Grabski v. Andreessen and Coinbase Global, Inc.
Court of Chancery of Delaware (Feb. 1, 2024)

McCormick, Ch.

Cryptocurrency platform Coinbase Global, Inc. went public through a direct listing. The defendants were directors and officers of Coinbase and sold $2.9 billion worth of stock in the direct listing. A month later, the company announced disappointing quarterly earnings and that it was raising capital through a notes offering. After this announcement, the company's stock price declined precipitously. By selling their shares before the announcement, the defendants avoided losses of approximately $1.09 billion. The plaintiff, who acquired Coinbase stock through the direct listing, filed this derivative suit alleging that the defendants sold their stock based on material non-public information and were unjustly enriched by the sales.

The defendants have moved to dismiss the complaint pursuant to Court of Chancery Rules 23.1 and 12(b)(6). They argue that the plaintiff has failed to plead facts sufficient to impugn the impartiality of the company's board for purposes of Rule 23.1. They further argue that the plaintiff has failed to adequately allege that the defendants had material non-public information and possessed the requisite scienter when selling their shares for purposes of Rule 12(b)(6).

Although the defendants' briefs read like a philosophical apology for direct listings, the plaintiff's claims do not place that relatively nascent transactional structure on the chopping block. Rather, this is yet another instance where a stockholder plaintiff calls on this court to deploy "well-worn fiduciary principles" to a new transactional setting. Applying those principles and drawing the plaintiff-friendly inferences called for at this stage of the litigation, the court concludes that plaintiff has met the demand futility requirement and stated a well-pled claim. The motions are denied.

A. Coinbase

Founded in 2012 by defendants Brian Armstrong and Frederick Ernest Ehrsam III, Coinbase is a Delaware corporation that owns and operates the largest cryptocurrency trading platform in the United States by trading volume. Coinbase was privately held until 2021, when it was directly listed on the Nasdaq exchange.

Over 90% of Coinbase's revenue derives from brokerage fees. Before the direct listing, the brokerage fee landscape was changing. Market analysts and research firms had highlighted the importance of retail fees to Coinbase's business model and cautioned about the industry's sensitivity to changes in brokerage fees. In early 2021, the Coinbase Board of Directors (the "Board") and its senior management considered the sustainability of Coinbase's fee revenues in the face of industry-wide "fee compression" and learned that customers and corresponding fee revenues were moving away from the Coinbase retail platform.

Also at that time, Coinbase was reviewing various capital raising options. Before the direct listing, the Board had studied projections on Coinbase's liquidity situation and sensitivity in shock situations.

B. Events Leading To The Direct Listing

The Board met on August 4, 2020, to discuss taking Coinbase public. A slide deck presented to the Board listed the following among the Board's objectives: "liquidity (first to employees, then to existing investors)" and "no dilution." Of the two paths to going public discussed by the Board—a traditional initial public offering ("IPO") or a direct listing—the Board viewed the direct listing as best suited to achieve its liquidity and anti-dilution goals. The Board therefore approved pursuing a direct listing. In October 2020, Coinbase filed a confidential registration statement on its Form S-1 with the SEC indicating its intent to go public by a direct listing without raising any capital (the "Registration Statement").

1. Overview Of Direct Listings

Through an IPO, a company sells a portion of its shares to one or more underwriters who, in turn, make the offering with their own capital. The underwriters' role in an IPO has at least two important consequences. First, the underwriters perform diligence before the transaction, which serves as a check on management. Second, underwriters typically require the company to implement a lock-up period for its directors and officers to prevent misuse of insider information.

Unlike an IPO, a direct listing involves the sale of existing company shares directly to the public. No new shares are required, and no underwriters are involved. Instead, the public purchases the shares held by the company's existing stockholders, who typically include directors and officers. The offering company has the option— but is not required—to implement safeguards to protect investors.

Direct listings have increased in popularity since Spotify's listing in 2018. Although a direct listing is cheaper and faster than an IPO, a direct listing's limited disclosure requirements, lack of underwriter diligence, and optional investor safeguards has raised scholarly concern.

The initial price in a direct listing, called the "reference price," is determined by the listing company with the help of accountants and other professionals. To determine this price, Nasdaq requires the listing company to provide certain information. Companies often hire investment bankers to run a mini-exchange—a secondary trading program—to gauge the public perception of the company's value. When setting the reference price, considerations include the company's public financial information, previous private market valuations, value of competitors, and internal discounted cash flow valuations. Nasdaq works in concert with the company's financial advisor to determine the reference price. …

6. The Direct Listing

On April 13, 2021, Nasdaq set Coinbase's reference price at $250 per share. The next day, Coinbase became a Nasdaq-listed company, and its stock opened at $380, rising to as high as $429 on the first day of trading.

Not constrained by a lock-up period, the members of Coinbase's board and its senior officers sold Coinbase stock worth $2.9 billion. Thirteen of the eighteen sales were completed by April 15, 2021. The only board member or officer who sold after April 15 was Fred Ehrsam, whose last sale was on April 22, 2021.

C. Events After The Direct Listing

By April 23, 2021, Coinbase's stock price had fallen to a range of $282.75 to $291.60 per share. During an April 28, 2021 meeting, the Board approved the issuance and sale of up to $2 billion of convertible notes. The objective of the notes offering was "to build [a] balance sheet for working capital and acquisition capacity[.]"

Two weeks after the Direct Listing, the Board reviewed Coinbase's pricing strategy and fee compression issues affecting peer companies. A slide from that presentation noted the "inevitability of fee compression" in the crypto industry. The Board also reviewed some initiatives under consideration to blunt the blow of fee compression to Coinbase's revenues.

On May 13, 2021, Coinbase announced that its retail transaction fee rate had fallen. Analysts noted that the fee rate was "largely driven by retail mix shift towards Coinbase Pro which has tiered pricing." Coinbase's stock dropped 2.54% on the day of the earnings release.

Coinbase announced the notes offering on May 17, 2021. The offering was met with market curiosity because Coinbase was "generat[ing] positive cash flow, [wa]s growing rapidly," and had just completed the Direct Listing. Within minutes of the issuance, Coinbase's stock dropped 2.9%.

D. This Litigation

Plaintiff Adam Grabski ("Plaintiff") bought Coinbase stock on the first day of the Direct Listing. He filed this action on April 26, 2023, asserting claims for breach of fiduciary duty (Count I) and unjust enrichment (Count II) against the five Coinbase directors (the "Director Defendants") and four Coinbase officers (the "Officer Defendants") (together, with the Director Defendants, "Defendants") who sold stock in the Direct Listing. The Director Defendants are Marc Andreessen, Ehrsam, Brian Armstrong, Kathryn Haun, and Fred Wilson. The Officer Defendants are Emilie Choi (Chief Operating Officer), Alesia Haas (Chief Financial Officer), Jennifer Jones (Chief Accounting Officer), and Surojit Chatterjee (Chief Product Officer).

At the time Plaintiff filed this action, the Board (the "Demand Board") comprised Armstrong, Andreessen, Ehrsam, Haun, Wilson, Kelly Kramer, Gokul Rajaram, and Tobias Lutke. All but Lutke were members of the Board at the time of the Direct Listing.

On June 30, 2023, Defendants moved to dismiss the Complaint pursuant to Court of Chancery Rules 23.1 and 12(b)(6), and the parties completed briefing on September 27, 2023. The court held oral argument on October 16, 2023.

