Earlier this week we witnessed a pretty awesome refutation of super strong versions of the Efficient Capital Markets Hypothesis.
Google announced its multi-billion dollar acquisition of Nest Labs, which makes stuff like internet-connected smoke alarms and thermostats.
As that happened, a company trading under the symbol NEST shot up 1,900 percent. The problem is that company, Nestor, has nothing to do with the company Google bought. Nestor is an empty shell that's been in receivership since 2009.
The blogger who styles himself KidDynamite brought this to the attention of those of us who follow him. And we all had another occasion to chuckle wisely about the foolishness of the notion that all securities always priced correctly. William Alden, of DealBook, somehow produced a rather straight-faced report on all this. He even explained what the company attached to the ticker NEST once did.
Matt Levine of Bloomberg Views asked a very clever question.
So I answered him: .
Since then I've gotten a few people asking how trading the shares of a company unrelated except through trader error could amount to insider trading. It seems almost absurd that the law would prevent you from buying a stock that really should be totally unrelated to the one you have inside information about. Plus, the only people who you're possibly taking advantage of here are loser idiots buying the wrong stock anyway, so who cares about them, right?
As persuasive as that may sound, that's not the way the law works.
Before I get into the technical legal reasoning, let's take a step back and think about what's going on in the scenario Levine proposed. He imagines a trader who has advanced knowledge of a deal buying up a stock of an unrelated company that then surges when the deal is announced.
The reason for buying the stock, of course, was in anticipation of this surge. The trader has profited because he had non-public information that moved a stock. That at least begins to look a bit more like insider trading.
(See also: Why insider trading shouldn't be considered a crime.)
Now to the technical legal stuff. There is no direct statutory bar on insider trading. Instead it is barred as a matter of practice by a more general prohibition on using a "deceptive device" in connection with securities trading. Basically, it's considered a species of fraud.
"Classical" insider trading law involved an executive at a public company buying or selling shares in the company in advance of the release of good or bad news to the public. In that kind of case, the courts see the insider at taking unfair advantage of the outside shareholders because the insider's position of trust required him to either disclose the information or refrain from trading.
The other main type of prohibited insider trading is called "misappropriation." This is a once-controversial but now pretty much settled and accepted theory of insider trading law that holds that a fiduciary can be held liable for insider trading when they breach a duty of loyalty to use the information to trade.
In US vs. O'Hagan, the Supreme Court explained the two different situations covered by classical and misappropriation theories of insider trading.
The two theories are complementary, each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities. The classical theory targets a corporate insider's breach of duty to shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate "outsider" in breach of a duty owed not to a trading party, but to the source of the information.
In the hypothetical Levine came up with, the trader is probably guilty of violating the ban on insider trading under the misappropriation theory.
He's using non-public information in breach of a duty to the source of information (presumably he learned it from Google or NEST) to trade securities. Nothing in the theory requires that the information be explicitly or even intelligently tied to the security you trade. All that is required is that you engage in self-dealing with the information, that you have some duty of loyalty and confidentiality, and that you trade a security as part of your self-dealing scheme.
That would have happened if you bought NEST in advance of the Google deal.
(Now read: The dumbest insider trading scheme ever)
This isn't really that shocking of a result. If the basic idea is that fiduciaries can't use non-public information to trade, it isn't clear why that rule wouldn't include trading in things that the ill-informed might buy when the information becomes public.
—By CNBC's John Carney. Follow him on Twitter @Carney