How to Make a Killing Trading on Insider Information - Legally

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In a perfect world, every investor would have access to all material information about a publicly traded stock. Investors could then collectively evaluate this information, resulting in a market price for the stock that would fairly reflect its current value.

Unfortunately, the world is not perfect. And to gain an unfair advantage, some traders, mutual funds and hedge funds game the system by obtaining insider information. The stakes can be very high, creating a meaningful incentive to do so.

I suspect most investors believe the use of insider information is illegal. If so, they are only partially correct. A recent decision by the U.S. Court of Appeals for the Second Circuit (United States of America v. Todd Newman, Anthony Chiasson et. al) will make it exceedingly difficult to prosecute a broad range of insider trading cases, even when insider information is used and huge profits are generated. Decisions by the Second Circuit are applicable to Federal courts in New York, Connecticut and Vermont.

Todd Newman and Anthony Chiasson were portfolio managers at different hedge funds. They allegedly used information obtained from a group of financial analysts, who in turn got it directly or indirectly from company insiders. Specifically, they learned of earnings numbers for two public companies (Dell and Nvidia (NVDA)) before they were released. Newman and Chiasson traded on this information and allegedly earned $4 million and $68 million, respectively, for their funds.

How would you feel if you were on the other side of these trades?

Newman and Chiasson Were Exonerated

Newman and Chiasson were convicted of securities fraud after a six-week trial. On appeal, their convictions were vacated.

The appeals court determined that simply using insider information is not illegal. In fact, the court found the government had an obligation in this case to prove beyond a reasonable doubt that the person conveying the insider information had obtained it from "an insider" at the public companies in question and that the insider did so in exchange for a "personal benefit."

Because the earnings information came from a group of financial analysts, the court concluded there was no evidence Newman and Chiasson either knew the source of the confidential information or that those insiders who disclosed it received any personal benefit in exchange for the disclosure.

How You Can Profit

Assuming that this opinion is not overturned by the Supreme Court and remains the governing precedent, maybe you can profit from it. If you have the good fortune to overhear a conversation at a posh restaurant between a CEO and an investment banker concerning the imminent takeover of a public company, you can trade on that information with impunity. Why? Because even if you know the information was coming from the CEO, the CEO did not disclose it in exchange for a "personal benefit."

Similarly, if you have a friend who is an attorney at a major law firm and he discloses confidential information about a publicly traded company that is a client of his firm, you can trade on that information as well. The lawyer presumably did not tell you where he got the information and he did not benefit from disclosing it to you. Of course, the lawyer violated both his legal obligation to his firm and his fiduciary obligation to his client.

Why This Is Unsettling

In an insightful article commenting on this decision, Robert Reich, a professor of public policy at the University of California at Berkeley and a senior fellow at the Blum Center for Developing Economies, noted that the use of inside tips is the "coin of the realm in securities markets." Reich observed: "Major players on Wall Street have been making tons of money not because they're particularly clever but because they happen to be in the 'realm' where a lot of coins come their way."

Most Main Street investors are not in the same "realm" as the big hitters on Wall Street. I also suspect many individual investors would find it ethically repugnant to profit from inside information at the expense of those on the other side of the trade. Wall Street is not constrained by an ethical compass.

At least you now know the new rules that govern the use of insider information. How you use them is up to you.

Daniel Solin is the director of investor advocacy for theBAM Allianceand a wealth adviser with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."
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