II. LEGAL ANALYSIS

This analysis first addresses the dismissal arguments concerning Count I for breach of fiduciary duty and then turns to the arguments concerning Count II for unjust enrichment.

A. The Fiduciary Duty Claims

In Count I, Plaintiff claims under Brophy v. Cities Service Co. that the Defendants breached their fiduciary duties by improperly selling their shares through the Direct Listing while in possession of material, nonpublic company information ("MNPI").

Defendants have moved to dismiss Count I under Rule 12(b)(6). The Rule 12(b)(6) standard in Delaware "is reasonable `conceivability.'" When considering such a motion, the court must "accept all well-pleaded factual allegations in the [c]omplaint as true . . ., draw all reasonable inferences in favor of the plaintiff, and deny the motion unless the plaintiff could not recover under any reasonably conceivable set of circumstances susceptible of proof." The court, however, need not "accept conclusory allegations unsupported by specific facts or . . . draw unreasonable inferences in favor of the non-moving party."

Defendants have also moved to dismiss Count I under Rule 23.1. A Brophy claim is derivative in nature "because it arises out of the misuse of corporate property—that is, confidential information—by a fiduciary of the corporation, for the benefit of the fiduciary and to the detriment of the corporation." As a derivative claim, Count I is subject to the demand requirement. …

When Plaintiff initiated this action, the Demand Board comprised eight directors. So, to adequately allege demand futility, Plaintiff must plead particularized facts creating reason to doubt that at least four of the eight were incapable of impartially considering a demand. Plaintiff argues that the five Director Defendants (Andreeseen, Armstrong, Ehrsam, Haun, and Wilson) on the Demand Board were incapable of impartially considering a demand.

Plaintiff advances arguments under the first and second prongs of Zuckerberg. Plaintiff argues that the Director Defendants are interested because they received material personal benefits when they sold stock worth billions of dollars in the Direct Listing. Plaintiff also argues that the Director Defendants face a substantial likelihood of liability based on the Brophy claims.

The analysis of Count I proceeds in three parts. First, the court addresses the argument that the Director Defendants are interested under Zuckerberg because they received material personal benefits.

Second, the court addresses the Director Defendants face a substantial likelihood of liability based on the Brophy claims. Because showing that a defendant faces a substantial likelihood of liability from a claim requires that the claim be legally viable, as to the Director Defendants, the Rule 23.1 analysis effectively folds into the Rule 12(b)(6) analysis.

Third, the court turns to Count I against the Officer Defendants, which largely overlaps with that of the Director Defendants. There is one point of divergence: The factual bases for the Brophy claim against the Officers Defendants are slightly from those alleged against the Director Defendants.

1. Material Personal Benefit

A director is disabled for demand futility purposes if they received a material personal benefit from the wrongdoing that was not shared equally with the stockholders. Whether a benefit is material is a question of fact that takes into consideration the amount, the recipient's wealth, and the circumstances surrounding the benefit.

Plaintiff alleges with particularity the details of the Director Defendants' (and Officer Defendants') trades, including the dates, number of shares, and amounts sold. The sales were for staggering amounts. $52 million for Haun, $61 million for Chatterjee, $99 million for Haas, $118 million for Andreessen, $219 million for Ehrsam, $223 million for Choi, $291 million for Armstrong, $1.8 billion for Wilson, and a paltry $43 million for Jones. These sales resulted in benefits to the Defendants totaling almost $2.93 billion, with no Director Defendant receiving less than $50 million.

Plaintiff argues that it is reasonably conceivable that this amount of money was material to each Director Defendant such that none could impartially consider a pre-suit litigation demand attacking the sales. Plaintiff need not allege facts concerning each Director Defendant's personal wealth to support this conclusion— $50 million is presumptively material. …

In all events, this court [is not required to] ignore basic aspects of human nature when evaluating whether a director received a material personal benefit. Just as it would be "unwise" to say that a director always materially benefits under Zuckerberg when she sells company stock, it would be unwise to say a director never materially benefits under Zuckerberg even if she receives a gargantuan financial benefit. In the real world, the billions of dollars made by the Director Defendants constitutes a material personal benefit that would render a director incapable of impartially considering a demand attacking those sales. Demand is excused on this basis.

2. Substantial Likelihood Of Liability

[…] Plaintiff has satisfied the demand requirement because the Director Defendants face a substantial likelihood of liability based on the Brophy claims.

To state a claim under Brophy, a plaintiff must plead that the defendants: (a) possessed MNPI; and (b) used that information to make trades because the defendants were motivated by the substance of that information (the scienter requirement). To plead a substantial likelihood of liability, a plaintiff must "make a threshold showing, through the allegation of particularized facts, that their claims have some merit." At the pleading stage, a Brophy claim "rests on circumstantial facts and a successful claim typically includes allegations of unusually large, suspiciously timed trades that allow a reasonable inference of scienter." Plaintiff has made the threshold showing as to both elements.

a. Possession Of MNPI

Plaintiff alleges that the Director Defendants possessed four categories of MNPI prior to the Direct Listing. Given that only one category must be pled, the court will restrict the analysis to one—the Andersen Report. Plaintiff claims that the Director Defendants knew that the Andersen Report valued the Company's stock well below its trading price when they sold into the Direct Listing.

Plaintiff has pled knowledge. Plaintiff alleges that the Board (containing the Director Defendants) approved the Andersen Report by unanimous written consent on March 26, 2021. From this, the court can infer that the Director Defendants had knowledge of the contents of the Andersen Report.

Plaintiff has pled that the Andersen Report was not public. It was not disclosed in the Registration Statement, the Q1 2021 pre-earnings release materials, or any other public source. Defendants concede that the Andersen Report was non-public because they consistently redacted its price out of the public versions of the Complaint until after oral argument.

Plaintiff has pled that the information in the Andersen Report was material. "For information to be material, there must be a `substantial likelihood' that the nonpublic fact `would have assumed actual significance in the deliberations' of a person deciding whether to buy, sell, vote, or tender stock." If the information were disclosed, it would "significantly alter[] the `total mix' of information in the marketplace." In determining materiality, the court will consider the context and reliability of the information, including whether the information was known to the market.

The Andersen Report determined that the fair value of the Company's stock was $303.75. This figure was the weighted average of the trading price of Coinbase stock in the Secondary Trading Program ($343.58) and a probability-based figure determined by Andersen ($263.90). Moreover, each Director Defendant knew that, using the management projections, Andersen's DCF analysis arrived at a valuation of Coinbase of $50.025 billion, which was below the total equity value implied by Andersen's per-share analysis. It was the Secondary Trading Program valuation of $343.58—set by buyers who had the same informational disadvantage as the rest of the market—that pushed the Andersen Valuation to $303.75 per share. The $303.75 valuation, DCF analysis, and underlying management projections concerning the value of Coinbase would have had actual significance to persons who purchased stock from Defendants in the Direct Listing in the $300s and $400s.  …

b. Scienter

To state a claim under Brophy, a plaintiff must allege that not only the fiduciary possessed material, nonpublic company information, but also that "the corporate fiduciary used that information improperly by making trades because she was motivated, in whole or in part, by the substance of that information."

This court considers a variety of factors when evaluating whether a plaintiff has adequately alleged the scienter necessary to support a Brophy claim. "[A]llegations of unusually large, suspiciously timed trades"are informative. Those allegations generally include:

• the timing of the trade, including the proximity between the trade and the time the defendants learn of MNPI, and the expiration date for any options or restrictions (like lock-ups);
• the size of the trade relative to the defendant's overall stock holdings; and
• the size of the trades and the type of compensation (cash or shares).

