Insider Trading: From Fantasy Football to Federal Prison?

“Santonio Holmes is out—four weeks with a strained hamstring. I heard Geno Smith will get the start, and the Jets will keep Kahlil Bell as their short yardage back. The official announcement isn’t supposed to come until later in the week, after Wednesday’s practice.”

Every year, from September through January, this type of water-cooler conversation can be overheard, as football fans discuss the weekend’s games and the latest gossip about their favorite players.

Such conversation seems harmless. But could it be a federal crime?

That possibility doesn’t seem so far-fetched now that Fantex Holdings, a Silicon Valley start-up, has launched an exchange where investors trade shares of athletes’ “brands.” It works like this: Fantex makes a one-time, lump-sum payment to an athlete in exchange for a cut of the athlete’s future earnings, including endorsements and other revenue from the athlete’s celebrity status. Two athletes have signed with Fantex so far—Arian Foster of the Houston Texans will receive $10 million in exchange for a 20 percent stake in his brand, while San Francisco 49ers tight end Vernon Davis will get $4 million in exchange for a 10 percent share.

To finance the lump-sum payout, Fantex issues a “tracking stock” linked to the revenue stream of a particular athlete. For example, the IPO for the Arian Foster tracking stock will offer 1,055,000 shares at $10 each, generating $10,550,000. (After paying Foster his $10 million, the remaining $550,000 covers expenses related to the IPO.) Owners of this stock can then trade shares on a special exchange that Fantex hosts. In theory, the value of the tracking stock reflects the value of Foster’s brand.

Securitizing sports—an industry already replete with gossip, hype and speculation—raises interesting insider-trading implications, particularly in light of recent enforcement efforts targeting insider trading beyond the “typical” Wall Street cases. Fantex provides a thought-provoking reminder that as financial markets evolve alongside changes in the ways in which investors obtain, process and use information, so does the risk of liability under insider trading law.

Insider Trading: The Basics

The basic prohibition on insider trading, which is derived from federal securities laws, is fairly straightforward: It is illegal to buy or sell a security on the basis of inside information—i.e., “material nonpublic information”—in breach of a duty of trust or confidence.

What constitutes material nonpublic information, however, is not always clear. “Material” information involves anything a reasonable investor would want to know when deciding to buy or sell a security. And information is “nonpublic” if it has not been effectively disseminated to the investing public. While these concepts are easy to define in the abstract, they can be difficult to apply in practice.

Moreover, trading on material nonpublic information is only illegal if it somehow “breaches a duty.” This duty can arise from a traditional fiduciary relationship such as an attorney-client or employer-employee relationship. But it can also arise from a fiduciary-like relationship such as a business or family relationship where there is an expectation to keep certain information confidential or to not use that information for personal gain. However, there is no hard-and-fast rule as to what constitutes a relationship sufficient to trigger liability. Thus, whether a violation has occurred—that is, whether information is material and nonpublic, and the requisite duty has been breached—is highly dependent upon the facts and circumstances of each individual case.

The Next Generation of Insider Trading Cases