Lesson 2 of 6
How the law gets there
Trading on inside information is not banned by a single sentence. Two theories and a tippee rule do the work, and each turns on a duty owed to somebody.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Rule 10b-5 forbids fraud in connection with the purchase or sale of a security. It does not mention inside information.
- The classical theory reaches insiders who owe a duty to their own shareholders; the misappropriation theory reaches outsiders who take confidential information from its source.
- Tippee liability is derivative: it depends on the insider breaching a duty for personal benefit, and on the tippee knowing or having reason to know.
There is no statute that says trading on inside information is illegal. The prohibition is built out of a general anti-fraud rule by decisions that ask, in every case, what duty the trader owed and to whom.
Three routes from a general anti-fraud rule to a prohibition
- 1Rule 10b-5Forbids any device, scheme or artifice to defraud in connection with the purchase or sale of a security
- 2Classical theoryAn insider trading on confidential information breaches a duty to the shareholders on the other side
- 3Misappropriation theoryAn outsider who takes confidential information from its source defrauds that source
- 4Tippee liabilityDerivative from the insider's breach, and only when the tippee knows or should know
The rule itself
Rule 10b-5 makes it unlawful, using interstate commerce, the mails or an exchange facility, to employ any device, scheme or artifice to defraud; to make an untrue statement of material fact or omit a material fact necessary to make statements not misleading; or to engage in any act, practice or course of business that operates as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
Nothing in those words is specific to insiders. The specificity comes from the decisions.
The two theories
O'Hagan, decided in 1997, describes both. Under the classical theory a corporate insider who trades in his corporation's securities on the basis of material confidential information obtained by reason of his position is deceiving the shareholders, because a relationship of trust and confidence gives rise to a duty to disclose or abstain from trading.
Under the complementary misappropriation theory, which that case upheld, a corporate outsider violates section 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, rather than to the persons with whom he trades. A fiduciary who pretends loyalty while secretly converting the principal's information for personal gain, the Court said, defrauds the principal.
The tippee rule, which is the one researchers meet
Dirks, decided in 1983, sets out when somebody who receives information is liable. A tippee's duty is derivative from the insider's. The Court held that a tippee assumes a fiduciary duty not to trade on material non-public information only when the insider has breached a fiduciary duty by disclosing it, and the tippee knows or should know that there has been a breach.
Why this structure matters to a reader
Because it means the same fact can be safe or dangerous depending on where it came from and why. Two questions follow every specific thing a researcher is told: did the person telling me owe a duty to somebody in respect of it, and did they get something out of telling me.
Those are questions of fact, they are decided by courts on evidence, and a person who finds themselves reasoning carefully about them in a live situation is already in a position where the right next step is a lawyer rather than a trade.
Check yourself
What does Rule 10b-5 actually say?
- That trading on inside information is unlawful
- That it is unlawful to employ a device or scheme to defraud, or to make a material misstatement or omission, in connection with the purchase or sale of a security
- That insiders must report their trades
Show the answer
Answer: B.
The rule is a general anti-fraud provision. The insider trading prohibition is built on it by decisions that identify a breached duty.Under the misappropriation theory, who is defrauded?
- The shareholders on the other side of the trade
- The source of the confidential information, to whom the trader owed a duty
- The exchange
Show the answer
Answer: B.
O'Hagan describes an outsider who misappropriates confidential information for trading in breach of a duty owed to the source, rather than to those he trades with.What does Dirks require before a tippee can be liable?
- Only that the information was non-public
- That the insider breached a duty by disclosing it, and that the tippee knows or should know of the breach
- That the tippee paid for the information
Show the answer
Answer: B.
Tippee liability is derivative from the insider's breach, and whether disclosure is a breach turns on whether the insider personally benefited.Sources
- 17 CFR 240.10b-5, read from the electronic Code of Federal Regulations on 2026-09-13.
- United States v. O'Hagan, 521 U.S. 642 (1997): the classical theory and the misappropriation theory, and the description of the fiduciary who converts the principal's information.
- Dirks v. SEC, 463 U.S. 646 (1983): tippee liability as derivative, the requirement that the tippee knows or should know of a breach, and the personal benefit test.
What this leaves out
- This is education about what published rules and decisions say. It is not legal advice and does not tell any reader what they may do.
- These are United States authorities as read on the date shown. Other jurisdictions reach the same subject differently, and the law changes.
- Later decisions refine each of these tests, and none of that development is covered here.
- Nothing here is advice about any security.