Cover Story: Commentary
INSIDER TRADING: THERE OUGHTA BE A LAW
Franz Kafka would have loved it. First, you buy some stock on a tip from a friend. Then, the government hauls you into court. But only later--maybe years later--does a court decide whether there even was a law prohibiting what it was you did.
That's how it has been for nearly three decades in prosecuting insider-trading cases. It's a little-known fact that unlike theft and other acts that have been misdeeds since the Code of Hammurabi, there is no law on the books that specifically says a person may not trade on inside information. Instead, investors are at the mercy of an abstruse, often confusing melange of court rulings. Depending on the precise circumstances, an investor who trades on a hot tip can end up either lauded in the financial press for his prescience or sent off to prison.
With insider-trading cases on the rise again, it's time to put a definition on the books. "If people are going to be convicted of criminal conduct," says former Securities & Exchange Commission General Counsel Harvey L. Pitt, "they should know what the crime is."
FEDS FOILED. The law as it currently stands is based on the Securities Exchange Act of 1934, which bans "any manipulative or deceptive device." The courts have put a fair amount of flesh on these bare bones. Back in 1968, the federal appeals court in New York decided that
corporate insiders must abstain from trading until they disclose "material" information--which could affect investment decisions. The
ruling was based on the fiduciary duty corporate officials have to shareholders.
Since then, the government has tried to expand this duty to other investors but with only limited success. Appellate courts have ruled that if you "misappropriate" information--that is, steal it--and trade, you're dead meat. The Supreme Court, further, has determined that it's illegal to trade on inside information if your source violated a duty to shut up and did so for direct or indirect gain--and if you knew or should have known that the source breached an obligation in disclosing it. However, the government lost a case against a securities analyst, Raymond Dirks, who passed on to customers good inside dope from altruistic souls trying to expose a corporate fraud. The feds also were defeated when they went after a broker who received information from a nephew-in-law of a corporate honcho.
What's badly needed now is an explicit congressional statement of what is legal and what is not. In 1987, a group of securities lawyers headed by Pitt came up with a good start. Its draft would ban misappropriation; trading based on breaches of fiduciary, employment, personal, or other relationships dependent on trust; and passing on inside information if the tipper knew the tip would lead to trading.
DRACONIAN MEASURE. Among other virtues, an insider-trading law would stop the SEC from using evermore artful arguments that camouflage what seems to be its real goal: finding a judge who will uphold the notion that mere possession of inside information imposes a duty to abstain from trading. So far, the courts have refused to go that far--with good reason. As information is passed along, fewer and fewer recipients know it originally was confidential. Such a draconian rule could sweep up lots of innocent investors. "You'd never know if you were violating it," complains Terry B. Adamson, a Washington lawyer who represents a client fighting insider-trading charges.
For years, the SEC and its allies on Capitol Hill opposed a fixed definition, fearing it would be too narrow and crimp the agency's flexibility to nail innovative schemers. But court setbacks have actually reduced its flexibility. Now, says SEC Enforcement Chief William R. McLucas, "a definition would not trouble me" as long as it would be broad enough to cover cases brought to date.
Senator Alfonse M. D'Amato (R-N.Y.) introduced legislation in 1987 based on the work of Pitt's group. That should be high on D'Amato's agenda when he takes over as chairman of the Senate Banking Committee in January. Lawmakers ought to set the rules of the game before the SEC punishes people for violating them.
WHAT'S LEGAL AND WHAT ISN'T
-- A friend tells you that his company is doing very well. You buy stock in the company. That's legal because the information wasn't "material," or important enough to affect investors' decisions.
-- You overhear two people saying they heard that Acme Widget Co. is a fabulous buy because a takeover is in the works. You invest in Acme Widget. That's legal--but only if you don't know whether or not the source of the information was an insider such as an officer of the company.
YOU'RE NOT O.K.
-- You're a psychiatrist and your patient mentions her company could face a hostile takeover. You buy its stock. That's illegal because you're "misappropriating" information by breaching your confidential relationship with your patient.
-- A high-ranking colleague tells you about an imminent takeover of your company. You don't trade on the information, but you tell a close friend who does. Courts would likely deem that your action was illegal on the grounds that there probably was a quid pro quo.Stan Crock