The court considers all these factors in their totality.

Plaintiff has adequately alleged scienter. Plaintiff pleads facts concerning: the timing of the trades; the size of the trades—above $40 million in the aggregate; the amount of "each sale by each individual defendant"; the lack of a lock-up as compared to the secondary trading program; the fact that management recommended no lock-up; the lack of time between the valuation and the trading; and that the Defendants received cash instead of options or some other renumeration. These facts are sufficient to support an inference that the Director Defendants were motivated by the substance of the MNPI.

Defendants advance two arguments in response. First, they cite Delaware cases for the proposition that the Director Defendants must have sold a larger proportion of their holdings to give rise to a pleadings-stage inference of scienter. Second, they argue that the Director Defendants lacked scienter because they could have made more money by selling more stock after the initial sales but did not.

As to the first point, the portion of shares sold can speak to the reasonableness of inferring scienter, but it is not the litmus test that the Director Defendants describe. To determine whether there is a reasonable inference of scienter, this court considers the totality of facts alleged, including the timing and size, not just the proportion of the sale to overall holdings. In In re Clovis Oncology, for example, the court did not infer scienter where the sales were made well before (half a year) the alleged MNPI was disclosed to the market, there were no deviations from past trading practices, and the sales were for a total of only $4 million, representing a small portion of each defendant's overall holdings. By contrast, here, the sales were made as soon as weeks before Coinbase's earnings showed that the company was not doing as well as the market originally anticipated. Further, Defendants sold $2.93 billion to avoid over $1.09 billion in losses. The totality of circumstances in this case support a pleadings-stage inference of scienter.

As to the second point, Plaintiff need not allege that Director Defendants maximized the value gained from their alleged impropriety or "misus[ed] [the] information more effectively" to state a claim. The Director Defendants made a lot of money from the trades. Maximum overindulgence is not a necessary element.

For these reasons, Plaintiff successfully alleges that the Director Defendants face a substantial likelihood of liability for insider trading under Brophy. Demand was therefore futile as to the Director Defendants.

3. The Officer Defendants

Where the factual allegations underlying claims against officers are "congruous" with the facts underlying claims against directors, then adequately alleging a substantial likelihood of liability as to the directors satisfies the demand requirement concerning the claims against the officers. This is because an investigation of the officers "would necessarily implicate the same set of facts" at issue in the claim against the directors.

Plaintiff alleges that all Defendants received the same MNPI at the same time and traded on that MNPI around the same time. The factual allegations are therefore congruous, and the analysis of the claims against the Officer Defendants "tread the same path" as the claims against the Director Defendants. Given the near-total overlap in allegations, the conclusion that the Director Defendants face a substantial likelihood of liability in connection with the Brophy claims renders demand futile under Rule 23.1 as to the claims against the Officer Defendants.

The Brophy claims against the Officer Defendants are also reasonably conceivable under Rule 12(b)(6). The facts alleged against the Officer Defendants are identical to those against the Director Defendants except for knowledge. The court inferred that the Director Defendants knew of the Andersen Report due to the unanimous written consent, which the Officer Defendants did not execute.

Nevertheless, Plaintiff has adequately alleged that the Officer Defendants knew of the contents of the Andersen Report. Plaintiff alleges that Chatterjee, Choi, and Haas attended meetings where interim Andersen valuations were reviewed. Plaintiff also alleges that all the Officer Defendants attended the February 23, 2021 meeting where the Board approved the Direct Listing and were presented with "market trends, valuation over time and an analysis of potential outcomes, including first day trading" in relation to the Direct Listing. Plaintiff further alleges that management assisted in the preparation of the Anderson report. Drawing plaintiff-friendly inferences from these facts, is reasonably conceivable that the Officer Defendants knew the Andersen Valuation given their presence at these meetings and involvement with the report. The motion to dismiss the Brophy claim against the Officer Defendants is therefore denied.

B. Unjust Enrichment

Generally, "where the Court does not dismiss a breach of fiduciary duty claim, it . . . does not dismiss a duplicative unjust enrichment claim." That is particularly true here, as "Brophy is a species of unjust enrichment" that focuses on the benefit to the wrongdoer. Accordingly, Defendants based their argument to dismiss Count II for unjust enrichment on Plaintiff's failure to state the predicate Brophy claim. Defendants thereby acknowledge that Plaintiff's claim for unjust enrichment rises or falls with the Brophy claim. Accordingly, the motion to dismiss Count II for unjust enrichment is denied.

III. CONCLUSION

Defendants' motions to dismiss under Rule 23.1 and Rule 12(b)(6) are denied.

Insider trading, a term that evokes images of Wall Street scandals and illicit profits, is a central focus of United States securities regulation. It refers to the practice of trading a public company’s stock or other securities based on material, non-public information. The legal framework governing insider trading is unique in that it is not explicitly defined by a single federal statute. Instead, it has been incrementally developed by the federal courts through the interpretation and application of the general anti-fraud provisions of the Securities Exchange Act of 1934.

At its core, federal insider trading law is built upon Section 10(b) of the Securities Exchange Act of 1934 and the corresponding Rule 10b-5 promulgated by the Securities and Exchange Commission (SEC). These provisions broadly prohibit fraud, deception, and manipulation in connection with the purchase or sale of securities. Over several decades, courts have interpreted these provisions to create two primary theories of liability for insider trading: the classical theory and the misappropriation theory. As the theories of insider trading developed over time they relied heavily on state law fiduciary duties, looking to state law doctrines like the “special facts” doctrine for inspiration.

The Classical Theory of Insider Trading

The classical theory represents the earliest and most straightforward application of insider trading prohibitions. It focuses on the breach of a fiduciary duty that corporate insiders, such as officers, directors, and employees, owe directly to the shareholders of their own company. Similar to the state law special facts doctrine, when these fiduciaries trade in their own company’s stock in reliance on inside information, they violate a duty and thus generate a liability under federal law.

Section 10(b) and Rule 10b-5

The entire edifice of federal insider trading law rests on the following statutory and regulatory language:

Section 10(b) of the Securities Exchange Act of 1934: 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... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe...

SEC Rule 10b-5:It shall be unlawful for any person, directly or indirectly... (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.

These anti-fraud provisions do not mention “insider trading.” The federal prohibition against insider trading was first articulated in a landmark SEC administrative opinion, In re Cady, Roberts & Co., and then given full force by the federal courts in cases like SEC v. Texas Gulf Sulphur Co.

In re Cady, Roberts & Co. (1961): The Origin of the "Disclose or Abstain" Rule

The true origin of the “disclose or abstain” rule can be traced not to a federal court case, but to a seminal administrative opinion by the SEC itself. In this 1961 matter, SEC Chairman William L. Cary laid the administrative groundwork for what would become the bedrock principle of insider trading law.

Cheever Cowdin was a director of the Curtiss-Wright Corporation and also a partner at the stock brokerage firm Cady, Roberts & Co. During a board meeting, the directors decided to reduce the company's quarterly dividend. Before this information was made public, Cowdin left the meeting and telephoned his partner at the brokerage firm, Robert M. Gintel. Gintel, now in possession of material, non-public information, immediately sold several thousand shares of Curtiss-Wright stock held in customer accounts, thereby avoiding the losses that would occur when the stock price declined upon the public announcement of the dividend cut.

