discussed previously, in this case a husband tipped a stockbroker based on

information that his wife received from her family members.96 The court did not dispute that the

husband’s statement to the broker that the corporation would be sold at a “substantially higher”

price than its market value was material, nonpublic information.97

In SEC v. Maio, 98 the Seventh Circuit found that an executive in the process of an

acquisition was in possession of material, nonpublic information when he allegedly disclosed

this information in a series of phone calls to his friend. The friend discussed this information

with a third individual, who then bought and sold various securities prior to the acquisition being

made public.99 The Court held that Rule 14e-3 establishes a “duty to disclose material nonpublic

information or abstain from trading in stocks implicated by an impending tender offer.”100

93
CFA Level I, Investopedia, available at http://www.investopedia.com/exam-guide/cfa-level-1/ethics-
standards/standard-nonpublic-information.asp.
94
Id.
95
Chestman, 947 F.2d at 557.
96
Id. at 555.
97
Id.
98
SEC v. Maio, 51 F.3d 623, 635 (7th Cir. 1995)
99
Id.
100
Id.

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 In O’Hagan, discussed above, the Supreme Court held that a lawyer who had knowledge

of a tender offer through his connection to the legal counsel of the corporation was in possession

of material, nonpublic information. 101 James O’Hagan was a partner in a law firm that was

retained as local counsel to represent Grant Metropolitan PLC (Grant Met) in a potential tender

offer for the common stock of the Pillsbury Company. O’Hagan did not do any work on the

representation of the company and the firm withdrew from representing the company less than a

month before the tender offer became public.

While the firm was still representing Grand Met, O’Hagan began to purchase call options

of Pillsbury stock giving him rights to purchase additional shares. By the time the tender offer

became public, he had owned 2,500 unexpired options, more than any other individual

investor.102 When the tender offer became public and the stock prices shot up, O’Hagan sold his

call options and common stock, with a profit of more than $4.3 million.103

The SEC began an investigation into these transactions alleging that O’Hagan defrauded

his law firm and its client, Grand Met, when using material, nonpublic information about the

planned tender offer for personal trading purposes. 104 A jury convicted O’Hagan on all 57

counts, but a divided panel of the Eighth Circuit reversed these convictions.105

The Supreme Court reversed the ruling of the Court of Appeals and held that under Rule

14e-3(a) trading based on material, nonpublic information “that concerns a tender offer and that

the person knows or should know has been acquired from an insider of the offeror or issuer, or

101
O’Hagan, 521 U.S. at 645.
102
Id. at 647
103
Id. at. 648.
104
Id.
105
Id. at 649.

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someone working on their behalf, unless within a reasonable time before any purchase or sale

such information and its source are publicly disclosed” is unlawful. 106

In Chiarella,107also previously discussed, the Supreme Court held that an employee of

financial printer that printed takeover bids was in possession of material, nonpublic information

when he deduced the names of the target companies (based on the information contained in

documents delivered to the printer) and purchased stock in the target companies. In this case,

however, the individual did not have a duty to disclose because he had no fiduciary duties to or

specific relationships with the shareholders in the corporation.108

Knowledge of confidential facts that could have a significant impact on the price of the

company’s stock can also constitute material, nonpublic information. In Texas Gulf Sulphur

Co.,109 the defendants had knowledge of confidential information regarding the results of TGS

drilling in Timmins, Ontario when such information was not publicly available, and a few

defendants disclosed this information to others for use.110 The court disagreed with the trial judge

and found that the knowledge of the discovery hole would have been important to a reasonable

investor and could have affected the price of stock; therefore, it was material information.

Furthermore, the Court stated that an important factor in determining whether this information

was material was “the importance attached to the drilling results by those who knew about it.”111

Similarly, in SEC v. Adler, the Eleventh Circuit held that an executive and board member

of a company was in possession of material, nonpublic information when he was told at a board

meeting that the company would be receiving fewer orders from one of its largest customers.112

106
Id. at 645.
107
Chiarell, 445 U.S. at 222.
108
Id.
109
Texas Gulf Sulphur Co., 401 F.2d at 848.
110
Id. at 840.
111
Id. at 851.
112
Adler, 137 F.3d at 1328.

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In addition, the Second Circuit held in Teicher113 that the defendant, a principal of a securities

firm, possessed material, nonpublic information when he received the names of the companies

on the Drexel “phantom list.” The list contained the names of companies Drexel would not be

able to trade in because the firm was working on transactions involving these companies.114

The information can be ‘soft’ and still be found material. The Ninth Circuit Court of

Appeals found that “‘soft,’ forward-looking information may be material in the meaning of Rule

10b-5” in United States v. Smith.115 In this case, the court held that “forecasts of future sales and

revenue” may be understood as “soft” information, but can still be material under specific

circumstances.116

Information about fraudulent corporate practices can also be material information. In

Dirks,117 the officer of the New York broker-dealer firm that received information from a former

officer of a corporation that the corporation had overstated its assets due to fraudulent corporate

practices.118 He urged Dirks to verify the alleged fraud and to disclose it publicly. Dirks began an

investigation and discussed his findings with investors and clients, which resulted in a number of

large investment advisers to liquidating their holdings of more than $16 million in the company’s

stock. As a result, the corporation’s stock fell dramatically. The Court found that the information

of fraud shared by Dirks was material, nonpublic information.119

D. Tippee Derivative Liability, “Personal Benefit” and Newman

As discussed above, the Court in Dirks rejected the view (of the SEC) that a tippee has a

duty to abstain from trading simply because he has received material, nonpublic information

113
Teicher, 987 F.2d at 119.
114
Id. at 115-16.
115
Smith, 155 F.3d at 1069.
116
Id. at 1064.
117
Dirks, 463 U.S. at 646.
118
Id.
119
Id. at 649.

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from an insider.120 Moreover, because the antifraud provisions of Section 10(b) and Rule 10b-5

require scienter,121 in order for tippee liability to exist, a tippee must also know or have reason to

know that the tipper has disclosed in breach of a duty of confidence. 122 Negligent disclosure of

information, however, is not sufficient. 123 Whether recklessness is sufficient remains open to

debate; the circuits are split on this question and the Supreme Court has yet to address it.124

The federal courts also remain divided as to whether (and the extent to which) a tippee-

violator must be aware of a personal benefit received by the tipper. As noted above, some courts

are content to infer that a tippee was complicit in the tipper’s breach simply on the basis of a

preexisting relationship between the two. Others, however, like the Second Circuit in Newman,

appear to require much more.125

In December of 2012, Newman and Chiasson were found guilty of committing securities

fraud in violation of sections 10(b) and 32 of the Securities Exchange Act and SEC Rules 10b-5

and 10b5-2, as well as of conspiring to commit securities fraud under 18 U.S.C. § 371.126 Todd

Newman and Anthony Chiasson who were convicted of insider trading in December 2012 for

trading on material, nonpublic information received third and fourth hand from an insider at Dell

and NVIDIA. Newman and Chiasson argued that neither knew the identity of the original source

120
Id. at 646.
121
Liability for securities fraud requires proof of scienter, defined as "a mental state embracing intent to deceive,
manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1991).
122
Dirks, 463 U.S. at 646.
123
Id.
124
See Obus, 693 F.3d at 286 (“[w]hile the Supreme Court has yet to decide whether recklessness satisfies section
10(b)'s scienter requirement . . . we have held that scienter "may be established through a showing of reckless
disregard for the truth, that is, conduct which is highly unreasonable and which represents an extreme departure
from the standards of ordinary care”).
125
See Newman 773 F.3d at 450 (requiring proof beyond a reasonable doubt that “(1) the corporate insider was
entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential
information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper's breach, that is, he
knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that
information to trade in a security or tip another individual for personal benefit”).
126
See Newman 773 F.3d at 442. 18 U.S.C. § 371 is the conspiracy statute.

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of information, nor that this source violated a duty of confidentiality or received a personal

benefit.127

On appeal to the Second Circuit, Newman and Chiasson argued that the district court

erred in failing to instruct the jury that it must find that a tippee knew the insider had disclosed

inside information in exchange for a personal benefit. 128 Because there was no evidence that

Newman or Chiasson possessed such knowledge, the defendants argued, the government had

failed to establish tippee liability under Dirks.129 In response, the government claimed that Dirks

only required that the “tippee know that the tipper disclosed information in breach of a duty,” not

a requirement that the tippee also know that the insider received a personal benefit in exchange

for information.130

The government further contended that the defendants were “sophisticated traders,” and

therefore, should have known that such information was disclosed by insiders in breach of a

fiduciary duty and not for a legitimate business purpose.131 The district court agreed with this

assessment and instructed the jury that the government had to only prove that the defendants

“must have known that [the insider information] was originally disclosed by the insider in

violation of a duty of confidentiality.”132 After being convicted by the jury on all counts, both

defendants appealed the decision on the grounds that the government needed to prove that they

had the knowledge of the personal benefit provided to the tippers under Dirks. They further

claimed that there was insufficient evidence to prove the tippers received a personal benefit in

exchange for the disclosed information.

