When Is It Legal To Trade on Inside Information?

You are on a crowded elevator standing next to a couple of executives from a company with offices on the floor just above yours. They are talking in low tones about a surprise announcement coming the next day. Their firm, AGA Software, is being sold to a big, famous technology company! “My options are going to be worth millions!” you hear one of them whisper to the other. Assuming AGA is a publicly traded stock, can you run home and buy AGA shares without breaking the law? Knowing when you can legally trade on inside information and when you cannot is tricky. This article will help you better understand the legal minefield.

The authorities (the U.S. Securities and Exchange Commission for civil cases and the U.S. Department of Justice for criminal cases) must prove several specific elements to convict someone for trading on or tipping confidential corporate information. First, a security must be bought or sold. Second, the trade must have been prompted by the possession of material, nonpublic information. Third, the defendant, whether a trader or tipper, must know that the information he or she is dealing with is “hot property.” Finally, insiders must be breaching a fiduciary duty owed to their corporation when they trade on or tip confidential corporate information. This stipulation almost always means that an insider cannot trade on such information and cannot tip others about it if the insider stands to gain by doing so.

Let’s do a quick legal analysis of our elevator case. First, if you buy the AGA shares, there clearly will be a purchase of securities. It would be different if you had been planning to sell AGA shares you already owned but decided not to after overhearing the conversation. The law does not penalize a failure to buy or a decision to hold.

Second, was the information you overheard both nonpublic and material? Yes. The executives were speaking in low tones on the elevator about an announcement to be made tomorrow. That sounds nonpublic. And the authorities can prove materiality if a reasonable investor would consider the information important in a decision to buy or sell. The average investor would certainly consider the acquisition announcement important.

Third, did you know that the information is hot? It seems so. The executives’ low tones led you to understand that this was a highly confidential matter.

Finally, does the executives’ loose talk, followed by your trading, involve a breach of fiduciary duty? You are not an employee of AGA, so you do not have any of the duties to it that an employee would. Nor are you bound to keep AGA secrets by contract, as a lawyer, accountant or consultant working for AGA might be. Finally, you are not a family member of any such person.

But what about the AGA executives? They have duties to AGA, but they are not tipping this hot information to you as part of a trading ring in which you and they will share the spoils. They gain nothing from their carelessness. Is their conduct imprudent? Yes. Is it self-interested? No. Case closed. You win.

So you are free to trade. Of course, your actions may spark the interest of securities regulators who monitor unusual trading activity before announcements like this. This can be both aggravating and damaging to your reputation. But you have not violated the law.

Now let’s change just one fact. Imagine you know one of the AGA executives, and this person deliberately whispers the secret information to you on that elevator ride. Over the past few years you and your friend have periodically sent business to and done favors for each other, but neither of you has ever given the other a stock tip. Can you trade now?

On the surface, things still look relatively innocent. Your friend appears to be making you a gift of this information in the hopes that you — but not he — will profit from it. Like the strangers on the elevator, he is a blabbermouth, but although he has violated his duty to keep company secrets, he does not stand to profit from your trade.

But wait. Is his tip really a pure gift? Or is it part of an ongoing, mutually advantageous business or personal relationship? If a tip is part of a flow of favors running between parties, the authorities have all they need to make an insider-trading case stick. Your friend clearly violated his duty by revealing company secrets, and he stands to gain personally from the eventual quid pro quo you will throw him — whether in the form of a reciprocal tip, a business referral or help getting his kid into college. In other words, his breach of duty was accompanied by the prospect of personal gain. Your informant’s self-interest makes all the difference.

Let’s add a final twist. Suppose your friend is an editor for Business Week. His inside information is that Business Week will be ranking innovative software firms in its next issue, and placing AGA first in its category. The news is sure to drive the price of AGA stock up sharply. Can you buy AGA shares based on that tip?

No. The law treats all secret information that might affect a stock’s price the same way, whether that information is good or bad and whether it originates from the firm itself, a business publication or a Wall Street research department. Business reporters, securities analysts, Wall Street printers, investment bankers and many other professionals have been snared when they traded on or tipped others about privileged information belonging to their employers.

Rounding out a working knowledge of insider-trading law are three special situations. First, confidential information related to a proposed tender offer — such as a hostile takeover — is too hot to handle no matter how innocently it comes to you. The law treats information about tender offers very strictly. The second concerns stock owned through employee stock-purchase plans, etc. As an employee, you are sure to know some confidential inside information, so how can you legally sell your stock? Under a new rule, securities regulators have created a “safe harbor” for employees. Employees who file selling plans with the SEC can sell their stock regularly on a set date (such as the first Monday of every month for one year). This avoids any risk of insider-trading liability. This is a formal technical procedure, so ask your company’s lawyers for advice.

The third situation applies to corporate officers, directors and those owning 10% or more of the shares of a firm. In those cases, a special, additional rule requires a six-month wait between any purchase and subsequent sale or sale and subsequent purchase. If you sell shares on Jan. 1, you must wait until June 30 to buy — and vice versa. The rule applies whether or not you know any company secrets.

Making money on the basis of inside information can get you into big trouble, but there are times when it is legal. So if you find yourself sitting next to a highly placed but loose-lipped stranger in a bar who wants to make you a gift of inside information, take it if you want. But don’t start buying your new friend drinks every happy hour. This payback is what transforms a random tip or overheard conversation into an illegal insider-trading ring. If you have any doubts about what to do, consult a legal expert or, even better, just don’t trade. Life is too short to spend even a small part of it with federal investigators.