In his administrative opinion, SEC Chairman Cary articulated a broad interpretation of Rule 10b-5's anti-fraud provisions. He argued that the obligation was not limited to traditional corporate insiders and that it extended to prevent the use of corporate information for personal advantage. The key takeaway from the opinion was the articulation of the “disclose or abstain” rule: an insider in possession of material non-public information must either disclose such information before trading or, if disclosure is impossible or improper, must abstain from trading. Cary reasoned that the inherent unfairness of a tippee (Gintel) taking advantage of information intended for a corporate purpose constituted a “fraud or deceit” under Rule 10b-5. While this administrative ruling did not create binding legal precedent, it established the principles that the SEC would advocate for and which the courts would soon adopt as the law of the land.

SEC v. Texas Gulf Sulphur Co. (1968): Affirming “Disclose or Abstain" and Defining its Scope

The Second Circuit’s decision in Texas Gulf Sulphur (TGS) is a foundational federal court case that affirmed and dramatically expanded upon the “disclose or abstain” principle first articulated in In re Cady, Roberts & Co. It was this case that cemented the rule within federal case law and established its broad scope.

Texas Gulf Sulphur, a mining company, conducted exploratory drilling in Ontario, Canada. In November 1963, a drill core, K-55-1, revealed an astonishingly rich mineral strike. The visual estimates were so remarkable that company insiders, including geologists, engineers, and vice presidents, described them as unprecedented. To facilitate the acquisition of surrounding land, TGS President Stephens instructed the exploration group to keep the results strictly confidential, even from other TGS officers and directors. While the company kept the discovery secret, a group of insiders, aware of the drill results, began purchasing TGS stock and call options at prices ranging from $18 to $26 per share. By the time the news was made public, the stock price had soared to over $58 per share.

As rumors of a major discovery began to circulate, TGS issued a press release on April 12, 1964, which was misleadingly pessimistic. It downplayed the significance of the drilling and stated that any rumors of a major strike were “without factual basis.” Just four days later, on April 16, TGS issued an official statement announcing a massive ore discovery of at least 25 million tons. Several insiders traded between the misleading press release and the official announcement. Other insiders traded immediately following the official announcement.

The Second Circuit’s ruling was expansive and established several key tenets of the classical theory:

Affirmation of the “Disclose or Abstain” Rule: The court adopted the principle from Cady, Roberts and gave it the force of federal law, stating that anyone in possession of material inside information must either disclose the information to the investing public or abstain from trading:

An insider is not, of course, always foreclosed from investing in his own company merely because he may be more familiar with company operations than are outside investors. An insider’s duty to disclose information or his duty to abstain from dealing in his company's securities arises only in those situations which are essentially extraordinary in nature and which are reasonably certain to have a substantial effect on the market price of the security if the extraordinary situation is disclosed.

Nor is an insider obligated to confer upon outside investors the benefit of his superior financial or other expert analysis by disclosing his educated guesses or predictions. The only regulatory objective is that access to material information be enjoyed equally, but this objective requires nothing more than the disclosure of basic facts so that outsiders may draw upon their own evaluative expertise in reaching their own investment decisions with knowledge equal to that of the insiders.

Definition of Materiality: The TGS court defined “material information” with a flexible, investor-centric standard:

The basic test of materiality * * * is whether a reasonable man would attach importance * * * in determining his choice of action in the transaction in question. Restatement, Torts § 538(2) (a); accord Prosser, Torts 554-55; I Harper & James, Torts 565-66.” (Emphasis supplied.) This, of course, encompasses any fact "* * * which in reasonable and objective contemplation might affect the value of the corporation's stock or securities * * *

Information that a reasonable information might believe is important in deciding whether to buy or sell shares or how to vote their shares is, under this definition, material. This includes facts that may affect the probable future value of the company and the desire of investors to buy, sell, or hold the company’s securities. The court found that the extraordinary nature of the mineral discovery was undoubtedly material, and the insiders' own trading activity served as strong evidence of its materiality. 

Who is an “Insider”? The TGS court made it clear that the duty to disclose or abstain is not limited to top executives. The rule applies to “anyone in possession of material inside information,” including any employee who has access to information intended only for a corporate purpose.

Insiders, including directors or management officers, are precluded from dealing unfairly inthe company's stock, but the Rule is also applicable to one possessing the information who may not be strictly termed an “insider” within the meaning of Sec. 16(b) of the Act. Cady, Roberts. Thus, anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.

The Timing of Disclosure: The TGS court also addressed the practical question of when insiders can trade after information is made public. It held that insiders must wait for a "decent interval" after the news has been disseminated through major news wires, allowing the market a reasonable opportunity to absorb it. Trading immediately upon release, before the public has had a chance to react, is a violation.

Although the only insider who acted after the news appeared over the Dow Jones broad tape is not an appellant and therefore we need not discuss the necessity of considering the advisability of a “reasonable waiting period” during which outsiders may absorb and evaluate disclosures, we note in passing that, where the news is of a sort which is not readily translatable into investment action, insiders may not take advantage of their advance opportunity to evaluate the information by acting immediately upon dissemination. In any event, the permissible timing of insider transactions after disclosures of various sorts is one of the many areas of expertise for appropriate exercise of the SEC’s rule-making power, which we hope will be utilized in the future to provide some predictability of certainty for the business community.

TGS affirmed the administrative principles from Cady, Roberts and created a broad, fairness-based framework for insider trading liability within the federal courts, premised on the idea that it is inherently unfair for insiders to use their privileged access to information to profit at the expense of the uninformed public.

Chiarella v. United States (1980): The Fiduciary Duty Requirement

For over a decade, the broad “equal access,” or “level playing field,” theory of TGS prevailed. However, the Supreme Court significantly narrowed this approach in Chiarella v. United States, tethering insider trading liability to the breach of a specific fiduciary relationship, conforming it to traditional state-based insider trading liability.

Vincent Chiarella was an employee of a financial printing company that printed documents for corporate takeovers. Although the names of the target companies were concealed with code words, Chiarella was able to deduce their identities from other information in the documents. Without disclosing his knowledge, he purchased stock in the target companies and sold the shares for a substantial profit immediately after the takeover bids were publicly announced. Chiarella was not an insider of the target companies whose stock he traded.

The Supreme Court reversed Chiarella’s conviction, rejecting the idea that a duty to disclose is owed to the entire marketplace. The Court held that a duty arises only from a fiduciary relationship. The Court grounded insider trading liability in the common law of fraud, holding trading while in possession of inside information can be fraudulent only when the trader has a duty to the source of the information. The Court clarified, a duty can arise from a relationship of trust and confidence between parties to a transaction. Application of a duty to disclose prior to trading guarantees that corporate insiders, who have an obligation to place the shareholder's welfare before their own, will not benefit personally through fraudulent use of material, nonpublic information.

The Court explicitly rejected the TGS notion from the Second Circuit that securities laws created a system of equal access to information. It stated that “not every instance of financial unfairness constitutes fraudulent activity under § 10(b).”

The Court of Appeals, like the trial court, failed to identify a relationship between petitioner and the sellers that could give rise to a duty. Its decision thus rested solely upon its belief that the federal securities laws have “created a system providing equal access to information necessary for reasoned and intelligent investment decisions.” The use by anyone of material information not generally available is fraudulent, this theory suggests, because such information gives certain buyers or sellers an unfair advantage over less informed buyers and sellers.