127
Id. at 444.
128
Id.
129
Id.
130
Id. at 447.
131
Id. at 443-44.
132
Id. at 444.

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 In December, 2014, the Second Circuit Court of Appeals found that, under Dirks, it was

necessary for the government to prove that the tippees knew the breach of duty was for a

personal benefit. The court reached this conclusion as follows: a tippee’s liability is derivative;133

therefore, a tippee cannot be held liable unless use of the information breaches a fiduciary duty

owed by the tipper to his clients or organization and, the insider must have realized a personal

benefit.134 The court further interpreted the language in Dirks as requiring the tippee to know

about the personal benefit to be liable.135 As the court explained, “insider trading liability is

based on breaches of fiduciary duty, not on informational asymmetries.” 136 Hence, the test

established in Newman necessitates a showing of proof beyond a reasonable doubt that:

(1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate
insider breached his fiduciary duty by (a) disclosing confidential information to a
tippee; (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s
breach, that is, he knew the information was confidential and divulged for
personal benefit; and (4) the tippee still used that information to trade in a security
or tip another individual for personal benefit.137
The court also held that the benefit must be objective, consequential, and represent a potential

gain of a pecuniary or similarly valuable nature, hence, a mere friendship was insufficient to

constitute personal benefit.138

The 2014 decision vacated the convictions and ordered the district court to dismiss the

indictment with prejudice because it found insufficient evidence to support a pecuniary benefit.

The Court of Appeals found that the district court incorrectly instructed the jury regarding the

government’s need to prove that the defendants were aware of a personal benefit and the

government failed to establish that the defendants willfully engaged in insider trading.

133
Id. at 450.
134
Dirks, 463 U.S. at 647.
135
Newman, 773 F.3d at 450.
136
Id. at 449.
137
Id. at 450.
138
Id. at 452-53.

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 The Newman court found that a “tippee’s liability derives only from the tipper’s breach of

a fiduciary duty, not from trading on material, nonpublic information”:139 “in both Chiarella and

Dirks, the Supreme Court affirmatively established that insider trading liability is based on

breaches of fiduciary duty, not on informational asymmetries.”140 The court further noted that the

“Supreme Court rejected the SEC’s theory that a recipient of confidential information (i.e. the

tippee) must refrain from trading whenever he received inside information from an insider.” 141

The Newman court pointed out that, according to Dirks, there can be no insider breach of

fiduciary duty unless the insider receives a personal benefit “in exchange for disclosure.” 142

Hence, the Second Circuit concluded that, even if a tipper has breached his or her fiduciary duty,

a tippee is liable only if he or she knows or should have known of the personal benefit. 143

According to the court, tippee knowledge of a breach of the duty of confidentiality, without

tippee knowledge of tipper personal benefit, is insufficient to impose criminal liability.144

E. The Limits of Newman

Newman leaves a large gap in its interpretation for potential inside traders to escape

liability. The Newman decision reaffirmed the personal benefit requirement for insider trading

convictions and illuminated the high evidentiary burden necessary for downstream tippees. 145

Prior to the holding in Newman, the government had worked to limit the Dirks benefit test. For

example, it found the test to be satisfied when the tip was made in exchange for “maintaining a

useful networking contact,” 146 or when it simply entailed “making a gift of information to a

139
Id. at 447.
140
Id. at 449.
141
Id. at 446.
142
Id.
143
Id. at 449.
144
See id. at 450.
145
United States v. Newman: Second Circuit Ruling Portends Choppier Waters for Insider Trading Charges Against
Downstream Tippees, Gibson Dunn, Publications (Dec. 15, 2014), available at aspx [hereafter “Gibson Dunn”].
146
United States v. Whitman, 904 F. Supp. 2d 363, 372 n.7 (S.D.N.Y. 2012)

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friend.”147 The Newman decision makes it more difficult for the government to win in cases

where evidence of a pecuniary benefit is not easy to prove. Reputational benefits, for example,

may not be sufficient to prove insider trading.

In its tippee liability formula, the Newman decision diverges from common federal

practice. Rather than allowing tippee knowledge of tipper breach of the duty of confidence to

satisfy the tippee scienter requirement, the Second Circuit requires that the tippee also know of a

personal benefit that will accrue to the tipper as a result of disclosure. Whether this distinction

makes any practical difference, however, remains somewhat unclear. This is because the court

must rely on the Dirks objective bases for proving tipper personal benefit in assaying tippee

knowledge of personal benefit—most notably, evidence of a relationship implying a quid quo

pro arrangement.

1. The nature of tippee/tipper relations

The Newman court held that the government had presented insufficient evidence of

“personal benefit,” in part, because insider tippers, Ray and Choi, “were not ‘close’ friends” and

“were merely casual acquaintances” with the first level tippees, Sandy Goyal and Hyung Lim. 148

The court, for instance, found the evidence that Goyal advised Ray on a variety of career

decisions and edited Ray’s resume insufficient to show the two had the kind of strong

relationship that would have supported an inference of a quid pro quo arrangement. 149

Nevertheless, the court apparently entertained the idea that such a showing could be made with

different evidence. Hence, personal benefit can still–and indeed should under Dirks—be inferred

where a preexisting relationship between tippee and tipper is sufficiently strong. And there is no

reason why the same evidence, which would support a jury inference beyond a reasonable doubt

147
Obus, 693 F.3d at 291.
148
Id.
149
Id.

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would not also be sufficient to establish that a tippee knew or should have known the tipper

disclosed information in order to gain a personal benefit.

The court establishes that one must have knowledge of the personal benefit to the tipper

and know that the trading is based on material, nonpublic information. Thereby, the ruling

“raises the bar” for the remote-tippee prosecutions.150 Still, the holding does not clarify whether

the showing of the remote tippee consciously avoiding learning of the personal benefit would

meet the standard. Therefore, the Newman standard may lead to more illicit insider trading

behavior aimed at escaping liability.

2. Legitimate reasons for breach

Similarly, the Newman court also discusses how the investor relations departments at

NVIDIA and Dell had a habit of disclosing material, nonpublic earnings data in advance of

quarterly earnings.151 Because insiders at these companies engaged in this practice for the good

of the company, the court found it unreasonable to infer that the circumstances under which

Newman and Chiasson received their tips were enough to support an inference beyond a

reasonable doubt that the original insider had disclosed in breach of her fiduciary duty. 152 But in

the absence of these special circumstances, such an inference might very well have been

warranted. And, were this the case, the same evidence used to support a jury inference of tipper

personal benefit may also support a jury inference that the tippee knew or should have known of

the personal benefit.

3. What Newman changes

In Newman, the Second Circuit raises the bar significantly regarding the kind of

relationship that will support an inference of a quid pro quo arrangement. In the Second Circuit,

150
Gibson Dunn, supra note 152.
151
See id.; Newman, 773 F.3d at 454-55
152
Gibson Dunn, supra note 152.

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the government will need to provide “proof of a meaningfully close personal relationship that

generates an exchange that is objective, consequential, and represents at least a potential gain of

a pecuniary or similarly valuable nature.” 153 Examples that meet the new standard include

tangible gifts, access to an investment club where stock tips and insight are routinely discussed,

close working relationship on real estate deals in which parties commonly split commissions on

transactions, and business referral relationships, such as dental work. 154 In many other federal

courts, the kinds of relationships evidenced in Newman might well have sufficed.155

F. The Purpose of the Dirks Requirement

The Newman court’s rigid adherence to the personal benefit requirement as a necessary

element of breach may overlook the reasons behind the requirement articulated in Dirks. As

noted above, the Court in Dirks presented the personal benefit requirement as a test that would

allow the judiciary to overcome a particular problem. Because there are legitimate (reasonable

doubt-creating) reasons for insider disclosure of material, nonpublic information—e.g.,

stimulating the interest of potential new financers/stock purchasers or, as in Dirks, whistleblower

tipping—the fact of disclosure alone is not enough to establish breach. For this reason, the Court

introduced the personal benefit requirement as a proxy for assaying disclosure (il)legitimacy.

Where a personal benefit exists, disclosure is presumptively illegitimate, and thus deceptive

under Section 10(b) and Rule 10b-5. Where there is no personal benefit, the disclosure must have

153
Newman, 773 F.3d at 452.
154
Id.
155
See, e.g., S.E.C. v. Ingram, 694 F. Supp. 1437, Fed. Sec. L. Rep. (CCH) ¶93788 (C.D. Cal. 1988) (discussing
how intent to personally benefit can, in the absence of another reasonable explanation, be inferred based on a strong
showing of the materiality of the information); SEC v. Blackwell, 291 F. Supp.2d 673 (S.D. Ohio 2003) (citing
S.E.C. v. Blackman, 2000 WL 868770 (M.D. Tenn. 2000)) (“A mere allegation that the insider has disclosed
material non-public information is sufficient to create a legal inference that the insider intended to provide a gift to
the recipient of the information, thereby establishing the personal benefit requirement.”).

