When Can Investors Talk to Companies?
Yesterday the Justice Department appealed the big Newman and Chiasson insider trading decision to the Supreme Court, and also explained what it thinks stock analysts do :
Effective professional analysis of the value of a company’s stock is a labor-intensive process that demands extensive research, an understanding of financial and other technical data, in-depth knowledge of the relevant industry, and sophisticated modeling. If certain analysts sidestep that labor by siphoning secret information from insiders in breach of their duties, thereby arriving at “predictions” of corporate performance that no model can equal, then other analysts will be discouraged from doing the work that is necessary for the markets to function effectively.
Er. Um. Sure. But another component of effective professional analysis of the value of a company's stock is talking to the company. There's a reason that companies have earnings calls. There's a reason that, when analysts get into the weeds on those calls, the companies say things like, "We'll follow up with you individually afterwards." There's a reason that companies selling stocks or bonds do one-on-one meetings with potential buyers. There's a reason that companies not selling stocks and bonds also do one-on-one meetings with current and potential investors. There's a reason that companies have investor relations departments full of people who talk to current and potential investors.
These are hugely awkward facts for insider trading law, or at least for insider trading rhetoric, which makes much of the notion that everyone should have the same amount of information. Analysts and investors talk to companies all the time. In principle the companies are not supposed to give the investors material nonpublic information during these conversations. In practice, the conversations are not social calls. The analysts hope to get something out of them. It's rarely "our earnings are going to be way better than anyone expected." It might be something vaguer and squishier than that: hints, body language, a general sense of how management thinks about the world, its industry, its competition, its opportunities. Or it might be something much narrower and more specific: The company might help the analyst with particular line items in her model, adding nuance to her sophisticated understanding of its financial situation.
These things are plausibly not "material nonpublic information." But they are obviously things that investors want. That's why investors meet with companies. That's why investors who meet with companies perform better than those who don't. And all of this is legal. Or legal-ish. Or at least in a broad gray area between legal and illegal. As the Supreme Court said in Dirks v. SEC:
Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market. It is commonplace for analysts to "ferret out and analyze information," and this often is done by meeting with and questioning corporate officers and others who are insiders. And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation's securities.
Here is how prosecutors say Todd Newman insider traded on Dell:
The insider at Dell was Rob Ray, who worked in the investor-relations department and then moved to the corporate-development department. Ray had access to specific information on Dell’s quarterly earnings—information that under Dell policy was to remain strictly confidential until Dell made a public earnings announcement. Despite that policy, Ray provided detailed, pre-announcement earnings information to Sandy Goyal, an analyst at Neuberger Berman (and former Dell employee), in multiple successive quarters. For instance, Ray told Goyal in August 2008—after the close of the quarter but before the earnings announcement—that gross margin was “looking at 17.5%” versus market expectations of 18.3%.
When Goyal wanted to speak to Dell’s investor-relations department, he had authorized contacts other than Ray with whom he generally communicated during business hours. In contrast, the conversations in which Ray provided Goyal with material, nonpublic information typically took place at night or on weekends, when Ray was away from his work cubicle and could not be overheard by his colleagues.
Goyal then passed this information on to Jesse Tortora, Newman's analyst, who then made trading recommendations to Newman. The government's theory is that Newman should have known that he was trading on illegal inside information because the guy who gave the information to the guy who gave the information to the guy who gave the information to Newman did so on weekends. If the guy who gave the information to the guy who gave the information to the guy who gave the information to Newman had done so at 3 p.m. on a Wednesday, it would have been totally legitimate. That guy (the first guy) was, after all, an investor relations employee at Dell. His job was to have relations with investors. I suppose some part of those relationships were built on, like, talking about baseball, but probably they were mostly built on talking about Dell, and investing.
But don't discount the baseball. The oddity of insider trading law is that if Ray told Goyal stuff, even secret stuff, for business reasons -- on behalf of Dell -- it was legal for Goyal (Tortora, Newman, etc.) to trade on it. If he told Goyal the same stuff for personal reasons -- in breach of his duty to Dell -- it wasn't. But that is a very hard line to police. Ray was not a robotic voice on a customer service line. He's a person, dealing with people, in a people business. His job was to develop relationships with investors, and those investors' jobs were to develop relationships with him. Those were business relationships, but the best business relationships have an element of social friendship too. You don't just call the investor-relations guy and bark, "So how are the numbers?" You chat him up first. You ask about his family. He asks about your family. You discuss each other's hopes and dreams. You try to help each other out. You make time to talk outside of work hours. You simulate a friendship. Maybe you even develop a friendship. A work friendship, sure, but work friendships can be real.