According to the Court, this reasoning suffers from two defects. First, not every instance of financial unfairness constitutes fraudulent activity under § 10 (b). See Santa Fe Industries, Inc. v. Green, 430 U. S. 462, 474-477 (1977). Second, the element required to make silence fraudulent, the so-called  duty to disclose, is absent in this case. No duty could arise from Chiarella's relationship with the sellers of the target company's securities, because Chiarella had no prior dealings with them. He was not their agent, he was not a fiduciary, he was not a person in whom the sellers had placed their trust and confidence. He was, in fact, a complete stranger who dealt with the sellers only through impersonal market transactions:

We cannot affirm petitioner’s conviction without recognizing a general duty between all participants in market transactions to forgo actions based on material, nonpublic information. Formulation of such a broad duty, which departs radically from the established doctrine that duty arises from a specific relationship between two parties, should not be undertaken absent some explicit evidence of congressional intent.

Chiarella was a pivotal decision. It established that the classical theory of insider trading applies only when an insider with a fiduciary duty to the source of the inside information trades in reliance of that information.

The Adler Presumption & 10b5-1 Plans

The obvious challenge for insiders, particularly insiders in the C-Suite, is that they are often in possession of inside information. Indeed, there are likely very few times in the year when they don’t know more than the average shareholder about the state of their own corporation. This makes the prospect of trading in the stock of their own corporation risky. In SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998), the Eleventh Circuit established a foundational principle for insider trading liability. The court held that insider trading requires actual use of material nonpublic information, not mere knowing possession. However, the court recognized the practical difficulty the SEC faces in proving what motivated an insider's trading decision. To address this evidentiary challenge, the court created a rebuttable presumption (or “strong inference”) framework that when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used in the trade. This inference shifts the burden to the insider to produce evidence demonstrating that the material nonpublic information did not cause or influence the trading decision. The factfinder then weighs all the evidence to determine whether the inside information was actually used.

The Circuit Court adopted this approach for several reasons. First, rightly or wrongly, it alleviates the SEC’s burden of proving the insider’s subjective motivation, which is “peculiarly within the trader’s knowledge.” Second, it comports with the statutory focus on fraud and deception in Section 10(b) and Rule 10b-5. Third, it is consistent with Supreme Court precedent emphasizing that violations require “using” information or “trading on the basis of” information, not merely possessing it.

The Adler court identified several types of evidence that can rebut the inference of use, including:

• Preexisting trading plans established before acquiring the material nonpublic information
• Trading patterns consistent with past practices
• Sale of only a small percentage of holdings
• Innocent explanations for the timing of trades
• Legitimate business reasons unrelated to the inside information

Critically, the court emphasized that even strong evidence of a preexisting plan may not conclusively rebut the inference as a matter of law. Instead, such evidence creates genuine issues of material fact for a jury to resolve, including whether the inside information “hastened the timing” of the sale or “affected the price” at which the insider was willing to trade.

Two years after the Adler decision, in August 2000, the SEC adopted Rule 10b5-1 to provide greater clarity and certainty for corporate insiders. The rule codified an affirmative defense to insider trading liability under Section 10(b) and Rule 10b-5. Rule 10b5-1 directly responds to the evidentiary framework established in Adler by creating a formal mechanism through which insiders (officers, directors, and >10% shareholders) can conclusively demonstrate that their trades were not “on the basis of” material nonpublic information.

Rule 10b5-1(c)(1) provides an affirmative defense for insiders (directors, officers, & >10% shareholders) when their trades are made pursuant to  written trading plans under the following conditions:

• No Material nonpublic information: Insiders must adopt plans during open trading windows when they possess no confidential market-moving knowledge.
• Fixed Formulas: Plans must dictate a clear, unalterable formula specifying the amount, price, and transaction dates.
• No Outside Influence: Transactions must executed by brokers. Insiders cannot exert subsequent influence over how or when the broker executes transactions.
• Good Faith: The participant must enter into and continuously operate the plan in honest good faith.
• Mandatory Cooling-Off Periods: Trades cannot occur immediately after plan adoption. Directors and officers must wait the later of 90 days or two business days after quarterly financial reporting. Non-officer employees face a shorter 30-day waiting window.
• Overlapping Plans Prohibited: Individuals generally cannot run multiple concurrent trading arrangements to hedge or manipulate execution paths.
  

The critical requirement is that the contract, instruction, or plan must have been adopted when the trader was not aware of material nonpublic information. This requirement directly addresses the Adler court’s concern about whether inside information influenced the trading decision.

These 10b5-1 plans function as a formalized preexisting plan, precisely the type of evidence that Adler recognized could rebut the inference of trading in reliance on material nonpublic information. However, Rule 10b5-1 goes further by establishing specific conditions that, when satisfied, provide a conclusive affirmative defense rather than merely creating a factual question for a jury.

The rule addresses the core issue in Adler: causation. By requiring that the plan be adopted when the insider was not aware of material nonpublic information, and by requiring that subsequent trades be executed according to the plan's terms, Rule 10b5-1 severs the causal connection between any material nonpublic information the insider later acquires and the trading decision. The trading decision was made at the time the plan was adopted, not at the time the trades were executed.

Under Adler, if an insider trades while in possession of material nonpublic information, a strong inference arises that the information was used. With a compliant Rule 10b5-1 plan in place, the insider has an affirmative defense to insider trading liability. If the plan satisfies all conditions of Rule 10b5-1(c)(1), the insider can conclusively demonstrate that trades were not “on the basis of” material nonpublic information. The Adler inference is rebutted as a matter of law, not merely as a factual question for a jury.

Extending Liability - Tippees and Temporary Insiders

The development of a fiduciary requirement in the federal common law of insider trading let a potential gap: what to do about remote traders (people in possession of material nonpublic information who are not in a fiduciary relationship to the corporation? The federal common law has responded to this gap in the law by extending the reach of insider trading liability to strangers of the corporation through a variety of theories. Perhaps the most important of these involves situations where insiders do not trade themselves but instead “tip” material inside information to others, or where outsiders who are temporarily brought into the corporate fold trade on inside information.

Dirks v. SEC (1983): The Law of Tippee Liability

In Dirks v. SEC the Supreme Court addressed the question of whether a person with no duty to the corporation receives a tip from an insider (a “tippee”) can be held liable for insider trading.

Raymond Dirks, a securities analyst, received information from a former officer of Equity Funding of America, alleging that the company's assets were vastly overstated due to massive fraud. Dirks investigated the allegations, interviewing other employees who corroborated the story. During his investigation, Dirks openly discussed his findings with clients and investors, some of whom sold their Equity Funding stock. Dirks also urged the Wall Street Journal to publish a story, but they declined. The stock price plummeted, and trading was halted. The fraud was eventually exposed, and the SEC charged Dirks with aiding and abetting insider trading.

The Supreme Court reversed the SEC’s censure of Dirks, establishing the controlling test for tippee liability:

Derivative Liability: A tippee’s liability is derivative of the tipper’s. A tippee can only be liable if the insider-tipper breached their fiduciary duty to the shareholders by disclosing the information to the tippee. In the absence of a breach of duty to shareholders by the insiders, there was no derivative breach by the tippee.