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been made (a) in the interest of the principal or (b) negligently—neither of which satisfies the

Section 10(b) and Rule 10b-5’s scienter requirement.156

This being the case, if the government can adduce compelling evidence that the insider-

tipper tipped knowingly (not accidentally) and that there is no reasonable explanation as to how

tipping might promote the best interests of the principal, it seems unnecessary to insist upon

evidence of a specific personal benefit. Rather, it would be logical under these circumstances to

allow a jury to draw the inference that disclosure must have been made for personal benefit. This

analysis would be particularly well-supported by Dirks, which allows similar inferences to be

drawn on the basis of pre-tipping tipper/tippee relationships and which includes the benefit of

making a gift of insider information to a trading friend or relative as a “personal benefit.” 157 If a

tippee knows the insider is not tipping negligently, and she knows there is no reason to think the

tipper’s disclosure will benefit the principal, then a jury should be permitted to draw the same

inference about the tippee—i.e., that she knew or should have known that the tipper was

disclosing information in exchange for a personal benefit (either to benefit herself or to benefit a

friend or relative).158

For example, consider the case where a major stockholder tips investment analysts in

order to spur favorable reports by the analysts, and to thus exert an upward influence on the price

of his stock. 159 In this situation, if the tippee knows there is no reason to think that the disclosure

is in the best interest of the principal, he knows what he is doing is wrong, just not precisely how

it is wrong. This wrongdoer should not escape justice simply because of his perplexity as to how

the insider expects to benefit from disclosure.

156
15 U.S.C. § 78j(b); 17 C.F.R. 240.10b-5.
157
Dirks, 463 U.S. at 647.
158
See Ingram, 694 F. Supp. at 1437; Blackwell, 291 F. Supp. 2d at 673.
159
http://www.sec.gov/investor/pubs/analysts.htm.

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 G. Reform Proposals

As a pushback against the 2014 Newman decision, there are now bills pending in

Congress to define insider trading. The House proposal would amend Section 10 of the

Securities Exchange Act to outlaw the purchasing or selling of “any security, or any securities-

based swap agreement, based on information that the person knows or, considering factors

including financial sophistication, knowledge of and experience in financial matters, position in a

company, and amount of assets under management, should know is material information or

inside information.” 160 The proposed legislation defines inside information as nonpublic, and

obtained illegally, “directly or indirectly from an issue with an expectation of confidentiality or

that such information will only be used for a legitimate business purpose or in violation of a

fiduciary duty.”161

On the other hand, the Senate bill would amend Section 10(b) to make it illegal to

(A) …purchase, sell or cause the purchase or sale of any security on the basis of
material information that the person knows or has reason to know is not publicly
available, (B) To knowingly or recklessly communicate material information that
the person knows or has reason to know is not publicly available to any other
person under circumstances in which it is reasonably foreseeable that such
communication is likely to result in a violation of subparagraph (A).162

The bill does not include “information that the person has independently developed from

publicly available resources” under the “not publicly available” category.163

III. The Paradox: Penalties for the Undefined Insider Trading Offense

As discussed above, neither the SEC nor Congress has yet defined the term “insider

trading.” Yet, Congress has established both civil and criminal penalties—including fines and

prison terms—for engaging in this behavior. The various penalties are described below.

160
Ban Insider Trading Act, H.R. 1173, 114th Cong. § 2(a) (2015).
161
H.R. 1173 § 2(a)(3)(A)(i-ii).
162
Stop Illegal Insider Trading Act, S. 702, 114 th Cong. §2 (d)(1)(A)(2015).
163
S.702 § 2(2).

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 A. Civil Penalties

Prior to 1984, federal legislation did not impose civil penalties on insider trading. The

SEC had to rely on federal court injunctions against future violations, as well as disgorgements

of profits, to enforce securities fraud prohibitions.164 Although insider trading is not statutorily

defined, in 1984, Congress enacted the ITSA165 to remedy the “inadequate deterrent provided by

enforcement remedies for insider trading,” noting that neither injunctions nor disgorgement

sufficiently penalized defendants for insider trading.166 The ITSA amended Section 21 of the

Securities Exchange Act to include, in relevant part, that the SEC:

may bring an action in a United States district court to seek, and the court shall
have jurisdiction to impose, a civil penalty . . . [the amount of which] shall be
determined by the court in light of the facts and circumstances, but shall not
exceed three times the profit gained or loss avoided as a result of such unlawful
purchase or sale, and shall be payable into the Treasury of the United States.167

Among the numerous changes implemented by ITSFEA,168 was expansion of the scope

of civil penalties on insider trading to “controlling” persons—those “who, at the time of the

violation, directly or indirectly controlled the person who committed such violation.” 169 Civil

penalties for a controlling person are limited to the greater of $1,000,000 or treble damages.170 If

the “controlled person's violation was a violation by communication, the [damages] . . . [are]

deemed to be limited to the profit gained or loss avoided by the person[s] to whom the controlled

person directed such communication.”171

164
See Carole B. Silver, Penalizing Insider Trading: A Critical Assessment of the Insider Trading Sanctions Act of
1984, 1985 DUKE L.J. 960, 983-84 (1985).
165
Insider Trading Sanctions Act of 1984, Pub. L. No. 98-376, 98 Stat. 1264.
166
See SEC v. Downe, 969 F. Supp. 149, 159 (S.D.N.Y. 1997) (quoting H.R. Rep. No.98-355, at 7-8 (1983),
reprinted in 1984 U.S.C.C.A.N. 2274, 2280-81).
167
Pub. L. No. 98-376, 98 Stat. 1264.
168
Insider Trading and Securities Fraud Enforcement Act of 1988, Pub. L. No. 100- 704, 102 Stat. 4677.
169
Pub. L. No. 100-704, 1 02 Stat. 4677.
170
Id.
171
Id.

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 Empirical evidence provided by Professor Seyhun shows that neither ITSA nor ITSFEA

was effective in reducing either the volume or profitability of insider trading. 172 In fact,

following these legislative changes, the volume of insider trading increased four-fold, while

abnormal profitability of insider trading doubled.173 Insiders did not reduce their trading even on

a temporary basis in response to these legislative initiatives.174 Seyhun concludes that among the

possible reasons for the ineffectiveness of the increased sanctions are the highly stringent

requirements for the legally material information.175

The Securities Act and the Exchange Act also provide for civil penalties in other

securities fraud contexts. Section 20(d)(1) of the Securities Act and Section 21(d)(3) of the

Exchange Act permit the SEC to impose monetary penalties against persons who violate the

Securities Act and the Exchange Act, respectively, “other than by committing a violation subject

to a penalty pursuant to [section 21A of the Exchange Act].”176 Both Section 20(d)(1) of the

Securities Act and 21(d)(3) of the Exchange Act provide three-tier penalty systems, where the

maximum penalty increases with the severity of the violation.177 The Second Circuit Court of

Appeals recently held that Section 21(a) of the Exchange Act is the only basis for ordering civil

penalties in insider trading cases brought in federal court.178 The court, however, did not have

cause to address the expanded scope of the Commission’s powers under the Dodd-Frank Wall

Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”).179

The Dodd-Frank Act significantly enhanced the SEC's enforcement powers by 1)

granting the SEC the ability to obtain monetary penalties in administrative proceedings against

172
See H. Nejat Seyhun, The Effectiveness of Insider Trading Sanctions, J. LAW & ECON. 35, 149-182 (1992).
173
Id. at 150.
174
Id. at 169.
175
Id. at 177.
176
15 U.S.C. §§ 77t(d)(1), 78u(a)(3)(A).
177
15 U.S.C. §§ 77t(d)(2), 78u(a)(3)(B).
178
SEC v. Rosenthal, No. 10-CV-01204, 2011 BL 152965 (2d Cir. June 9, 2011).
179
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111- 203, 124 Stat. 1376 (2010).

