When Does Information Become Illegal?

Written by Alexis Datta

Imagine that you are a full-time investment banking analyst at a large bank in New York. As an investment banker, it is your job to work with companies and their private data in order to help them form strategy and raise money (we’re talking broad strokes here). After a deal is finished, the information about it goes public, people can act on it, and hopefully you are praised for the amazing results achieved. Now, let’s slightly modify the scenario. Say that before you finish your work and the information goes public, you decide to trade based on what you know is about to happen. Just to pick a number, let’s say you pocket a neat $98,750 in an account you haven’t disclosed to your employer (let’s say RBC). You buy yourself a nice bottle of wine, and go on to finish your work. The information goes public, everyone else can act on it, and you are praised for the amazing results achieved.

Was that unfair? You acted on – basically – information asymmetry, which exists everywhere in business and life. What could possibly be wrong with it?

Four months later, on August 11th, you are sitting at home enjoying your bottle of wine, and you hear a knock at the door. You open it to find a U.S. Securities and Exchange Commission officer along with at least one FBI enforcement agent. It turns out that the government thought it was unfair of you to act upon the nonpublic information you had, and the call you get from RBC later confirms that they agree.

It also turns out that this practice has been going on for many years prior to your indiscretion, and it’s been given a name – insider trading. When someone trades on material nonpublic information without telling the SEC about their plans beforehand, they are trading with ‘insider’ knowledge that they only gained because they were party to the transaction. Anyone and everyone can illegally trade if they possess insider knowledge and subsequently trade off of it, and everyone involved in perpetuating the spread of that information can be charged.

Recently, a scenario similar to the one I described above happened to a former Stern student, who, during his time as a student, had served as President of the Stern Student Council. Most of the details behind what happened are unknown, however, and most people were left to speculate whether the circumstances surrounding this event happened because of negligence or intent. While that may not be as important for current students, a better discussion might revolve around the curriculum that prepares students for the immense power of the information that they will deal with.

At Stern, our curriculum does a good job of covering a breadth of topics concerning insider trading – we discuss legality in Law, Business and Society during junior year and the vast social impact core contemplates the ethics behind decision-making. But what happens when the two are not necessarily the same – in other words, what is legal is not ethical, and vice versa?

Say that you are at a coffee shop and you overhear two bankers discussing an upcoming deal that they are working on. Despite their hushed tones, you hear the details of a merger that will happen a month from now but is not disclosed yet. You quickly leave without getting any more information about the bankers, and you open up your Robinhood account to trade based on what you heard. Insider Trading? One might think so, but the regulations require that, to be insider trading, you must be an ‘insider’. While courts have historically used a broad definition of ‘insider’, one of the general requirements for conviction is a beneficial relationship. Although this rule doesn’t necessitate a financial transaction, it does require that the two parties are related to each other.

Let’s go back to the example we discussed at the beginning of the article. What if the ex-student’s lawyers were able to prove that the trading was unintentional or was simply a mistake? Especially if you have already taken LBS, you’ve learned about Actus Rea and Mens Rea – action and intent. For most crimes, you need both to be convicted (i.e. if you stole someone’s backpack accidentally because it looked like yours, you could be absolved if it was an honest error), so would this individual be exonerated? If you thought so, you would be wrong. Insider trading is one of the few crimes that does not require mens rea, which essentially means that you can mistakenly become a criminal.

Now imagine that instead of being on the banking side, you were part of the C-Suite for the company. Does that mean that you can’t trade in your own shares? After all, you know more about the company than even your bankers (hopefully). No, and in fact, this loophole has gotten a fair amount of attention recently. When the period of time that a company official can buy or sell her shares coincides with a period of share buybacks (if the company is buying back shares, which reduces supply and signals confidence in the company, the stock price generally rises), the company official can net a significant profit. However, this is completely legal.

No one questions the power of information, but what we do with that information in the world of finance is increasingly restricted. So maybe the question we should be asking is not what Stern is teaching us, but how the material is taught. After all, the curriculum covers both legality and ethics. But in a world where the two forces are not clearly distinguishable, shouldn’t we be thinking about each in the context of the other?