Personal Benefit Test: The Court held that an insider breaches their fiduciary duty by disclosing information only when they do so for a “personal benefit.” The test is whether the insider will personally benefit, directly or indirectly, from the disclosure. This benefit does not have to be pecuniary; it can be a reputational benefit that translates into future earnings, a quid pro quo, or simply the benefit of making a “gift” of confidential information to a trading relative or friend:

But to determine whether the disclosure itself “deceive[s], manipulate[s], or defraud[s]” shareholders, Aaron v. SEC, 446 U. S. 680, 686 (1980), the initial inquiry is whether there has been a breach of duty by the insider. This requires courts to focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings. Cf.  40 S. E. C., at 912, n. 15; Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws, 93 Harv. L. Rev. 322, 348 (1979) (“The theory . . . is that the insider, by giving the information out selectively, is in effect selling the information to its recipient for cash, reciprocal information, or other things of value for himself. . .”). There are objective facts and circumstances that often justify such an inference. For example, there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient. The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.

Tippee’s Knowledge: For a tippee to be liable, they must know or have reason to know that the tipper breached their fiduciary duty by disclosing the information for personal benefit.

In Dirks’ case, the Court found that the insiders who revealed the fraud to him did so not for personal benefit, but to expose the crime. The tipper did not receive a personal benefit in exchange for giving the inside information to DIrks. One could also argue that the tipper was motivated by his loyalty toteh company in wanting to see wrong doing at the company uncovered. Since the tipper did not breach his fiduciary duty, Dirks, as the tippee, inherited no duty to disclose or abstain and could not be held liable.

Temporary Insiders: In a footnote in the Dirks opinion (footnote 14), the Supreme Court also articulated the concept of “temporary insiders.” The Court noted that outsiders such as underwriters, accountants, lawyers, or consultants may become fiduciaries of the shareholders when they are given access to confidential information solely for corporate purposes. In such cases, they acquire the insider's duty to disclose or abstain from trading:

Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries for purposes of insider trading liability. Remember, the basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes.

United States v. Newman (2014): Raising the Bar for Criminal Liability

Many times tips do not come directly from the insider, but they come from a guy who knows a guy. Or, these days, they come from an anonymous poster on an Internet message board. What’s a tip and what is just a random Reddit post? Sometimes the daisy chains of tips can be quite lengthy, and at some point it becomes hard to justify imposing criminal or civil liability for trading on information that might just be a market rumor. The Second Circuit’s decision in United States v. Newman significantly clarified and strengthened the requirements for criminally prosecuting “tippees,” particularly those who are several steps removed from the original source of inside information. The ruling established a more stringent definition of what constituted a “personal benefit” for the tipper and held that remote tippees must have knowledge of that benefit to be held liable, making it substantially more difficult for the government to criminally prosecute downstream recipients of inside information.

Todd Newman and Anthony Chiasson were portfolio managers at the hedge funds Diamondback Capital and Level Global, respectively. They were convicted of insider trading based on tips about the quarterly earnings of Dell and NVIDIA. The information originated with low-level employees in the finance and investor relations departments of those companies. The insiders (the “tippers”) passed the information to a small group of hedge fund analysts, who in turn disseminated it through their network. This created a tipping chain that placed Newman and Chiasson three to four levels away from the original corporate insiders.

In its criminal prosecution, the government presented no evidence that Newman or Chiasson knew the identity of the insiders or that the insiders had received any personal benefit for disclosing the information. To the extent there was evidence of a benefit to the original tippers at all, it was scant. In one case, it consisted of career advice that the recipient testified he would have given anyway, and in the other, it was based on a casual friendship between the tipper and the first-level tippee. The trial judge instructed the jury that it did not need to find that Newman and Chiasson knew the insider received a personal benefit, and the jury convicted them.

The Second Circuit Court of Appeals reversed the convictions, holding that the government's evidence was insufficient and the jury instructions were erroneous. The court made two clarifications to the law of tippee liability established in Dirks v. SEC:

“Personal Benefit” Test Requires a Consequential Exchange: The court held that to prove a tipper received a personal benefit, the government must show more than just a casual friendship. The benefit must be part 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. The court found that simple career advice or the existence of a casual acquaintance was insufficient to meet this standard. An inference of a personal benefit is impermissible in the absence of proof of a meaningfully close personal relationship.

Tippee Must Know About the Personal Benefit: The court’s most significant holding was that for a tippee to be criminally liable, the government must prove beyond a reasonable doubt that the tippee knew the insider disclosed the confidential information in exchange for a personal benefit. The court reasoned that since a tipper’s liability is predicated on the breach of a duty for personal gain, a tippee cannot be said to know of the “breach” without also knowing about the personal benefit that made the disclosure a breach in the first place. The court rejected the government's argument that the specificity and accuracy of the information were so suspicious that the tippees must have known it was improperly disclosed.

The Newman decision established that a tippee’s criminal liability requires proof not only that a personal benefit was given to the insider but also that the tippee was aware of that benefit. This significantly increased the burden on the government seeking to criminally prosecute cases involving remote tippees who are far removed from the original source of the information and have no direct knowledge of the circumstances of the initial tip.

Thus, following Newman in the Second Circuit, to establish criminal liability for insider trading on a tip, the government would have to meet all of the following elements:

1. The corporate insider had a fiduciary duty to the source of the information;
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 used that information to trade in a security or to tip another individual for personal benefit.

Salman v. United States (2016): Gift-Giving as Personal Benefit

The Supreme Court’s unanimous decision in Salman v. United States resolved a critical circuit split regarding the “personal benefit” requirement for insider trading liability. The Court reaffirmed its holding in Dirks v. SEC, clarifying that an insider who makes a “gift” of confidential information to a trading relative or friend receives a sufficient personal benefit to establish a breach of fiduciary duty, even without receiving a pecuniary or tangible benefit in return.

Maher Kara, an investment banker at Citigroup, had a very close relationship with his older brother, Michael. Maher began sharing highly confidential information about upcoming mergers and acquisitions with Michael, intending to benefit him and expecting him to trade on it. Michael, in turn, passed these tips to his friend and brother-in-law, Bassam Salman. Salman was fully aware that the source of the information was Maher. Over time, Salman made more than $1.5 million in profits by trading on these tips.

Following his conviction, Salman appealed, arguing that his case should be governed by the Second Circuit’s recent decision in United States v. Newman. Under the Newman standard, a tipper only receives a personal benefit from a gift of information if there is 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.” Salman argued that because Maher received nothing tangible for tipping his brother, there was no personal benefit and, therefore, no breach of duty.

The Supreme Court rejected Salman’s argument and the heightened standard set by Newman, instead reaffirming the long-standing rule from Dirks v. SEC. The Court’s analysis was direct and unambiguous:

Gift to a Relative is a Personal Benefit: The Court held that when an insider “makes a gift of confidential information to a trading relative or friend,” the personal benefit element is satisfied. The Court reasoned that giving such a gift is legally indistinguishable from the insider trading on the information themselves and then giving the resulting profits to the recipient. The tipper benefits personally in either scenario.

Rejection of part of the Newman Standard: The Court explicitly held that the Newman requirement that the tipper must also receive something of a “pecuniary or similarly valuable nature” in exchange for a gift to a relative or friend is “inconsistent with Dirks.” However, the Dirks standard does not require an additional, tangible exchange when the tip is a gift to a close friend or family member.

In Salman, the Supreme Court resolved the tension created by the Newman decision. It clarified that the simple act of giving a gift of confidential information to a trading relative or friend is enough to constitute a personal benefit, thereby triggering insider trading liability for both the tipper and any downstream tippees who know about the breach.