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all individuals, not just those associated with regulated entities, and 2) increasing the civil

penalties that the SEC can seek in administrative cases. 180 Section 21B as amended states, in

part:

In any proceeding instituted pursuant to sections 15(b)(4), 15(b)(6), 15D, 15B,

15C, 15E, or 17A of this title against any person, the [SEC] or the appropriate
regulatory agency may impose a civil penalty if it finds . . . that such penalty is in
the public interest and that such person—
(A) has willfully violated any provision of the Securities Act of 1933, the
Investment Company Act of 1940, the Investment Advisers Act of 1940, or this
title, or the rules or regulations thereunder, or the rules of the Municipal Securities
Rulemaking Board;
(B) has willfully aided, abetted, counseled, commanded, induced, or procured
such a violation by any other person;
(C) has willfully made or caused to be made in any application for registration or
report required to be filed with . . . any . . . appropriate regulatory agency under
this title, or in any proceeding before the [SEC] with respect to registration, any
statement which was, at the time and in the light of the circumstances under
which it was made, false or misleading with respect to any material fact, or has
omitted to state in any such application or report any material fact which is
required to be stated therein; or (D) has failed reasonably to supervise, within the
meaning of section 15(b)(4)(E) of this title, with a view to preventing violations
of the provisions of such statutes, rules and regulations, another person who
commits such a violation, if such other person is subject to his supervision.181

Section 21(b) contains civil penalty provisions applicable in administrative proceedings similar

to those in Section 21(d)(3) for judicial proceedings, except notably, 21B does not contain the

“21(a)” exemption found in Section 21(d)(3).182 The three-tier penalty structure under Section

21(b) also imposes the same maximum penalties as the penalty structure of Section 21(d)(3).183

While the applicability of Section 21B to insider trading is still the subject of debate, 184 the SEC

180
Id. at § 929P(a) (2010) (codified at 15 U.S.C. § 78u–2).
181
Id.
182
See id.
183
See id.; 15 U.S.C. § 78u(a)(3)(b).
184
Larry P. Ellsworth, SEC Overreaching In Applying Penalty Act to Insider Trading, BLOOMBERG,
https://jenner.com/system/assets/publications/39/original/SEC_Overreaching_In_Applying_Penalty_Act_to_Insider
_Trading.pdf?1319655869 (2011).

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has continued using this section to impose civil penalties for insider trading in their

administrative forum.185

Additionally, Section 753 of the Dodd-Frank Act expanded the “anti-manipulation”

authority of the Commodity Futures Trading Commission ("CFTC") by amending Section 6 of

the Commodity Exchange Act.186 The amended Section 6(c)(1) is closely modeled after Section

10(b) of the Securities Exchange Act, and CFTC Regulation 180.1, promulgated in accordance

with Section 6(c)(1), is the functional analog of Rule 10b-5. 187 However, the CFTC has

recognized that unlike securities markets, “derivatives markets have long operated in a way that

allows for market participants to trade on the basis of lawfully-obtained, material nonpublic

information,”188 and therefore has limited the scope of CFTC Regulation 180.1 with regard to

insider trading. CFTC Regulation 180.1 only prohibits trading based on misappropriated

information obtained or used in breach of a pre-existing duty.189 Furthermore, the Commission

has noted that CFTC Regulation 180.1 does not create an affirmative duty of disclosure (except

such disclosure that may be required “as necessary to make any statement made to the other

person in or in connection with the transaction not misleading in any material respect”). 190 The

CFTC may assess in any case of manipulation or attempted manipulation a civil penalty of not

more than $1 million or triple the monetary gain to the person for each violation.191

B. Criminal Penalties
185
See, e.g., In the Matter of Michael S. Geist, Adm. Proc. File No. 3-16269 (Nov. 12, 2014).
186
Pub. L. No. 111-203, § 753 (2010) (codified at 7 U.S.C. § 9, 15).
187
See Prohibition on the Employment, or Attempted Employment, of Manipulative and Deceptive Devices and
Prohibition on Price Manipulation, 76 Fed. Reg. 41,398, 41403 (July 14, 2011).
188
Id.
189
"Depending on the facts and circumstances, a person who engages in deceptive or manipulative conduct in
connection with any swap, or contract of sale of any commodity in interstate commerce, or contract for future
delivery on or subject to the rules of any registered entity, for example by trading on the basis of material nonpublic
information in breach of a pre-existing duty (established by another law or rule, or agreement, understanding, or
some other source), or by trading on the basis of material nonpublic information that was obtained through fraud or
deception, may be in violation of final Rule 180.1." Id.
190
7 U.S.C. § 9(1) (2010).
191
Id. § 9(10)(C)(ii) (2010).

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 Most criminal prosecutions for violations of the federal securities laws, including the

insider trading provisions, are brought under Section 24 of the Securities Act and Section 32(a)

of the Exchange Act.192 Other bases for criminal liability in the insider trading context include

the federal mail and wire fraud statutes,193 as well as the federal criminal offense of securities

fraud (enacted as part of SOX).194 Section 24 of the Securities Act195 and Section 32(a) of the

Exchange Act196 generally authorize criminal prosecutions for “willful violations” of provisions,

rules, or regulations under the respective acts. In the insider trading context, the most common

bases for criminal liability are violations of Section 10(b) of the Exchange Act and Rule 10b-5,

although Rule 14e-3 and Section 17(a) of the Securities Act are also frequently used.197

Section 24 of the Exchange Act provides that “any person who willfully” (1) violates any

of the provisions or related rules and regulations of the Act or (2) provides materially false or

misleading information on a registration statement under the Act, is subject to a maximum fine

of $10,000, a maximum prison term of five years, or both.198 Section 32(a) of the Exchange Act

provides that any natural person who willfully violates any provision of the Act, other than

Section 30,199 may be subject to a maximum penalty of $5,000,000, a maximum prison term of

20 years, or both.200 A corporation may be subject to a fine not exceeding $25,000,000.201

One of the primary contributions that SOX made to the insider trading statutory scheme

was the new criminal securities fraud offense. 202 Among other things, the provision makes it

192
See WILLIAM K.S. WANG & MARC I. STEINBERG, INSIDER TRADING § 7.2.1 (3rd. ed. 2010).
193
See generally 18 U.S.C. §§ 1341-51 (2012).
194
18 U.S.C. § 1348 (2012).
195
15 U.S.C. § 77x (2012).
196
Id. at § 78ff(a).
197
Karmel, supra note 22, at 2-7.
198
15 U.S.C. § 77x.
199
Section 30 of the Exchange Act, codified as 15 U.S.C. § 78dd-I, contains anti-bribery provisions.
200
15 U.S.C. § 78ff(a) (2012).
201
Id.
202
Pub. L. No. 107-204, § 807 (2002) (codified at 18 U.S.C. § 1348).

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unlawful to execute or attempt to execute a scheme or artifice to defraud a person in connection

with any security.203 The statute provides for a fine, a term of imprisonment of not more than 25

years, or both.204 In 2009, the provision was amended by the Fraud Enforcement and Recovery

Act of 2009 to extend the criminal penalties to commodities fraud.205

The DOJ has often relied on the federal mail and wire fraud statutes in criminal

prosecutions by alleging Rule 10b-5 violations, including insider trading cases.206 The federal

mail and wire fraud statutes prohibit the use of mail or wire, radio, or television communications

“for the purpose of executing any scheme or artifice to defraud.” 207 Although these statutes may

lack teeth in most securities fraud prosecutions, in insider trading cases, the wire and mail fraud

statutes may enable prosecutors to reach conduct outside of the scope of Section 10(b).208 For

example, under a wire or mail fraud theory, a crime is complete once a company is defrauded of

its confidential information regardless of whether the information is used by anyone for purposes

of trading. Also, the “materiality” required for wire and mail fraud may be easier to meet than

that of securities fraud.209 Wire and mail fraud carry the same statutory penalties as a violation of

203
18 U.S.C. § 1348 (2009).
204
Id.
205
See The Fraud Enforcement and Recovery Act of 2009, Pub. L. 111–21, 123 Stat. 1617, § 2(e)(1)(A)-(C) (2009)
(inserting “and commodities” before “fraud” in section catch line, and “any commodity for future delivery, or any
option on a commodity for future delivery, or” before “any security”).
206
Peter J. Henning, Insider Trading Case Could Push Congress to Define a Murky World, N.Y. TIMES, Feb. 23,
2015, http://www.nytimes.com/2015/02/24/business/dealbook/insider-trading-case-could-push-congress-to-define-a-
murky-world.html?_r=0.
207
See 18 U.S.C. §§ 1341, 1343 (2008).
208
See U.S. v. Autuori, 1998 WL 774232, at *22, n. 9 (D. Conn. Aug. 28, 1998), aff’d in part, rev’d in part by U.S.
v. Autuori, 212 F.3d 105 (2d Cir. 2000).
209
Compare Basic, 485 U.S. at 231-32 (1988) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449
(1976)) (information is material in the federal securities law context if there is "a substantial likelihood that the
disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the
'total mix' of information made available”) with Autuori, 1998 WL 774232, at *22 (information is material under the
mail fraud statute when it “would be important to a reasonable person in deciding whether to engage in a particular
transaction or to engage in certain conduct”).

