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.