The Misappropriation Theory – Closing More Gaps

In addition to tippees the Chiarella decision left other gaps in the law, particularly the potential liability of insiders who obtained confidential information but who owed no fiduciary duty to the company in whose stock they traded. For example, if an insider obtained information about a third party and traded on that information, they could not be held liable for classical insider trading liability, as classical theory requires trading the stock of the company to whom the insider owed a duty. In response to this problem the misappropriation theory was developed to close this gap.

United States v. O'Hagan (1997): Misappropriation

After years of application in the lower courts, the Supreme Court officially adopted the misappropriation theory in United States v. O'Hagan.

James O'Hagan was a partner at the law firm Dorsey & Whitney, which was representing Grand Metropolitan PLC in a potential tender offer for the Pillsbury Company. O'Hagan was not working on the transaction, but he learned of it through his position at the firm. He was, apparently, quite the gossip and would talk to lots of fellow attorney about their deals over lunch and coffee in the office. In addition to being an office gossip, O'Hagan had been embezzling client escrow funds (to the tune of $1 million) to pay for his expensive lifestyle and failing real estate investments. O'Hagan then began purchasing large quantities of Pillsbury call options and common stock in reliance on the information about Grand Met's potential offer. When the Grand Met tender offer was announced, Pillsbury’s stock price soared, and O'Hagan made a profit of more than $4.3 million.

The Supreme Court upheld O'Hagan’s conviction, cementing the misappropriation theory as a valid basis for insider trading liability.

Fraud on the Source: The misappropriation theory holds that a person commits fraud “in connection with” a securities transaction when they misappropriate confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Unlike the classical theory, which focuses on a duty to the shareholders of the traded company, the misappropriation theory focuses on a fraud against the source of the information to whom the trader owes a duty of loyalty and confidence.

The “misappropriation theory” holds that a person commits fraud “in connection with” a securities transaction, and thereby violates § 10(b) and Rule 10b—5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. … Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information. The Court reasoned that the misappropriator’s fraud is consummated when they feign loyalty to the principal while secretly converting the principal’s information for personal gain. O'Hagan deceived his law firm and its client, Grand Met, by using their confidential information for his own profit. This deception was the cornerstone of the fraud.

Similarly, full disclosure forecloses liability under the misappropriation theory. Because the deception essential to the misappropriation theory involves feigning fidelity to the source of information, if the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no “deceptive device” and thus no § 10(b) violation—although the fiduciary-turned trader may remain liable under state law for breach of a duty of loyalty.

SEC v. Panuwat (2023): The “Shadow Trading” Theory and Misappropriation

In 2023 in a case of first impression, the Securities and Exchange Commission (SEC) advanced a novel application of the misappropriation theory, often referred to as “shadow trading.” The case, SEC v. Panuwat, addresses whether an insider violates Section 10(b) by using their own company’s material, non-public information to trade in the securities of a different, but economically-linked, company. The shadow trading theory is a close cousin of the misappropriation theory.

Matthew Panuwat, a senior director at the biopharmaceutical company Medivation, was privy to confidential information regarding his company’s impending acquisition. On August 18, 2016, he received an internal email from Medivation’s CEO confirming that the pharmaceutical giant Pfizer was aggressively pursuing an acquisition that was expected to be finalized within days. This information was highly confidential and known only to a handful of executives.

Just seven minutes after receiving this email, Panuwat purchased highly speculative, out-of-the-money call options in Incyte Corporation, a separate but comparable mid-cap oncology company. He did not trade in the stock of his own company or the acquirer. The SEC alleged that Medivation and Incyte were so closely linked in their niche market that the acquisition of Medivation would make Incyte a more valuable and likely takeover target, thus increasing its stock price. When the Medivation acquisition was announced, Incyte's stock price rose 7.7%, and Panuwat realized a profit of $107,066 from his trades.

The SEC charged Panuwat under the misappropriation theory of insider trading. Panuwat moved for summary judgment, arguing that the information about Medivation was not material to Incyte and that he had not breached a duty. The U.S. District Court for the Northern District of California denied his motion, finding that the SEC had presented sufficient evidence to proceed to a jury trial. The court’s analysis focused on four key elements:

Materiality in an Economically-Linked Company: The central legal question was whether information about Medivation’s acquisition could be considered material to Incyte. The court found that the SEC had shown a genuine dispute of material fact on this issue. The evidence included:

Market Connection: Analyst reports and financial news repeatedly linked the two companies, speculating that Medivation’s acquisition would make Incyte a more attractive target due to the “scarcity of valuable biotech assets.”

Internal Analysis: Medivation’s own investment bankers had identified Incyte as a “comparable peer.”

Stock Price Movement: The 7.7% increase in Incyte’s stock price immediately following the public announcement of the Medivation deal was considered “strong evidence” of materiality.

The court concluded that a reasonable investor could indeed view the imminent, high-premium acquisition of a key peer as significantly altering the total mix of information available about Incyte.

While the general acquisition process was known to the market, the court found that the specific details in the CEO’s email—the identity of the final bidder (Pfizer), the aggressive timeline ("in this weekend"), and the specific price—were non-public. This inside information was far more certain and reliable than public rumors, giving Panuwat a clear informational advantage.

The court found that Panuwat had breached his duty to his employer, Medivation. This duty arose from two sources:

Confidentiality Agreement: Panuwat had signed a broad insider trading policy that explicitly forbade him from using Medivation’s confidential information for personal benefit by trading in the securities of another publicly-traded company.

Duty of Trust and Confidence: Citing traditional principles of agency law, the court held that an employee has a duty of loyalty and confidentiality to their employer. By using his employer’s confidential information (which is considered company property) for his own personal gain, Panuwat defrauded Medivation of the exclusive use of that information.

The court’s denial of summary judgment in Panuwat represents a significant endorsement of the “shadow trading” theory, confirming that the misappropriation theory is broad enough to cover situations where an insider uses confidential information to trade in the securities of an economically-linked third party. It establishes that a breach of duty to the source of the information is the critical element, regardless of which company’s stock is ultimately traded.

Rule 10b5-2: Duties of Trust or Confidence

In the wake of O'Hagan, the SEC adopted Rule 10b5-2 to provide a non-exclusive list of circumstances under which a “duty of trust or confidence” exists for the purposes of the misappropriation theory:

10b5-2 Duties of trust or confidence in misappropriation insider trading cases.

(a) Scope of Rule. This section shall apply to any violation of Section 10(b) of the Act (15 U.S.C. 78j(b)) and § 240.10b-5 thereunder that is based on the purchase or sale of securities on the basis of, or the communication of, material nonpublic information misappropriated in breach of a duty of trust or confidence.

(b) Enumerated “duties of trust or confidence.” For purposes of this section, a “duty of trust or confidence” exists in the following circumstances, among others:

(1) Whenever a person agrees to maintain information in confidence;

(2) Whenever the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality; or

(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, by establishing that he or she neither knew nor reasonably should have known that the person who was the source of the information expected that the person would keep the information confidential, because of the parties' history, pattern, or practice of sharing and maintaining confidences, and because there was no agreement or understanding to maintain the confidentiality of the information.

Some examples of applications of this rule follow below:

(b)(1): Agreement to Maintain Information in Confidence

A duty of trust or confidence exists "[w]henever a person agrees to maintain information in confidence." This is the most straightforward prong of the rule. The agreement can be explicit (written or oral) or implicit, based on the conduct and communications between the parties.