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Section 10(b) (with a few exceptions – notably if “the violation affects a financial

institution”).210

Although federal judges have the right to impose any sentence for insider trading

convictions, they are required to keep in mind the criminal sentencing guidelines. In the Dodd-

Frank Act, Congress issued directives to the U.S Sentencing Commission to "review and, if

appropriate, amend" various sentencing guidelines and policy statements applicable to fraud

offenses. 211 The Sentencing Commission promulgated amendments to the federal sentencing

guidelines for securities fraud, which took effect in 2012.212

First, the Sentencing Commission adopted a new minimum offense level of 14 (which

equates to a recommended prison range of 15-21 months for defendants with no criminal

record) 213 for any "organized scheme to engage in insider trading." 214 The commentary lists

factors that courts may consider in determining whether an insider trading scheme is

"organized"—whether it involved "considered, calculated, systemic, or repeated efforts to . . .

trade on insider information, as distinguished from . . . opportunistic instances of insider

trading." 215 For cases where there is minimal gain from insider trading, this will mean an

automatic increase of six offense levels for all participants in the offense.216 As the profitability

210
Both the wire and mail fraud statutes provide that “[i]f the violation affects a financial institution, such person
shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.” 18 U.S.C. §§ 1341, 1343.
The mail fraud statute also provides for this increased penalty if the violation involves “a Presidential declared major
disaster or emergency.” 18 U.S.C. §§ 1341.
211
Pub. L. No. 111-203, 124 Stat. 1376 (2010).
212
See Sentencing Guidelines For United States Courts, 77 Fed. Reg. 28225 (May 11, 2011), available at
http://www.ussc.gov/sites/default/files/pdf/amendment-process/federal-register-
notices/20120511_FR_Sub_to_Congress_Amendments.pdf.
213
U.S. SENTENCING GUIDELINES MANUAL, ch. 5, pt. A (2014).
214
Id. at § 2B1.4.
215
See id. cmt. n.1.
216
An offense level of 8, for criminals with 0 or 1 criminal history points under the Sentencing Guidelines chart,
equates to a recommended prison term of 0-6 months.

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of a scheme increases, however, the effect of this new provision diminishes, disappearing

entirely when the overall gain from the scheme reaches $30,000.217

The amendments to the insider trading guideline also broadened the applicability of the

"abuse of trust" enhancement. Previously, defendants received increased punishment under the

guidelines if their abuse of a position of public or private trust significantly facilitated the crime;

this provision was not triggered unless the defendant's position was characterized by “substantial

discretionary judgment that is ordinarily given considerable deference.” 218 The amendment

loosened that requirement, specifying that the enhancement applies if “the position of public or

private trust . . . contributed in some significant way to facilitating the commission or

concealment of the offense.”219

The Sentencing Commission also added a special rule for determining loss in cases

involving fraudulent inflation or deflation in the value of publicly traded securities or

commodities. 220 The amended commentary directs use of what has become known as the

"modified rescissory method" for determining actual loss.221 The commentary also directs the

court to presume that the modified rescissory method has accurately calculated the actual loss,

but a party may rebut that presumption and persuade the court that it is not a "reasonable

estimate of the actual loss."222 The court may consider, among other factors, the extent to which

the amount so determined includes significant changes in value not resulting from the offense

(e.g., changes caused by external market forces, such as changed economic circumstances,

217
Both the pre-2012 amendment and post-2012 amendment guidelines recommend a base offense level of 8 for
insider trading.
218
U.S. SENTENCING GUIDELINES MANUAL, § 3B1.3 cmt. n.1 (2010).
219
U.S. SENTENCING GUIDELINES MANUAL, § 3B1.3 cmt. n.1 (2014).
220
Id. § 2B1.1 cmt. n.3(F)(ix).
221
First, calculate the difference between (i) the average share price during the fraud period; and (ii) the average
share price during the 90-day period after the fraud was disclosed to the market. Second, multiply the difference by
the number of shares outstanding. See id.
222
Id.

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changed investor expectations, and new industry-specific or firm-specific facts, conditions, or

events).223

Finally, the Sentencing Commission expanded the provisions in the fraud guideline that

govern when a judge may depart above or below the recommended guideline range.224 First, the

Commission noted that an upward departure may be warranted if the offense created a risk of

substantial loss beyond the loss determined under the guideline, “such as a risk of a significant

disruption of a national financial market.”225 Second, the Commission provided new guidance on

downward departures, adding the example of a securities fraud where fraudulent

misrepresentations inflate the price of a stock in a manner that produces “an aggregate loss

amount that is substantial but diffuse, with relatively small loss amounts suffered by a relatively

large number of victims.”226

III. Our Proposal: A New Evidentiary Standard

Many scholars227 agree that a clear statutory definition of illegal insider trading should be

established, arguing that it is preferable to further judicial interpretation.228 Our proposal for

reform follows below.

A. Requirements

We propose that the government be allowed to establish a prima facie case of illegal

insider trading on the basis of material, nonpublic information when it can prove the following

three elements: (1) the information giving rise to the trade is of the type that requires an 8-K
223
Id.
224
Id. § 2B1.1 cmt. n.20.
225
Id. § 2B1.1 cmt. n.20(A).
226
Id. § 2B1.1 cmt. n.20(C).
227
Former Commissioner of the Securities and Exchange Commission and Centennial Professor of Law at Brooklyn
Law School.
228
See, e.g., Karmel, supra note 22, at 2.

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filing by the corporation; (2) its announcement must lead to statistically significant, abnormal

stock returns; and (3) the putative insider trading must have occurred within two months prior to

the announcement of the information.

The first and third requirements are factual and can easily be satisfied. The second

requirement can be satisfied by following a similar procedure as we described in Section IV.

Given that corporations file 10-Q and 10-K reports every three months, these conditions in effect

require that all insider trading to be confined to approximately one-month window after each

earnings announcement.229 If all three conditions are satisfied, then the burden of proof must be

on insiders to show that their particular transaction does not meet the material, nonpublic

information requirement. Similarly, any trades made by individuals receiving tips from insiders

(of any information satisfying the three conditions above) must also shift the burden of proof, in

this case, to the tippee(s) accused of committing securities fraud.

We expect additional clarity will allow all insiders who want to be on the safe side of the

law to ensure that their transactions do not meet any of the conditions set forth above. Insiders

already know which events trigger an 8-K filing. By not trading or tipping during the two-month

window preceding an upcoming 8-K filing, insiders can easily ensure that at least two of the

three conditions will not be satisfied. The benefit of this additional clarity should enable courts

to separate routine insider trading from opportunistic trading and increase the confidence in the

public equity markets.

B. 8-K Filing Requirements

229
Typically, one week after earnings announcements is also considered an additional black-out period to allow to
markets to fully digest the earnings information. This in effect confines insider trading (on information contained in
the forms) to between weeks one and four after each earnings announcement.

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 Form 8-K (“Form”) is a broad form used to notify investors of any material event that is

important to shareholders or the SEC. The SEC usually considers an event to be material when

“there is a substantial likelihood that a reasonable investor would consider the information

important to making an investment decision.”230 It is one of the most common forms filed with

the SEC and supplements the public companies’ annual reports on Form 10-K and quarterly

reports on Form 10-Q. Public companies are required to file the Form under the Securities

Exchange Act. These reports are available to the public on the SEC’s EDGAR website.231

The Form is used for reports under Section 13 or 15(d) of the Securities Exchange Act

and filed pursuant to Rule 13a-11 or Rule 15d-11, as well as for reports of nonpublic information

required to be disclosed by Regulation FD (17 CFR 243.100 and 243.101).232 The Form may be

used to satisfy the filing obligations under (1) Rule 425 of the Securities Exchange Act (17 CFR

230.425) for written communications relating to business combination transactions; (2) Rule

14a-12 under the Exchange Act (17 CFR 240.14a-12) for soliciting materials and pre-

commencement communications for tender offers; (3) for pre-commencement communications

under Rule 14d-2(b); and (4) for pre-commencement communication under Rule 13e-4(c) under

the Exchange Act (17 CFR 240.14d-2(b) and 240.13e-4(c)).233

Triggering events apply to registrants and subsidiaries. 234 The Form consists of nine

sections. Under Section 1,235 a company is required to file the Form when there is (1) an entry

into a material definitive agreement; (2) termination of such agreement; (3) bankruptcy or

receivership; as well as (4) reporting of shutdowns and patterns of violations in mine safety.

230
Investor Bulletin: How to Read an 8-K, SEC, (May 2012) at 1, available at
http://www.sec.gov/investor/pubs/readan8k.pdf.
231
Available at www.sec.gov/edgar/searchedgar/companysearch.html.
232
Form 8-K, U.S. SEC, may be accessed at https://www.sec.gov/about/forms/form8-k.pdf.
233
Id.
234
Division of Corporate Finance: Current Report on Form 8-K, Frequently Asked Questions (Nov. 23, 2004),
available at http://www.sec.gov/divisions/corpfin/form8kfaq.htm [hereafter FAQ].
235
Form 8-K, Fast Answers, SEC, access at http://www.sec.gov/answers/form8k.htm [hereafter Fast Answers].

