Last December, I wrote an UpTick (“There ought to be a law”) about a decision in the Second Circuit Court of Appeals that appears to be wreaking havoc with insider trading prosecutions past and present. The Second Circuit has now rejected a Justice Department request to reconsider the decision, and so we now face a period of uncertainty regarding whether and to what extent insider trading can be prosecuted.
Since the terms “inside information” and “insider trading” have never been defined, one suggestion is that Congress should enact legislation that would define one or both terms. That’s a good idea in principle, but the proposals that have been bandied about thus far provide little confidence that legislation would clarify the situation. For example, one bill would prohibit trading on information that “is not publicly available” but not “information that the person has independently developed from publicly available sources”. I’m not sure this helps; after all, Ray Dirks (the subject of an SEC vendetta that, in my opinion, led to the current confusion on what is and is not insider trading) independently developed the information in question, but the SEC prosecuted him anyway.
Another bill would (1) define inside information as nonpublic information obtained illegally from the issuer “with an expectation of confidentiality” or “in violation of a fiduciary duty” and (2) remove the requirement that a tipper receive a personal benefit for leaking the information. I like the second part, but I’m not sure that the first part works; for example, if I hear the information from someone who heard it from someone who heard it from the issuer, does that remove the taint?
There are also suggestions that Congress may consider a broader approach – i.e., making it illegal to trade when in possession of confidential information regardless of how it’s obtained. This reminds me of a hypothetical posed years ago by Stanley Sporkin, then the very feisty Director of the SEC’s Enforcement Division: you’re flying in a plane and look out of your window to see XYZ Corporation’s biggest plant going up in flames. As interpreted by Mr. Sporkin, if you got off the plane and called your broker with a sell order, you would be engaging in illegal insider trading. Of course, these days you could place the order online well before the plane lands. Is that really how we’d like it to turn out?
It seems to me that before Congress even thinks about acting (not that Congress can act on very much if anything these days), we need to think about what goal we’re trying to achieve. If the objective is to create a level playing field for all investors, that’s one thing, and would probably require a much broader approach. If the goal is less ambitious -- i.e., to curtail trading based on knowing leaks and thefts of inside information -- that’s another. In any case, wishing for legislation on this topic reminds me of the old saw about being careful what you wish for.
A great deal has been written about the recent reversal of two insider trading convictions. Specifically, the U.S. Court of Appeals for the Second Circuit threw out the convictions of Todd Newman and Anthony Chiasson, hedge fund traders found guilty at the District Court level.
The press reports have treated the reversal as a major slap in the face for Preet Bharara, the U.S. Attorney for the Southern District of New York. Bharara has made a big name for himself on the backs of numerous alleged – and quite a few convicted – insider traders, including Raj Rajaratnam. While I’m sure Mr. Bharara isn’t happy about the reversal, he should take solace from the convoluted – no, byzantine – legal route by which insider trading convictions are achieved.
I suspect that most readers will not remember the SEC’s pursuit of Ray Dirks and a few others charged with insider trading many years ago. Dirks, a securities analyst, uncovered a massive fraud perpetrated by a company named Equity Funding. He alerted the SEC and some media about the matter, but neither did anything. When he couldn’t gain any traction, Dirks advised his clients to sell the company’s stock. For reasons that remain murky (including rumors of bad blood between the SEC and Dirks), the SEC decided to pursue insider trading charges against Dirks and a few other people who arguably should never have been prosecuted.
The courts have a way of dealing with cases that shouldn’t have been brought in the first place, and in this and some other prosecutions the outcome was the “misappropriation” theory of insider trading. Simplistically stated, insider trading is not insider trading unless the tipper owed some duty to the company whose information was misappropriated (though not necessarily the company about which information was leaked) and derived a personal benefit from leaking the information. Subsequent cases have generated many more wrinkles in what the theory really means. As for Messrs. Newman and Chiasson, their convictions were reversed because even though their tipper derived a personal benefit from giving the tip, they didn’t know that he was deriving that benefit.
So if you think that the point of insider trading prosecutions is to maintain a level playing field, think again. It’s not about what you know, or who you know; apparently, it’s about what you know about who you know. There ought to be a law, but this isn’t it.
I’d like to know what you think.
A few weeks ago - “From the same wonderful folks who brought you conflict minerals (among other things)” – I complained about Senator Blumenthal’s attempt to tell the SEC what to regulate and how to regulate it. I had an equal and opposite reaction to the recent news that Commissioner Gallagher and former Commissioner Grundfest had gone after the Harvard Shareholder Rights Project, in effect telling the Project (AKA Lucian Bebchuk) that its actions violate the federal securities laws.
I agree with some (though not all) of Commissioner Gallagher’s views. I’m also troubled by the notion of an esteemed academic institution taking aggressive, one-size-fits-all positions on corporate governance matters. However, in this case, I’m inclined to think that Commissioner Gallagher should have taken a higher road – encouraging discussion, maybe even holding an SEC Roundtable on the topic. And if he really thinks that there’s a violation here, perhaps he should have whispered in the ear of the Enforcement Division that it might want to look into this. Instead, he’s behaving somewhat like a bully – not that the Good Professor is likely to be quaking in his boots about it.
Also, it strikes me as downright inappropriate for a Commissioner to make a statement about a matter that the Commission could conceivably have to rule on if the matter ever does result in an enforcement action. At a minimum, he’d have to recuse himself on the matter, which could mean the difference between victory and defeat. And given recent criticisms of the SEC for (1) pursuing more matters as administrative proceedings than court cases and (2) unfairly touting its enforcement record, does Commissioner Gallagher think he's enhanced the stature of the SEC by doing this?