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Insider Information – A Working Definition

Insider Trading - Insider Information - Expert NetworksIn its ongoing coverage of Galleon Group founder Raj Rajaratnam’s trial for insider trading the Wall Street Journal’s Law Blog brings up a good question: what exactly is insider information?

Before attempting an answer, let’s have a quick look at what exactly insider trading is:

For the most part, the insider trading laws prohibit trading in a company’s securities on the basis of material, nonpublic information in breach of a duty of trust or confidence owed to the company, its shareholders or the source of the information.

There are two general theories of liability for insider trading:

  • the classical theory, under which a traditional insider–such as an officer, director or employee–or a constructive or temporary insider–such as a company’s outside counsel, accountants or bankers–trades in a company’s securities on the basis of material, nonpublic information in breach of a duty of trust or confidence owed to the company or its shareholders; and
  • the misappropriation theory, under which a non-insider trades in a company’s securities on the basis of material, nonpublic information acquired in breach of a duty of trust or confidence owed to the source of the information.

Under either theory a tippee, such as Raj Rajaratnam is alleged to be, may be held liable for trading in a company’s securities on the basis of material, nonpublic information acquired from a tipper, such as Rajiv Goel, formerly of Intel Capital, where the tippee knew or should have known that the information was disclosed in violation of the tipper’s fiduciary duties, and the tipper personally benefited from the disclosure.

Information that is both material and nonpublic, or “insider information”, is a necessary component under each theory of liability.  But, when is information material and when is it nonpublic?

As a general matter, information is material if there is a substantial likelihood that a reasonable investor would consider it important in determining whether to buy, sell or hold a company’s securities, or would view it as altering the total mix of information available. And, information is nonpublic if it has not been disseminated in a manner that makes it available to investors generally.

Note, however, that trading on the basis of information that is nonpublic but also non-material is not illegal insider trading. Rather, piecing bits of non-material information together to uncover material information about a company falls under a legitimate theory of analysis called the mosaic theory, which is often asserted as a defense to allegations of insider trading, as it is in the Galleon case.

Based on trial coverage available in the WSJ and New York Times’ DealBook it appears that, at least so far, Rajaratnam’s defense team is only arguing that the information on which Galleon’s trades were based was publicly available.  I haven’t seen any materiality arguments come up yet, though we’re only two weeks into a potentially 10 week trial. The concept of materiality is a difficult one, especially in retrospect and in the context of the mosaic theory. It’ll be interesting to see what kind of information the prosecution focuses on and what, if anything, it adds to the current understanding of material information.

Now this doesn’t quite answer the question of: what exactly is insider information? But it does give us an operable framework.  Perhaps by the time the jury deliberates we can add on some factual information and come up with a better answer.

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