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 Item 1.01 requires a disclosure of material agreements not made in the ordinary course of

business, or any material amendments to those. A material definitive agreement can be both

written and oral.236 Taking out a loan with a bank or signing a long-term lease would require this

disclosure, but signing a lease for an additional store when the retailer already has a chain does

not. If the agreement was not material at the time the registrant entered into it, but becomes

material at a later time, the registrant does not need to file Form 8-K. In either case, the registrant

is required to file the agreement as an exhibit to the periodic report in the period in which the

agreement became material.237 Furthermore, the registrant must file the Form if an agreement is

not “immaterial in amount or significance” within the meaning of Item 601(b)(10)(iii)(A) of

Regulation S-K, unless it is not required to be disclosed under Item 601(b)(10)(iii)(C). This issue

is considered from the perspective of a reasonable investor and within established standards of

materiality.238

Item 1.02 requires disclosure of a termination of an agreement prior to the established

expiration, but not an agreement that expires under its terms. Once notice of termination is

received, the Form is required, even if the registrant intends to negotiate and in good faith

believes that the agreement has not been terminated.239 Importantly, the triggering event is the

notice, not the termination of the agreement.240 Under Items 1.03 and 1.04, the registrant may

include the company’s plan for Chapter 11 reorganization or Chapter 7 liquidation, and the

court’s confirmation of the plan.241

236
FAQ, supra note 241.
237
Id.
238
Id.
239
Id.
240
Id.
241
Investor Bulletin, supra note 237, at 1.

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 Under Section 2, a company must report in Form 8-K: (1) the completion of acquisition

or disposition of assets; (2) results of operations and financial condition; (3) creation of a direct

financial obligation or an obligation under an off-balance sheet arrangement of a registrant; (4)

triggering events that accelerate or increase a direct financial obligation or an obligation under an

off-balance sheet arrangement; (5) costs associated with exit or disposal activities; or (6) material

impairments.242

Item 2.01 requires a company to disclose any time a significant amount of assets are

acquired or disposed, such as when a company buys or merges with another company, or sells a

business unit. If a merger results in a “shell company” 243 becoming a company in its own right,

the registrant would provide investors with information about this company under this item.

Under Item 2.02, the company usually summarizes the full financial statement, which often

appears later in the company’s quarterly report or annual report. The company often announces

these results in a press release and a Form 8-K simultaneously. Item 2.03 requires the basic terms

of material financial obligations, including long-term debt, capital or operating lease, as well as

short-term debt beyond ordinary course of business, to be disclosed. Any material financial

obligations arising out of off-balance sheet arrangements, whether direct or contingent, must also

be disclosed. 244 The materiality of the financial obligation is “a facts and circumstances

determination.”245

Item 2.04 requires the disclosure of any event that triggers the acceleration or increase of

a financial obligation as long as the event is material, such as defaults on loans. In the case of a

loan default where the company must pay the entire amount owed, the company must disclose

242
FAQ, supra note 241.
243
The SEC defines a “shell company” as “a company that either has little or no operations or has little or no assets
other than cash and cash equivalents.” Investor Bulletin, supra note 237, at 2.
244
Id. at 2.
245
See FAQ, supra note 241.

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the amount to be repaid, the terms of such repayment and other financial obligations that may

have to be repaid on different terms as result of the initial default. Item 2.05 requires disclosure

of restructuring plans where the company would incur material charges, such as the decision to

close some of its stores, or lay off workers. Under this provision, the company must also disclose

the costs estimates when it is able to determine them.246

Lastly, under Item 2.06, a company must disclose write-downs, otherwise known as

impairments. These occur when a company significantly lowers its estimates of the value of

some assets.247 If the impairment is determined routinely as the company prepares its financial

statements for its periodic report, then the company may make the disclosure in the periodic

report, and not Form 8-K.248

Under Section 3, a company must file Form 8-K when there is: (1) a notice of delisting or

failure to satisfy a continued listing rule or standard or transfer of listing, (2) unregistered sales

of equity securities, or (3) material modification to rights of security holders. Under Item 3.01,

a company must disclose if the stock exchange notifies it that it can no longer be listed. If the

company has a grace period to return to compliance, it must disclose any steps it will take to

avoid delisting. Item 3.02 mandates public companies to disclose private sales of securities

above 1 percent of its outstanding shares of that class (or five percent for smaller reporting

companies). Public offerings registered with the SEC, however, do not need to be disclosed.

Under Item 3.03, companies are required to disclose material changes to instruments that define

the rights of shareholders or material restrictions on the rights of security holders resulting from

246
Id.
247
Id.
248
Investor Bulletin, supra note 237, at 2-3.

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the issuance or modification of another class of securities, such as loan term restricting dividend

payments, adoption of an antitakeover device, or issuance of preferred stock.249

Under Section 4, matters related to accountants and financial statements, such as (1)

changes in the registrant’s certifying accountant or (2) non-reliance on previously issued

financial statements or a related audit report or completed interim review, must also be filed.

Public companies must disclose if they dismiss their independent auditor, if she resigns or

declines to stand for re-appointment, as well as if the company hires a new auditor. As the SEC

notes in its Investor Bulletin,250 a change in auditors may be a red flag for investors. Therefore,

companies must disclose three major events if they occurred in the previous two fiscal years.

First, it must disclose whether the departing auditor gave an adverse or qualified opinion on the

company’s statements. Second, it must disclose disagreements it had with the departing auditor

over accounting principles or practices, financial statements, or the scope or procedure of the

audit. Finally, companies are required to disclose whether the former auditor advised the

company that: (a) “the necessary internal controls to prepare reliable financial statements do not

exist,” (b) “the auditor can no longer rely on management’s representations or is unwilling to be

associated with the financial statements prepared by management,” (c) “the auditor believed it

should further investigate a matter or significantly expand the scope of its audit, and the author

did not do so,” or (d) “the auditor has found new information that materially impacts the fairness

or reliability of current or prior financial statements, and the issue has not been resolved to the

auditor’s satisfaction.”251

Item 4.02 requires a disclosure of any error in the previously issued financial statements

to establish that these should not be relied upon. Additionally, a company must disclose if the

249
Id. at 3.
250
Investor Bulletin, supra note 237, at 3.
251
Id.

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auditor believes that the previously issued audit reports or interim reviews of these statements

should not be relied upon. The company must demonstrate whether its audit committee, full

board or authorized executive officer has discussed the issue with the auditor.252

Section 5 discusses corporate governance and management. A company must file Form

8-K when: (1) there are changes in control of registrant; (2) there is departure of directors or

certain officers; election of directors; appointment of certain officers; compensatory

arrangements of certain officers; (3) there are amendments to articles of incorporation or bylaws

or change in fiscal year; (4) temporary suspension of trading under registrant’s employee benefit

plans; (5) amendments to registrant’s Code of Ethics, or waiver of a provision of the Code of

Ethics; (6) change in shell company status; (7) submission of matters to a vote of security

holders; and lastly, (8) shareholder director nominations.

Under Item 5.01, the company must disclose an event where there is a change of control

of the company, including identifying the persons acquiring the control and the percentage of

voting securities they now possess, any arrangements between the previous and new control

groups relating to election of directors or other important issues.253 In the event that a board

member resigns or will not stand for re-election due to disagreement with the company in

regards to its operations, policies, or practices, or a director is removed for cause from the board,

the company has an obligation to disclose the circumstances of the disagreement under the Item

5.02.254 If there is a letter from the director to this effect, the letter must be filed as an exhibit. In

the event that a high-level executive officer retires, resigns, or is terminated, or alternatively, a

new officer is appointed, the company must disclose this fact along with any related

252
Id. at 4.
253
Id.
254
Investor Bulletin, supra note 237, at 5.

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compensation arrangements. Any changes to the compensation of the current high-level officers

must also be disclosed.255

Unless the company already disclosed the proposed amendments or fiscal year change in

a proxy or information statement, the company must disclose any amendments to its articles of

incorporation or bylaws, or changes to its fiscal year under Item 5.03. It should be noted that

companies that issue only debt securities are usually exempted from this item. 256

Under Item 5.05, companies are required to report any changes to their code of ethics or

waivers that apply to the CEO, CFO, CAO or controller, or others performing similar duties.

