The Gray Line of ‘Confidential’ Information

The insider trading case against SAC Capital Advisors seems to be all about the trading “edge,” a term the firm’s owner, Steven A. Cohen, once said he hated. Under the securities laws, proving a violation requires showing that the information used was nonpublic, which means it was not already available in the stock market â€" the edge that can make for lucrative profits and sidestepping big losses.

The charges filed last week against Sandeep Aggarwal for tipping off a SAC portfolio manager to give that edge raise the question of when information is sufficiently confidential that its use constitutes insider trading.

Sometimes it is easy to identify information as confidential because a company will go to great lengths to keep it secret by limiting access and using code names. The obvious example is information about a pending merger or acquisition, which companies want to remain secret to prevent a run-up in the stock price of the company being acquired so that the deal announcement gives the appearance of a significant premium being paid to shareholders.

Traders also frequently seek a trading edge on a company’s earnings. That can be especially important when the number falls short of Wall Street’s expectations or blows past the consensus estimate.

Other types of information fall into a grayer area, particularly when there is significant media speculation about pending developments at a company. In those cases, the government has to prove that what was provided to those accused of insider trading was more specific than other speculation already available to the market.

Mr. Aggarwal, who was an Internet research analyst at Collins Stewart, is accused of giving inside information to Richard Lee, a former SAC portfolio manager who has pleaded guilty to insider trading charges and is cooperating in the Justice Department’s prosecution of the firm. As DealBook reported, Mr. Lee will play a featured role in that case because it appears the firm ignored warning signs about his use of inside information.

The information Mr. Aggarwal provided involved negotiations between Microsoft and Yahoo in July 2009 for a strategic partnership that was expected to help bolster Yahoo’s earnings by $500 million. His source was a friend at Microsoft.

Mr. Aggarwal had issued research reports discussing the negotiations, and in June 2009, he lowered the probability of the two companies reaching an agreement to 50 percent from 80 percent. But on July 9, his source at Microsoft said that the negotiations were heating up and that a deal could be announced in the next two weeks. That sounds like inside information because it alters the prior speculation about the deal and was not readily available to the public.

What happened next, however, may give Mr. Aggarwal a defense to the insider trading charge. He participated in a “morning call” at his firm with sales executives in which he discussed the increased likelihood of a Microsoft-Yahoo partnership. One listener followed up by sending an e-mail to clients that said the “deal talks are starting again.”

In addition, the affidavit filed as part of the charges stated that Mr. Aggarwal “spoke to approximately 14 traders or portfolio managers at various hedge funds” about the resumption of negotiations. Those discussions included a recorded call in which he told a trader at an unidentified hedge fund that a “senior guy at Microsoft” had provided detailed information about developments between Microsoft and Yahoo.

Only after that did Mr. Aggarwal speak with Mr. Lee, also in a recorded telephone conversation. In that call, Mr. Aggarwal provided detailed information in response to questions from Mr. Lee about the reliability of the source, after which SAC bought a large number of Yahoo shares. Mr. Lee, too, purchased Yahoo shares for his personal account.

This is not the typical insider trading case because Mr. Aggarwal comes across as willing to tell anyone who would listen about his information, doing so rather freely on a recorded telephone line. The issue is whether his willingness to talk effectively removed the veil of confidentiality over the progress of the Microsoft-Yahoo negotiations so that Mr. Lee’s trading did not violate the securities laws.

In the usual case, the issue of confidentiality would depend on when the company publicly disclosed the information, and the Securities and Exchange Commission requires that the information be made available to all investors at the same time. But the courts have also recognized that when stock analysts have dispensed information to traders, it will usually be incorporated almost immediately into the price of a stock and is no longer confidential.

In United States v. Contorinis, the United States Court of Appeals for the Second Circuit stated that “information is also deemed public if it is known only by a few securities analysts or professional investors.” At that point, the information is not confidential because under what is known as the “efficient capital market hypothesis,” investors rely on the market to quickly reflect all available information in the value of a company’s securities.

So Mr. Aggarwal’s revelation to the sales staff at his firm and other hedge funds may have turned otherwise confidential information from Microsoft into data that was sufficiently available to the market that his later disclosure to Mr. Lee did not constitute illegal tipping.

Whether he may still have violated the securities laws will depend on how much information he revealed to others before the discussion with Mr. Lee. In Contorinis, the court noted that “a tip that provides additional reliability to existing information about the status of a transaction based on the source’s access to inside information may be material because it lessens the risk from uncertainty.”

Other evidence cited in the government’s charges may show that Mr. Aggarwal viewed the disclosures as questionable, which can help to show that he intended to give inside information. When questioned by Collins Stewart about whether he had received the information illegally, he lied about his source by claiming it was from a former Microsoft employee.

The securities laws prohibit schemes to defraud, so even a tipper who tells too many people can still be found guilty for just trying to engage in insider trading. But Mr. Aggarwal may well be able to defend his case by claiming that, at least when he spoke to Mr. Lee, the information about the Microsoft-Yahoo negotiations was no longer confidential.