California Law and Private Company Equity Transactions, Part II: Insider Trading

This article was originally published on LinkedIn on January 10, 2025. It is the second in a series—start with Part I: Introduction.

This is the second in a series of articles about the California laws governing private company stock transactions and insider trading that I think every person and company in the startup ecosystem should know.

I wrote in Part I that California has a straightforward law prohibiting insider trading that applies to startup stock transactions. I want to outline that statute in more detail here, because it’s California’s most direct prohibition of insider trading.

The Statute: Corporations Code Section 25402

California Corporations Code section 25402 provides:

It is unlawful for an issuer or any person who is an officer, director or controlling person of an issuer or any other person whose relationship to the issuer gives him access, directly or indirectly, to material information about the issuer not generally available to the public, to purchase or sell any security of the issuer in this state at a time when he knows material information about the issuer gained from such relationship which would significantly affect the market price of that security and which is not generally available to the public, and which he knows is not intended to be so available, unless he has reason to believe that the person selling to or buying from him is also in possession of the information.

Breaking It Down

Assume Party A knows Startup’s confidential information because they’re a high‑level executive or board member. Party B is an early employee or angel investor who owns some stock in Startup but does not know (or have access to) Startup’s confidential information. That confidential information would affect the value of Startup’s stock if it were publicly disclosed. Party A enters into a contract to buy Party B’s stock in Startup without disclosing the confidential information to Party B. In this situation, Party A is engaging in insider trading in violation of section 25402.

This rule applies to the private company itself, and to its officers, directors, and other employees and advisors who have access to the company’s confidential information because of their relationship with the company. It also applies to any stock transaction occurring within California. Perhaps most importantly, the person acting as Party A doesn’t need to intend to engage in insider trading or otherwise defraud Party B. As one court explained, liability for violating section 25402 extends to “some negligent conduct.”

A Key Exception

There’s a key exception. Corporations Code section 25502 provides that, if Party A can prove that Party B would have still bought the stock even if Party A had shared the confidential information, Party A is not liable to Party B. That strikes me as a hard thing to prove absent unusual circumstances—if Party B would have bought the stock anyway, it’s unlikely they’d accuse Party A of insider trading in the first place.

What an Insider Owes

Assuming the exception doesn’t apply, what does Party A owe Party B? California law is fairly straightforward here too. Section 25502 provides that Party A is liable to Party B for damages equaling the difference between the transaction price and what the stock was actually worth had the confidential information been publicly disclosed. In addition, Party A has to pay interest to Party B at the legal rate (generally, 10% per annum). In other words, California law tries to make Party B whole—as though the transaction occurred at the market price and the unpaid amount was a loan entitling Party B to interest.

Key Takeaways

• If you’re an insider and you want to buy or sell your company’s stock to an outsider, you need to consider disclosing all nonpublic information that could affect the company’s stock or risk a lawsuit—think of it as providing the information necessary for the outsider to perform sufficient due diligence.
• If you’re an outsider and you want to buy or sell a private company’s stock from the company or one of its executives, understand that you’re entitled to full disclosure of all material, confidential information related to the company’s fair market value—and ask for it.
• In my work on these cases, I haven’t found any legal authority saying you don’t have to disclose all material confidential information if you obtain a waiver in a stock purchase agreement, so both insiders and outsiders should be aware that there are risks to trying to contract around it (although there might be a few other ways to address it if there are practical constraints to full disclosure).

Red Flags I’ve Observed

• The company and/or its executive want to buy shares from early employees, founders, or other investors who have moved on and have less access to company information.
• The company wants to “clean up its cap table” to encourage additional investment, or the company or its executive doesn’t see a near‑term opportunity for the shareholder to cash out.
• The offer is at the most recent 409A price, and the company won’t be determining a fair market value for the shares in the foreseeable future.
• The company or executive wanted to “come to you with this opportunity first.”

Of course, Party A’s misconduct and liability might not start with section 25402 and end with section 25502. Party A might also have to disgorge any profits to Startup pursuant to Corporations Code section 25502.5—this depends on how big Startup is and how many shareholders it has. More fundamentally, Party A might have violated other laws and be liable to Party B in other ways too, several of which I’ll discuss in subsequent posts.

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