Example 1 - The Non-Disclosure Agreement (NDA): A private equity firm is considering acquiring a publicly-traded company. Before conducting due diligence, the firm and the target company sign a Non-Disclosure Agreement (NDA). An analyst at the private equity firm, who is bound by the NDA, learns that the acquisition is highly likely to proceed at a significant premium. If the analyst uses this information to purchase stock in the target company for his personal account, he has breached the explicit agreement to maintain confidentiality, creating liability under Rule 10b5-2(b)(1).

Example 2 - The Oral Agreement (SEC v. Cuban): In SEC v. Cuban, the SEC alleged that Mark Cuban, the largest shareholder of Mamma.com, received a call from the company's CEO. The CEO wanted to inform him of an upcoming private investment in public equity (PIPE) offering, which would dilute existing shareholders. Before disclosing the information, the CEO allegedly told Cuban, "I have confidential information for you." After Cuban agreed to keep the information confidential, the CEO told him about the PIPE offering. Cuban allegedly became angry and ended the call by saying, "Well, now I'm screwed. I can't sell." Shortly thereafter, he sold his entire stake in the company before the PIPE was publicly announced, avoiding significant losses.

The Fifth Circuit found that the SEC had plausibly alleged that Cuban's statement constituted an agreement to maintain the information in confidence, which he then breached by trading. This case serves as a prime example of how an oral agreement, even a brief one, can create a duty of trust and confidence under this subsection.

(b)(2): History, Pattern, or Practice of Sharing Confidences

A duty of trust or confidence exists "[w]henever the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality."

This subsection applies to relationships where confidentiality is implied by the parties’ past behavior, even without an explicit agreement for the specific information shared.

Example - The Entrepreneur and the Mentor: An experienced entrepreneur regularly meets with a young founder to provide mentorship. Over several years, they have shared sensitive business plans, unannounced product details, and confidential financial projections, with the mutual understanding that these conversations are private. One day, the mentor, who is also a director at a public company, discusses her company's confidential plan to acquire a smaller firm. The young founder, recognizing the value of this information, buys stock in the target firm.

In this scenario, a duty of trust and confidence exists under Rule 10b5-2(b)(2). Even though the founder never explicitly agreed to keep the acquisition information secret, their established history, pattern, and practice of sharing confidences created a reasonable expectation of confidentiality. The founder knew or should have known that the mentor expected her to keep the information private, just as they had with all other sensitive business matters discussed in the past.

(b)(3): Information Obtained from a Close Family Member

A duty of trust or confidence exists "[w]henever a person receives or obtains material nonpublic information from his or her spouse, parent, child, or sibling..." This rule creates a presumption of a duty of trust and confidence when information is shared between close family members. The burden of proof shifts to the recipient of the information to demonstrate that no such duty existed.

Example 1 - The Family Tip (Salman v. United States): In Salman v. United States, an investment banker at Citigroup, Maher Kara, repeatedly shared confidential information about upcoming mergers with his older brother, Michael Kara. Michael, in turn, passed these tips along to his brother-in-law, Bassam Salman. Salman traded on the information and made significant profits. The Supreme Court upheld Salman's conviction, reaffirming the principle from Dirks that a gift of confidential information to a trading relative or friend is a breach of fiduciary duty.

This case perfectly illustrates the presumption in Rule 10b5-2(b)(3). When Maher shared the information with his brother Michael, a duty of trust and confidence was presumed to exist. Michael breached that duty by trading and by passing the information to Salman, who inherited the duty. Salman could not rebut the presumption because there was a clear expectation of confidentiality within the family relationship.

Example 2: Rebutting the Presumption: Imagine two siblings who are estranged and have not spoken in years. The first sibling, an executive at a pharmaceutical company, is quoted in a news article discussing a new drug trial. The second sibling, after reading the article, calls their elderly parent to complain about the first sibling. During the call, the parent, who had just spoken to the executive sibling, accidentally mentions that the company is about to announce a major setback with the drug trial. The second sibling, who has no history of sharing confidences with either the parent or the executive sibling, immediately shorts the company's stock.

In this scenario, the second sibling could potentially rebut the presumption of a duty of trust and confidence. They could argue that due to the estranged relationship and the lack of any “history, pattern, or practice of sharing and maintaining confidences,” they neither knew nor should have known that the parent or the executive sibling expected them to keep the information confidential. The success of this defense would depend on the specific facts demonstrating the complete breakdown of a confidential relationship.

SEC v. Dorozhko (2009): Hacking and Deception Without a Fiduciary Duty

The misappropriation theory was stretched to its conceptual limits in the relatively novel case of SEC v. Dorozhko, which addressed whether a computer hacker could be liable for insider trading without breaching a fiduciary duty. Although the court did not agree with the SEC’s application of the misappropriation theory, the court found other ways to apply 10b-5 anti-fraud rules to find the insider trading by hackers is illegal.

Oleksandr Dorozhko, a Ukrainian national, executed a sophisticated computer hack into the secure servers of Thomson Financial, the firm that managed the online release of earnings reports for IMS Health. Minutes after the IMS earnings data was uploaded to the secure server, Dorozhko successfully hacked in and downloaded the report, which was scheduled for release after the market closed. The report contained negative news: IMS Health’s earnings were 28% below Wall Street expectations.

Armed with this stolen information, Dorozhko, who had never before traded in his online brokerage account, purchased over $41,000 in IMS “put” options—an extremely risky bet that the company’s stock price would decline sharply and suddenly. The next day, after IMS officially announced its poor earnings, its stock price plummeted by approximately 28%. Dorozhko sold all his options within minutes of the market opening, realizing a net profit of over $286,000 overnight.

The district court initially denied the SEC’s request for an injunction, reasoning that under Chiarella and O’Hagan, a breach of a fiduciary duty is a required element of any deceptive device under Section 10(b). Since Dorozhko was a corporate outsider with no relationship to IMS Health or Thomson Financial, he owed no fiduciary duty and therefore could not be held liable.

The Second Circuit Court of Appeals reversed this decision, creating a significant carve-out to the fiduciary duty requirement. The court drew a critical distinction between fraud based on nondisclosure (silence) and fraud based on affirmative misrepresentation.

Fiduciary Duty Applies to Nondisclosure: The court affirmed that the precedents of Chiarella and O’Hagan established that when an insider trading allegation is based on silence or nondisclosure, there can be no fraud absent a fiduciary duty to speak.

Affirmative Misrepresentation is Different: However, the court held that computer hacking is not mere silence; it is a form of affirmative misrepresentation. The court reasoned that hacking to gain access to a secure computer system inherently involves a deceptive act: typing in someone else's login credentials. It stated that “misrepresenting one’s identity in order to gain access to information that is otherwise off limits, and then stealing that information is plainly ‘deceptive’ within the ordinary meaning of the word.”

In essence, the Second Circuit concluded that while a fiduciary duty is necessary to create a duty to disclose, it is not a prerequisite for liability when the trader’s conduct is, in itself, a deceptive act. By hacking the server, Dorozhko engaged in a fraudulent scheme to obtain the information, and that deception was sufficient to satisfy the requirements of Section 10(b), regardless of the absence of a fiduciary relationship. This decision expanded the scope of insider trading liability to include outsiders who steal information through deceptive means, even when they owe no duty to the source of the information.

§ 240.10b-5 Employment of manipulative and deceptive devices.

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.