And then he gives you information, and you trade. If he gave you the information as part of the job, that's fine. If he did it as part of the friendship, it's a crime.
That's crazy! Law can't really work that way! How could you ever know? So the courts developed a clear test of whether a corporate insider is providing inside information in violation of his duties to his company. It's from the Supreme Court's Dirks decision:
The test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.
This is usually called the "personal benefit" test. What is nice about it is that it makes the law reasonably clear. If you call up the IR guy at a company and talk about the quarter for a while, you won't go to jail. If you also talk about sports, you won't go to jail. If you also ask after his kids, you won't go to jail. If you also "talked about going on joint vacations," as Goyal and Ray did, you won't go to jail.
If you hand him a bag of cash in a parking lot in exchange for the information he gives you, you'll go to jail. But really if you hand anyone a bag of cash in a parking lot you should be getting ready for prison. The law, under the personal benefit test, is clear and understandable and intuitive. As the U.S. Court of Appeals for the Second Circuit said in reversing Todd Newman's and Anthony Chiasson's conviction (which is what prosecutors are appealing here), "a breach of the duty of confidentiality is not fraudulent unless the tipper acts for personal benefit, that is to say, there is no breach unless the tipper 'is in effect selling the information to its recipient for cash, reciprocal information, or other things of value for himself.'"
So it's a clear rule, but also sort of a weird one. If you read it too literally, it would mean that, say, a corporate insider could give inside information to his brother, or an executive could give inside information to his golf buddy, and the brother or buddy could trade on it, and no one would get in trouble as long as no money changed hands. That doesn't seem quite right, does it? The Supreme Court also said in Dirks:
The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.
That's what's going on in the Salman case in the Ninth Circuit, decided earlier this month. There, banker Maher Kara allegedly passed inside information on to his brother Michael, who passed it along to Bassam Salman. Maher Kara "testified that he 'love[d] [his] brother very much' and that he gave Michael the inside information in order to 'benefit him' and to 'fulfill whatever needs he had.'" Salman argued that since Michael Kara never gave anything to Maher in return for the information, it couldn't be illegal insider trading. The Ninth Circuit disagreed. This seems intuitively sensible: Clearly Maher was passing the information on for personal reasons, not for job-related reasons, and everyone involved knew that. For one thing, they had no job-related reason to be discussing the information. For another, come on, they're brothers. As Judge Rakoff said in Salman:
If Salman’s theory were accepted and this evidence found to be insufficient, then a corporate insider or other person in possession of confidential and proprietary information would be free to disclose that information to her relatives, and they would be free to trade on it, provided only that she asked for no tangible compensation in return.
The typical golf-course case is similar: When a corporate executive tells his golf buddy about an upcoming merger, he's probably not doing it as part of his job. He's probably doing it to help his buddy make a little free money. It would be weird if that was legal.
So it's illegal "when an insider makes a gift of confidential information to a trading relative or friend." But if you read that too literally, you run right back into the first problem. There you are, at your job, talking on the phone with a company's investor relations department. The IR guy helps you with some questions about your model. You get off the phone convinced that the company is a buy. You go to buy stock. But wait. Your relationship with the IR guy is pretty cordial. You mentioned your love of fishing, and he said, "Hey, we ought to go fishing together sometime," and you said, "Sure, that sounds great," not that either of you meant it. Are you ... friends, now? Did he help you with the model because it's his job, or as "a gift of confidential information to a trading relative or friend"? Will you go to jail for using his information?
This really shouldn't be that hard a question. If an insider tells you about an upcoming merger and you split the profits on your trade: jail. If an insider tells you about an upcoming merger and also is your brother: jail. If the insider works in investor relations, and talks to investors as part of his job, and helps you with your earnings model: no jail, even if you talk on weekends and discuss hypothetical vacations. Most of the time, you know it when you see it. As the Second Circuit said in Newman:
This standard, although permissive, does not suggest that the Government may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature. If that were true, and the Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity. To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades “resemble trading by the insider himself followed by a gift of the profits to the recipient,” we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.
Emphasis added, and honestly the stuff after the emphasized part doesn't make sense to me. But you get the idea: If there's no possible legitimate business purpose for the tip, if it's obvious to everyone that this was an exchange of secret information between close friends, it's illegal. If it occurs in, or around, or plausibly close to, the ordinary course of investor/company interaction, it's not a crime. Even if you went to school together.