Companies may elect to disclose this information on their website instead of filing an 8-K.257

Under Item 5.07, companies are required to file the results of the shareholder votes in director

elections and on all other issues put to a vote within four business days of the end of an annual or

special meeting. If such results are unavailable at the time, it is required to file preliminary

results and an amended 8-K with final vote results within four business days of those results

being available.258

Under Section 6, a public company must disclose any: (1) asset-backed securities (ABS)

informational and computational material, (2) change of servicer or trustee, (3) change in credit

enhancement or other external support, (4) failure to make a required distribution, or (5)

Securities Act Updating Disclosure.259

Section 7 discusses Regulation FD Disclosure. The purpose of this regulation is to

“prevent companies from selectively disclosing material, nonpublic information.” Generally,

255
Id.
256
Id.
257
Id.
258
Id.
259
The Securities Act Updating Disclosure requires that, with respect to offerings of asset-backed securities, “any
material pool characteristic of the actual asset pool at the time of issuance of the asset-backed securities [that] differs
by 5% or more . . . from the description of the asset pool in the prospectus” requires a disclosure regarding the
characteristics of the actual asset pool.

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companies are required to disclose material information to the public at the same time as it is

provided to others, including securities market professionals. Companies may submit an 8-K

under this Item or Item 8.01 to comply with the Regulation FD’s public disclosure requirement.

Disclosures include announcements of dividends, quarterly sales of figures, etc.260

Section 8 is a catch-all section where the registrant can report events that are not

specifically called for by the Form, but the registrant nevertheless considers important to security

holders. Finally, Section 9 discusses financial statements and exhibits that a company may be

required to furnish to supplement other parts of the form.

A report must be filed or furnished within four business days 261 of the occurrence of the

event for items in Sections 1-6, and 9. If the form is being furnished only to satisfy its obligation

under Regulation FD, the due date may be earlier.262 If a triggering event occurs within four

business days before the registrant’s filing of a periodic report, it may be disclosed in that

periodic report instead of filing of Form 8-K, unless it is required under Item 4.01 or Item

4.02.263

IV. Exploitation of Vagueness in Standards: Profitability of Insiders’ Transactions

Given the vagueness of the insider trading laws, insiders have been able to exploit their

material, nonpublic information by buying and selling the shares of their firms prior to the public

dissemination of this information through 8-K filings, without facing legal consequences. To

test our hypothesis, we obtained stock price information from the Center for Research in Security

Prices (CRSP). The insider trading data come from the union of the Thomson Reuters Insider

260
Investor Bulletin, supra note 237, at 7.
261
Day one is the first business day after the occurrence.
262
Fast Answers, supra note 242.
263
FAQ, supra note 241.

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Filing Data Feed (1996 to 2013) and backward extensions using archived annual purchases from

the National Archives (1975 to 1995). We henceforth refer to this database as the “Back-

Extended Thomson Reuters” Database or simply the combined insider trading database. Our

sample includes U.S. common stocks (CRSP share codes of 10 or 11) that are covered by all

three databases. The time period is from January 1975 through December 2013. We restrict

attention to this interval due to the availability of insider trading data, which first became

available in January of 1975. We include observations beginning only from the time when the

firms first appear in the combined insider trading database. Following Shumway (1997), we

adjust stock returns for delistings using the CRSP delisting file. Our final dataset has over

20,000 unique CUSIPs and over 3,500,000 observations.

The combined Insider Filing Database includes all trades reported to the SEC-Ownership

Reporting System. The data contains all open market purchases and sales by officers, directors,

and beneficial owners (direct or indirect owners of more than 10% of any equity class of

securities) of publicly traded firms.264 Shares acquired through exercise of options, stock awards,

and trades with corporations are excluded. The final sample is limited to firms for which stock

return data are available in CRSP. Finally, in order to deal with potential misreports and

incorrect outliers, three filters are used. On the insider transaction date, (1) the insider

transaction price must be less than twice the closing price of the stock, (2) the number of shares

of the insider transactions will be less than the daily volume of trade of the stock, and (3) the

264
For most of the sample period analyzed here (prior to August 29, 2002), Section 16(a) of the Securities and
Exchange Act requires that insider transactions be disclosed within the first 10 days of the month following the
month of the trade. Section 16(b) prohibits insiders from profiting from short-term price movements defined as
profitable offsetting pairs of transactions within 6 months of each other, while Section 16(c) prohibits profiting from
short-sales. Sarbanes- Oxley Act of 2002 (effective August 29, 2002) has modified insider trading regulations in
many significant ways. First, the new reporting requirement states that insider transactions must be reported
electronically by the end of the second business day following the day on which the transaction is executed both
through EDGAR and corporate public websites. Sarbanes-Oxley also prohibits purchase and sale of securities during
black-out periods.

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number of shares of the insider transaction will be less than the outstanding number of shares for

the stock.265

We measure the profitability of insider trades starting from the insider trade date. We

measure abnormal stock return behavior using the cumulative market-adjusted abnormal daily

stock returns (CAR) starting from the trade date (date 0) for a period of T days:

T
CARi ,T   H i ,t (ri ,t  rm.t ) ,
t 0

where Hi,t takes the value 1 for insider purchases and -1 for insider sales. Thus, we define an

insider purchase to be abnormally profitable if the stock price outperforms the general stock

market after the purchase. Similarly, we define an insider sale to be abnormally profitable if the

stock price underperforms the general stock market after the sale. The variable ri ,t is the cum-

dividend return to stock i for day t, and rm ,t is the cum-dividend return to the CRSP equally-

weighted portfolio of all New York Stock Exchange, American Stock Exchange and NASDAQ

stocks for day t. We examine the profitability of insider trades for T=5, 10, 20, 30, 40 and 50

days following insiders’ transactions.

To focus on insider transactions that are likely to be based on material, nonpublic

information, we first require that the abnormal profitability (CAR) of insiders’ transactions

exceed 5% by day 5, 10, 20, 30, 40 and 50. The results using insider trading data for the last 40

years are shown in table 1.

Our evidence shows that a significant portion of insider transactions exhibit immediate

profitability. During the decade of 1975-1984, over 60,000 transactions showed almost

immediate abnormal profitability by beating the general stock market more than 5% during the

first five days after the trade date. Given the quick stock price reaction and immediate

265
Qualitative results do not change if these filters were not enforced. Results are available upon request.

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profitability, these translations are likely to be based on material, nonpublic insider information.

By day 50, the proportion of highly profitable transactions rises to about 40% of all trades by

insiders.

Over the next three decades, the number of transactions with immediate abnormal

profitability steadily rose. In the most recent decade (2005 to 2014), over 200,000 large-volume

transactions show immediate profitability by day five. The number of transactions that showed

significant abnormal profitability by day 50 exceeded 500,000 during the decade 2005-2014,

again constituting about 35% of all trades by insiders.

As a second test of materiality, we now require that profitability of insider trades exceed

10% within 5 days after trade. These results are shown in table 2. The overall sample period

shows that there were more than 190,000 such transactions. By day 50, the number of highly-

profitable transactions approaches one million. These highly profitable transactions constitute

about 27% of all insider trades.

The average abnormal profitability of these selected insider transactions is shown in table

3. Within five days after insiders’ trade, insiders’ average abnormal profit reaches about 17% for

the entire sample period, and rising further to about 20% by day 50. The average abnormal

profits for this highly profitable sample appear to be stable over the past four decades.

To compute statistical significance of our findings, we compared the statistical

distribution of actual insiders’ abnormal profits with the hypothetical distribution if insiders’

transaction had insiders not traded on material, nonpublic information. To generate the

hypothetical distribution, we took the actual insider transactions and then randomized the date of

trade as well as the purchase/sale indicator using a random number generator. About 53% of

actual insider transactions show abnormal profitability while exactly 50% of the randomly

generated hypothetical trades show abnormal profitability. This difference is statistically

significant at the 1% level and translates to over one hundred thousand transactions for our
sample.

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 We also repeated this exercise for large transactions involving 10,000 or more shares. In

this case, the difference grew to 4% (54% versus 50%), which is again statistically significant at

the 1% level. Finally, we repeated this exercise for large transactions involving 10,000 or more

shares by top executives. In this case, the difference grew to 4% to 6% for various holding

periods (54% to 56% for actual trades versus 50% for hypothetical trades), which is again

statistically significant at the 1% level.

The fact that tens of thousands, to hundreds of thousands of additional trades exhibit high

abnormal profitability demonstrates that Congress’ approach to leaving the definition of illegal
insider information purposefully vague is not working. To the contrary, our evidence indicates

that insiders are taking advantage of this vagueness of the law to exploit their material, nonpublic

information. We suggest that Congress take up this opportunity to define the boundaries of what

constitutes material, nonpublic and therefore illegal insider trading information.

Conclusion

The 40 year time period from 1975 to 2014 that we investigated has seen a number of

changes in insider trading laws. While Congress kept increasing civil and criminal penalties for

criminal insider trading, it kept the definition of what is material, nonpublic information

purposefully vague. The 1984 ITSA established a civil penalty up to three times the profit or

loss avoided for both insiders as well as tippers.266 The 1988 ITSFA provided for private right of

action for contemporaneous trading, a bounty program to collect up to 10% of the insiders’

illegal profits, while also increasing the maximum penalties for violations of insider trading laws

to $1 million in fines and 10 years in prison.267 Finally, the 2002 Sarbanes-Oxley Act further

increased the penalties for purposeful violations of the insider trading laws to $5 million in fines

266
Pub. L. No. 98-376, 98 Stat. 1264.
267
Pub. L. No. 100- 704, 102 Stat. 4677.

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and prison sentence up to 20 years.268 Clearly, none of these increases in penalties have been

successful in even slowing down profitable insider trading.

