A Nest thermostat. This picture is about as related to this post as Nest is to Nestor. Photographer: David Paul Morris/Bloomberg

Insider Trading Law Can't Handle Nest and Nestor

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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The Nestor/Nest insider trading thing that we talked about earlier is pretty dumb but there's actually an important question lurking in it. Financial fraud law is built around a thing called "materiality." So to be guilty of insider trading, you need to trade on "material nonpublic information" that you obtained through someone violating a duty to someone else. The duty stuff is complicated and people frequently forget it. But "material" is hard too, and worth talking about.

What does material mean? Well here are some words, though I don't know that they're all that edifying:

materiality is established when there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."

Those words are from a Supreme Court case finding that something does not need to be statistically significant to be "material." So there's that.

So, I don't know, you can go read those words and see what you think, and that's more or less what courts do. So here are some fact patterns to try out; I have suggested some answers but they are Not Legal Advice:

  • You know that Company A is going to be bought at a big premium by Company B, and you trade on it. Suggested answer: Bad.
  • You know that Company A is in talks to be acquired at a big premium by Company B, and that the deal has a pretty good likelihood of going through, and you trade on it. Also bad.
  • You know that Company A is going to be bought at a big premium by Company B, and you figure "well, Company C is an industry peer to Company A, and maybe this will spark merger rumors about Company C," so you trade in Company C stock. I don't know, this seems like an interesting case.
  • You know that Company A is going to be bought at a big premium by Company B, and you figure "well, Company A has nothing to do with Company D, but it is a penny stock with a similar ticker, and there are a lot of idiots," and you trade in Company D stock. This seems pretty obviously okay to me, because no "reasonable" investor would treat Company A news as relevant to Company D. Only stupid investors would do that.

Because there are those words, right? "Would have been viewed by the reasonable investor" as significantly important or whatever. I don't know if that really defines anything more clearly than the word "material" does, but the point is that the law looks at whether a thing is "material" or "significantly alters the total mix" or whatever from the perspective of the "reasonable investor."

I think the reasonable investor and the marginal investor might be two different people.

Here, you look like a reasonable person, let's do a thought experiment. What would you have done if I told you yesterday that Goldman would beat earnings estimates of $4.18/share by over 10 percent? You'd be like, "well, Goldman's stock price is based on its expected future earnings, and if the actual earnings are higher than the market expected, then the price will go up." So you'd go buy some stock yesterday, and then today when Goldman announced its earnings of $4.60 a share you'd gleefully take your profits of ... negative 2 percent. Oops!

Or here's another one. You're a reasonable person, how much would it alter your total mix of information to know consumer confidence numbers five milliseconds before everyone else? It will give you enough time to, like, blink before trading on the information, so that's pretty nice if you enjoy blinking. But I don't think it'll make you any money. On the other hand there was a big to-do over exactly this issue, because someone was (maybe) making money on it.

There are some obvious things -- a cash takeover at a premium, a big clean earnings beat -- that any reasonable investor will view as material and that will predictably move the stock. There are a lot of other things that are of interest to investors but whose effects on the stock price are less clear.

And then there is a third category of thing that has no narrative significance, and that no human would care about, but that moves the stock price. There's a whole industry of finding correlations between (1) facts about a company and (2) that company's stock price, and then doing levered automated trading to capture those correlations. If your model told you that, I don't know, CEOs with ankle tattoos outperform the market by 0.05 percent per year on average, and you went around sneaking looks at CEOs' ankles so you can feed that information into your multi-factor model that trades billions of dollars of stock relying on thousands of similar weak but positive signals, then ... I don't know, you'd be really weird, but would you be insider trading? Your computer can use that information but a reasonable investor couldn't.

The materiality standard that controls so much of securities law comes from an earlier, simpler time; a time when reasonable people could look at a piece of information and say "oh, yes, of course that will move the stock up" (or down), and if they couldn't then they wouldn't bother with it. Modern financial markets are not so intuitive: Algorithms are interested in information that reasonable humans cannot process, with the result that reasonable humans can't always predict how significant any piece of information is. That's a world that is more complicated for investors, but it also seems to me to be more complicated for insider trading regulation. And I'm not sure that regulation has really kept up.

  1. The question of whether information is "nonpublic" is occasionally interesting but not that interesting.

    Materiality also comes up in other financial-fraudy contexts. So a big question in the Fab Tourre Abacus case was: Would investors find it "material" that John Paulson was short rather than long Abacus, or were the only "material" facts things like the contents of the security?

  2. And of course (1) it's not publicly known and (2) the information is somehow ill-gotten.

  3. That's kind of the fact pattern of Basic Inc. v. Levinson, the big case about materiality (though not an insider trading case). There are fun nuances here.

  4. I can't find any case law on it. (And I've asked Twitter! And Google. It's practically legal research, I'll send you the bill.) I imagine that in some cases it could be material. If you knew that China was launching an investigation of Nu Skin, you might short Herbalife, and that link is so clear that a court might find it material. (Consider also that material nonpublic information about Company A doesn't have to really be about Company A: Knowing what, say, a Wall Street Journal columnist or a research analyst will say about a stock could be material nonpublic information, even though it doesn't come from the company.)

    A related but easier case is that if you have advance knowledge of Microsoft earnings, you might buy shares of an ETF made up of Microsoft and other stocks in its industry (in which Microsoft is a major component). I don't know of that being tested in court, but the SEC takes the view that that's illegal insider trading: Your knowledge of Microsoft is material information about the ETF. That seems reasonable to me.

  5. Also, btw, in addition to not being legal advice, you have to understand that there's a big gray area where the answer is likely to be indeterminate forever because no one will ever bring charges over it. So like we can argue about the "right" answer on some of these but they seem pretty unlikely ever to be tested in court. But who knows.

  6. This probably gets to the issue of "nonpublic" rather than "material" but you get the idea.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matthew S Levine at mlevine51@bloomberg.net