Still there is vagueness and uncertainty here; this standard isn't perfectly clear. But what's weird is that Newman is such a bad case for the government. It's not a close case. It's a case of an analyst talking to an investor relations guy. Sure there was a personal relationship -- they used to work together, they talked about vacations, etc. -- and sure the conversations were out of business hours and, apparently, out of bounds. But Newman and Chiasson were two levels removed from those conversations. They didn't know the details. They knew that an analyst talked to an investor relations employee at the company. That is what analysts, and investor relations employees, do, all day long. It would be very odd if Newman and Chiasson were guilty of a crime based on that.
Prosecutors obviously don't like the breadth of the Second Circuit's ruling in Newman. They're not alone; lots of politicians want to get rid of the personal benefit test. Salman, the Ninth Circuit ruling, is a good one for the government, finding that Newman shouldn't be read as broadly as some people -- including me -- initially thought. It's a ruling that the Supreme Court might well agree with.
But that's not the one getting appealed to the Supreme Court. Newman is, and the facts of Newman are terrible for the government. In pretty much every insider trading case that I've written about, whether or not the tippees paid the tippers for information, it was clear that they were conspiring with the tippers and knew they weren't supposed to have the information. Newman and Chiasson are the rare exception. Their alleged insider trading looks just like the normal work of stock analysis.
The Supreme Court doesn't have to take the case, though it takes most cases that the Justice Department asks it to. If it does, it's hard to imagine it going all that well for the government. Justice Antonin Scalia seems to be looking for an opportunity to narrow insider trading law. And it's hard to imagine the court broadening the law on these facts. Prosecutors catch unsympathetic insider traders all the time. But they're taking the sympathetic ones to the Supreme Court.
Three points for the lawyers:
- Citations are omitted here and in other quotations from the certiorari petition and other legal documents throughout this post.
- You don't "appeal" to the Supreme Court (except in rare cases not relevant here). The Justice Department, through the Solicitor General's office, filed a petition for a writ of certiorari. Which is like appealing, but with more Latin.
- The case is usually called "Newman," though it involves two people, Todd Newman and Anthony Chiasson.
And it is probably the case that any illegality here consists of Regulation FD violations -- companies telling investors things they weren't supposed to -- rather than insider trading violations. Reg FD is the company's problem, not the investor's. You won't go to jail for trading on an FD violation, though the company may be fined for it. But, you know: not legal advice!
I mean, it might still have been a violation of Dell policy. But Newman wasn't an expert on Dell's investor relations policies. The evidence that he knew this information was tainted was that, "Tortora told him that the Dell tips came from Goyal and that Goyal had a source inside Dell, and Newman knew that the Dell insider did the tipping at nights and on weekends rather than during normal business hours." So Newman's personal guilt here hinges on the nights-and-weekends thing.
The prosecutors also say that the information that Newman got was also "distinct from anything that might have trickled out from the company in the normal course in advance of a public announcement," but that is a weird assertion, since it did trickle out from the company in advance of the public announcement.
Incidentally, Tortora seems to have paid Goyal for the information, which is perhaps fishy, though investors do pay consultants and experts sometimes. And Goyal was not the insider, which is the important thing.
The cert petition says that they talked about it, but not that they did it, which sure makes it sound like a work friendship.
I mean, given current norms about insider trading law. Of course many smart people think it should be legal.
The Newman/Chiasson case also involves tips about Nvidia, which came from a finance employee, not an IR guy, and so are more suspect. But the pattern is similar: Again, Newman and Chiasson were very indirect tippees. And the Nvidia tipper (Chris Choi) and direct tippee (Hyung Lim) were not brothers, or golf buddies, or close friends. As the Second Circuit said:
Choi and Lim were merely casual acquaintances. The evidence did not establish a history of loans or personal favors between the two. During cross examination, Lim testified that he did not provide anything of value to Choi in exchange for the information. Lim further testified that Choi did not know that Lim was trading NVIDIA stock (and in fact for the relevant period Lim did not trade stock), thus undermining any inference that Choi intended to make a “gift” of the profits earned on any transaction based on confidential information.
The other notable oddity in Newman is that neither of the tippers (Ray and Choi) was ever charged with a crime, undermining the notion that their behavior was clearly criminal.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the author on this story:
Matt Levine at email@example.com
To contact the editor on this story:
Zara Kessler at firstname.lastname@example.org