We’ve all heard the expression “hard cases make bad law.”  But sometimes bad law is the result of bad cases – i.e., cases that should never have been brought in the first place.  That’s the case with the SEC’s prosecution of Ray Dirks, who died on December 9 at age 89.  I suspect that many of you are too young to have heard of Dirks or the prosecution, but the SEC’s vendetta against him is one of the factors that has led to our screwed-up approach to prosecution of insider trading.

The events in question took place in 1973.  Dirks was a well regarded securities analyst working for a major (since defunct) research firm when a former executive of Equity Funding informed him that the company was one massive fraud.  He conducted his own investigation, determined that the information he’d received was accurate, and reported it to the SEC, which ignored him.  (Can you say “Bernie Madoff”?)  He also told The Wall Street Journal what he had learned and advised his clients to sell their holdings of Equity Funding.  They did just that before the information became public.

Turns out he was right.  Equity Funding collapsed, and some of its executives were prosecuted, convicted, and imprisoned.

You’d think that the SEC would have apologized or at least acknowledged that he was right, right?  Wrong!  The SEC censured him for insider trading, among other things, which would have resulted in penalties, including suspension.  Dirks fought back, and in 1983 the US Supreme Court overturned the censure and rejected the SEC’s interpretation of insider trading.  Instead, the Court said that liability for insider trading depends upon whether the source of the information – the tipper – had breached a legal duty to the corporation’s shareholders in passing along the information; that the tipper in this case was motivated by a desire to expose the fraud; and that “there was no derivative breach” by Dirks.

I don’t blame the Court for coming up with this rather convoluted route to Dirks’s exoneration; after all, one of my law school professors used to beat us over the head with the notion that courts will sometimes bend over backwards to fashion a remedy where the strict letter of the law leads to an unjust result.  That seems to me to be a good thing.  Also, I know that I’m in the minority – possibly a very small minority – that believes that the goal of insider trading law should be to create a level playing field rather than to punish breaches of fiduciary duty.  Still, the Dirks case has resulted in decades of confusion over what is – and what is not – insider trading, and I believe that we’d have all been better off if the SEC had not engaged in overzealousness where Dirks was concerned – particularly given the agency’s non-response to the allegations he’d brought to its attention.