The recent Second Circuit decision in Newman represents a step backward in clarifying

what is material, nonpublic information and should be reversed. According to Newman,

establishing tippee liability under Section 10b of the Securities Exchange Act 269 and Rule 10b-5

of the SEC270 requires tippee knowledge of tipper personal benefit. The Second Circuit interprets

the Supreme Court’s decision in Dirks stringently,271 reversing the trend in the federal judiciary

over the past 30 years of allowing the Dirks personal benefit requirement to be satisfied by proof

that (1) the tippee knew the insider-tipper breached a fiduciary-like duty 272 in disclosing

confidential information and (2) that the insider expected to obtain a personal benefit in

exchange for disclosure. 273 Moreover, apart from expounding this strict interpretation of the

elements needed to establish tippee liability, the Newman court also set surprisingly high

evidentiary standards for proving these elements.

268
18 U.S.C. § 1348.
269
15 U.S.C. § 78j(b).
270
17 C.F.R. 240.10b-5.
271
See Dirks 463 U.S. at 662 (holding that derivative (tippee) liability can only be found where the insider-tipper
“personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no
breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.”). In Dirks, the
insider-tipper shared personal information with an analyst (the defendant) in order to expose an insurance scam
being perpetrated by the tipper’s company. Id.
272
See Chiarella 445 U.S. at 228 (describing the relevant duty as a “fiduciary or other similar relation of trust and
confidence”); Donna M. Nagy, Insider Trading and the Gradual Demise of Fiduciary Principles, 94 IOWA L. REV.
1315, 1337-1340 (2009) (discussing the tendency among courts to base insider trading liability on breaches of duties
that fall outside the (typically) more narrow confines of traditional fiduciary duties).
273
See Avi Weitzman et al., Second Circuit Injects New Life into Dirks Personal Benefit Test in United States v.
Newman, 29 CORP. & SEC L. ADVISOR 1, 3 (2015) (outlining how the federal courts have generally “diminished the
Dirks personal benefit test” over the past 30 years; “[e]ven absent any pecuniary benefit to the tipper, insider trading
charges were brought against…downstream tippees who knew neither the identity of the individual tipper nor
whether the tipper had personally benefitted from providing the tip. It was the rare case indeed for a court to dismiss
insider trading cases for lack of a Dirks personal benefit to the tipper.”); see, e.g., Obus, 693 F.3d at 276
(enumerating the elements of tippee liability without including knowledge of the tipper’s expected personal benefit
as a separate element).

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 The combination of these legal and evidentiary adjustments to the Dirks test could have

serious implications for the government’s efforts to deter insider trading. The reason for this is

quite simple. When potential tippees know they can trade on confidential information without

recourse—just so long as they are careful to receive that information from “a friend of a friend of

[a friend]”274—this easily circumvented liability rule should be expected to give rise to informal

information sharing networks. 275 By habitually sharing inside information with friends and

associates, insiders could easily engage in indirect, mutual-back-scratching relationships,

disclosing valuable information to the network in the hope that similarly situated individuals

“three and four levels removed from the inside tipper”276 will reciprocate. Such arrangements

could lead to significant increases in insider trading activity, and thus exacerbate the practice’s

primary consequences: the unfair transfer of wealth from ordinary investors to insider traders and

the diminution of the public’s confidence and participation in securities markets 277 (which, in

turn, would likely promote less efficient allocations of investor capital and reduced liquidity in

the financial sector).278 Considering these negative consequences, it is imperative that the legal

community find ways to circumvent the constraints Newman imposes on prosecutors.

This article puts forth a solution, identifying evidence that could demonstrate a tippee’s

knowledge of tipper benefit without requiring actual knowledge of the confidential information’s

source. By using the 8-K filing as a proxy for tippee knowledge of tipper breach of duty and
274
Id. at 453.
275
See Why Insider Trading Is Hard to Define, Prove and Prevent, KNOWLEDGE@WHARTON, Nov. 11, 2009; see
also Weitzman, supra note 283, at 3 (explaining how previous insider trading cases considered the ability to
maintain networking contacts by disclosing inside information to be a considerable “reputational benefit,” a benefit
that typically satisfied the Dirks personal benefit requirement).
276
Newman, 773 F.3d at 443.
277
See O'Hagan, 521 U.S. at 658 (noting that, where insider trading goes unregulated, “investors likely would
hesitate to venture their capital [into the] market”).
278
Zohar Goshen & Gideon Parchomovsky, The Essential Role of Securities Regulation, 55 DUKE L.J. 711, 733-37
(2006) (discussing the harmful impact that insider trading, and the market’s perceptions of insider trading, can have
on market liquidity and overall market performance). But see Eric Engle, Insider Trading: Incoherent in Theory,
Inefficient in Practice, 32 OKLA. CITY U. L. REV. 37, 60 (2007) (arguing that there is no evidence to suggest that
insider trading leads to significant decreases in market liquidity).

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personal benefit, this approach puts tippees on notice that the specific information has been

disclosed contrary to law and in violation of fiduciary duties. Because there should be no

legitimate business purpose for disclosing such information without filing an 8-K, the failure to

file should also be strong enough circumstantial evidence to support an inference that the tipper

has shared confidential information in order to secure a personal benefit. This is because no

rational insider would assume the liability risk associated with such a disclosure if she did not

expect to benefit from it. This evidentiary presumption is not only consistent with Newman and

other insider trading case law, it also promises to significantly expand the ability of prosecutors

to bring cases against putative insider traders. Moreover, this approach exemplifies how similar

evidentiary presumptions might be employed to bridge the ‘knowledge gap’ that now makes it so

difficult—and under Newman practically impossible—to establish downstream tippee liability.

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Table 1: The number and percentage of highly profitable insider transactions exceeding
5% in abnormal profits
Total number
of open
market After 5 After 10 After 20 After 30 After 40 After 50
Decade trades Days Days Days Days Days Days
1975-1984 380,315 61,759 93,072 123,375 139,147 149,452 156,731
16.2% 24.5% 32.4% 36.6% 39.3% 41.2%
1985-1994 428,432 70,652 102,463 137,748 156,942 170,001 177,843
16.5% 23.9% 32.2% 36.6% 39.7% 41.5%
1995-2004 1,134,154 215,859 300,885 387,741 435,868 462,386 483,736
19.0% 26.5% 34.2% 38.4% 40.8% 42.7%
2005-2014 1,578,253 204,042 309,572 418,712 477,534 528,742 563,082
12.9% 19.6% 26.5% 30.3% 33.5% 35.7%
1975-2014 3,521,154 552,312 805,992 1,067,576 1,209,491 1,310,581 1,381,392
15.7% 22.9% 30.3% 34.3% 37.2% 39.2%

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Table 2: The number and percentage of highly profitable insider transactions exceeding
10% in abnormal profits.
Total number
of open
market After 5 After 10 After 20 After 30 After 40 After 50
Decade trades Days Days Days Days Days Days
1975-1984 380,315 19,399 38,054 65,928 84,540 97,537 108,743
5.1% 10.0% 17.3% 22.2% 25.6% 28.6%
1985-1994 428,432 23,867 43,314 74,524 96,700 113,231 125,716
5.6% 10.1% 17.4% 22.6% 26.4% 29.3%
1995-2004 1,134,154 86,822 146,557 228,735 289,818 328,642 357,715
7.7% 12.9% 20.2% 25.6% 29.0% 31.5%
2005-2014 1,578,253 61,022 117,456 204,991 268,452 323,513 368,269
3.9% 7.4% 13.0% 17.0% 20.5% 23.3%
1975-2014 3,521,154 191,110 345,381 574,178 739,510 862,923 960,443
5.4% 9.8% 16.3% 21.0% 24.5% 27.3%

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Table 3: Average Abnormal Profitability of Insider Trades Conditional on Exceeding 10%
in 5 Days.
Total number
of open
market After 5 After 10 After 20 After 30 After 40 After 50
Decade trades Days Days Days Days Days Days
1975-1984 19,399 16.6% 16.3% 15.9% 16.2% 16.4% 16.9%

1985-1994 23,867 16.6% 15.6% 16.1% 16.7% 17.6% 18.1%

1995-2004 86,822 18.4% 18.1% 19.4% 20.5% 21.5% 22.6%

2005-2014 61,022 17.1% 17.4% 17.1% 17.8% 17.5% 17.6%

1975-2014 191,110 17.6% 17.4% 17.9% 18.8% 19.2% 19.9%

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