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When it comes to insider trading, you've probably been looking for materiality in all the wrong places

Nest Learning Thermostat, made by Nest Labs
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Nest Learning Thermostat, made by Nest Labs

Matt Levine, who started this discussion about hypothetical insider trading in Nestor, has a smart (but ultimately wrong) post up about an angle that I didn't consider in my earlier delve into the subject.

For those of you just joining us at home, the other day shares of a company with the ticker symbol NEST soared 1,900 percent after Google announced the acquisition of Nest Labs. This was incredibly stupid because Nest Labs has nothing at all to do with NEST. It seems like a case of mistaken identity.

So the question Levine raised is whether trading in shares of NEST would be insider trading if you had advanced knowledge of the Google deal? Does the law prohibit you from using non-public information about a deal to profit off of people stupidly buying a different stock altogether?

In my earlier piece, I argued that insider trading law does say you can't do this. If you got the information because you were, say, a guy making deal toys for the people involved, you aren't allowed to take the information that you were entrusted with and that belongs to others, in this case Google and Nest, and use it to trade for yourself. And if you got the information from your buddy who was involved in the deal somehow, then you inherit his breach of fiduciary duty and so you're in trouble.

Not so fast, says Levine. To give rise to insider trading liability, information must not only be non-public. It must also be "material." And, to make a long Levine post short, since Nest Labs has no relationship to NEST, information about Nest Labs cannot be material to NEST.

That seems rather straight forward and smart. But it's wrong.

Here's how the judge instructed the jury in the recent case against Mark Cuban:

"Materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information. Materiality is not judged in the abstract, but in light of the surrounding circumstances. Information is material if there is a substantial likelihood that, under all the circumstances, the information would have assumed actual significance in the deliberations of the reasonable shareholder."

So here's something both the federal courts and the SEC consider to be an important factor when considering materiality: The effect on the stock's price. As the Third Circuit put it in Oran v. Stafford, "when a stock is traded in an efficient market, the materiality of disclosed information may be measured post hoc by looking to the movement, in the period immediately following disclosure, of the price of the firm's stock."

The price of NEST shares rose 1,900 percent when the deal was disclosed. That pretty much screams materiality.

Levine says that the information isn't material because the connection just isn't "reasonable." Or, rather, that no reasonable investor in NEST would care about the acquisition of Nest Labs. Sure the stock price moved, but that was unreasonable. And stupid. So it's not material.

The problem with this line of argument is that in Levine's scenario, the investor with inside information buys shares of NEST as part of a scheme to trade from a mistake he anticipates occurring when the deal is announced. And then that mistake happened. That may be stupid but it's not unreasonable

Let's put it this way. Would knowledge of the Google deal have played a part in the decision of owners of NEST to sell their shares the day before the deal was announced? It may not have been decisive but surely it would have played some part. I mean, you own shares of worthless stock that could have value tomorrow based on investor error. Why not hold it an extra day?

More importantly, I think Levine is wrong about the touch point of materiality. He assume that the information needs to be material about the company in which the shares actually were traded. That's incorrect, in my opinion. Keep in mind that in a misappropriation case, the duty breached that gives rise to illegality is not owed to the person on the other side of the trade. It's owed to the person who is the source of the information. The line of materiality should also connect not to the investors in NEST but back to the investors in the source of the information, Google. And for Google investors, the multi-billion acquisition almost certainly was material.

Misappropriation is about using the information that belongs to others for your own benefit, in breach of a duty of loyalty and confidentiality toward them. When judging materiality, it only makes sense that the correct place to look is to the owners of the information.

—By CNBC's John Carney. Follow him on Twitter @Carney

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