Defining The Undefined: What Should Be Considered Material, Nonpublic, Illegal Insider Information?

Our insider trading laws remind us of an old Churchill quote: It is a riddle, wrapped in a mystery, inside an enigma.[1] Insider trading laws have never defined what constitute illegal insider trading information. Yet, the statutory penalties for illegal insider trading may result in a twenty year prison sentence and millions in fines. In spite of this fact, we see insiders make tens of thousands of lucrative transactions every year without seeming to worry about consequences. To add to the mystery, as the statutory penalties have increased so have insider trading. Is there a key for this riddle and if so, what is it?

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 takeovers 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.

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, an individual’s penalties from insider trading can reach up to 20 years in prison and the greater of five million dollars or twice the gain 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. In a paper available here,[12] forthcoming in Fordham Journal of Corporate and Financial Law, 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 unless Congress defines insider trading in a more precise form.[13]

Therefore, we argue that 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 our 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 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.

By using the 8-K filing as a proxy for tippee knowledge of tipper breach of duty and 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.


[1]  A quote by Winston Churchill, made in a radio broadcast in October 1939.

[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.

[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.


[13] Beeson, Ed, SEC Loses Insider Trading case on Home Court”, Law360, September 14, 2015. See

[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.

The preceding post comes to us from Cindy A. Schipani, the Merwin H. Waterman Collegiate Professor of Business Administration and Professor of Business Law at the University of Michigan, Ann Arbor, Michigan, and H. Nejat Seyhun, the Jerome B. & Eilene M York Professor of Business Administration and Professor of Finance, University of Michigan, Ann Arbor, Michigan. The post is based on their article, which is entitled “Defining ‘Material Nonpublic’: What Should Constitute Illegal Insider Information?” forthcoming in the Fordham Journal of Corporate & Financial Law and available here.