CASE 1: Fred, a janitor at the headquarters of Worldwide Widget, is cleaning the office of Mary, Worldwide's corporate treasurer. Fred complains about his financial troubles, and Mary, taking pity, gives him a tip: Worldwide is negotiating to merge with Consolidated Widget and expects to buy Consolidated's stock for twice its current market value. Fred invests his life savings in Consolidated, and, when the merger is announced, makes a $25,000 profit.
CASE 2: Robert is sitting in a fancy restaurant when he overhears two executives saying the firm in which they are officers will be signing a lucrative contract with XYZ Corp. that will probably cause the price of XYZ stock to jump. Robert tells his sister-in-law, Sally, a stockbroker. Sally and Robert buy options on XYZ stock, the contract is announced, and they make a $350,000 profit by exercising their options.
CASE 3: Jane, a stock analyst who follows Corp. X, calls John, a Corp. X vice president. In response to Jane's questions, John says the company's new product line is doing poorly and that its profits, to be announced in a month, will be well below projections. John has not told this to other analysts, and the company does not publicly disseminate the information. Jane sells her Corp. X stocks and tells her clients, who also sell. When the lower profits are announced, Corp. X stock drops $10 a share.
ANSWER ONE: Neither Fred nor Mary is likely to be found to have violated the law.
Mary owes a fiduciary duty as treasurer of Worldwide not to use inside information to trade in its stock, but she owes no such duty to Consolidated, whose stock was traded. For that same reason, Fred, as recipient of her tip, does not owe a duty to Consolidated.
Because Mary obtained no personal gain by tipping off Fred, she probably would not be held liable under the alternate legal theory that she had "misappropriated" inside information. Consequently, Fred would not be liable as the recipient of Mary's tip. Finally, it is unlikely that Fred would be found to have directly misappropriated information because he owes no legal duty to Worldwide Widget and did not act improperly in obtaining the information.
The government could, however, argue that Mary violated her duty to Worldwide because Fred's purchases could drive up the price of Consolidated stock to the detriment of her employer. It might also claim that her tip to Fred is a "gift" that would result in some personal benefit to her. To get Fred, the government would then have to show he knew or should have known that Mary was acting improperly.
ANSWER TWO: It is doubtful that Robert, Sally or the indiscreet executives have violated the law.
First, none of them has a fiduciary duty to shareholders of the XYZ corporation or is a tippee of a person with such a duty.
Second, on the misappropriation theory, the executives have a duty to their corporation not to trade in XYZ stock for their own benefit, and they have not. When they inadvertently tipped off Robert and Sally, they did not obtain "personal gain" by doing so. Robert and Sally would only be liable as tippees if they acquired information in breach of a duty or used the information in breach of a duty, and they have not.
ANSWER THREE: Neither John nor Jane is apt to get in trouble here.
John has a duty to shareholders of Corp. X to refrain from trading on this information, and he has not traded. Under the Supreme Court's decision in Dirks v. SEC he could get in trouble only if he passes on information for his personal gain or benefit; there is no indication of that in this case.
Jane is liable only if she knows that John passed her information in violation of his fiduciary duty and for his personal gain. This would be hard to show, especially because an analyst usually can assume that a corporate source has acted in a manner consistent with the corporation's policies about making the information public.
These hypothetical situations and answers are based on those outlined in a 1985 report of the American Bar Association Task Force on Regulation of Insider Trading.