The Don’t Ask, Don’t Tell Guide to Trading on Inside Information
On Friday, July 27, 2012, Phil Mickelson received a phone call. It wasn’t just any call; it was, according to the U.S. Securities and Exchange Commission, a transmission of business intelligence potentially worth millions of dollars. Mickelson’s friend, a gambler named William Walters, was calling to urge him to buy shares of Dean Foods. The Dallas-based dairy conglomerate was going to announce a spinoff of its organic foods unit the following week, and the company’s board thought it would cause Dean stock to pop. Walters had gotten the tip from the best possible source, a board member who’d participated in the conference call where the board encouraged the Dean chief executive officer to move ahead. It was about as close to a sure thing as you could get, and Walters, who understood odds better than most people, had already accumulated almost 4 million shares, an aggressive bet worth about $50 million.
The golf great was hardly a high-velocity stock trader. Mickelson, who’s made almost $80 million over his playing career, had never before invested in Dean, according to the government. Yet that following Monday and Tuesday, he allegedly purchased 200,240 shares, partly on margin, for $2.4 million. A week later, on Aug. 7, Dean announced the spinoff, and as the board had predicted, the stock shot up 40 percent. Walters made $17.1 million and Mickelson $931,000.
Three people, one a celebrity athlete, with access to internal information about a publicly traded company. Advantages the majority of investors in the market didn’t—and aren’t supposed to—have. Several perfectly timed trades yielding millions in profit. If one were to describe the transaction to a layperson, it’s likely that it would sound like a crime.
Securities investigations travel at an inchworm’s pace, and almost four years later, on May 19, the U.S. attorney for the Southern District of New York, Preet Bharara, stood in front of a room full of reporters to announce securities fraud charges against Walters and his source, former Dean board member Thomas Davis. Davis had cooperated and pleaded guilty; Walters had been arrested the night before. With the snappy language he’s known for—Bharara called Davis a “secret bug in the boardroom”—the U.S. attorney explained that Walters and Davis had used an anonymous prepaid cell phone and a code, “Dallas Cowboys,” to refer to the target company. “These bets were no gamble at all,” Bharara said of their trades, because Walters “had tomorrow’s headlines today.”
“Brazen insider trading continues to be a blot on our securities markets,” Bharara continued, “and the integrity of our markets continues to be a priority of our office.”
So why wasn’t Mickelson charged?
The answer is that certain kinds of behavior previously understood to be insider trading are now effectively legal—or at least not prosecutable. More than 20 years after the imprisonment of Ivan Boesky, the infamous arbitrageur, it’s become vastly harder to convict someone for insider trading—the result of several years of legal challenges that handed Wall Street an enormous victory. An appeals court ruling in December 2014 basically legalized the don’t-ask, don’t-tell information-gathering model employed by many hedge funds; it’s now OK to trade on questionable information that one receives secondhand, as long as you don’t know too much about how it was obtained.
Offering someone a pile of cash in exchange for confidential, market-moving intelligence is still clearly over the line. But to cite an example Bharara himself has used: Say a CEO knows his company is being taken over in a few weeks—he could, potentially, pass that information to a nephew for nothing in return, and the nephew and his friends could, in theory, trade on it. Alternatively, the CEO could share the plans with a bookie in exchange for forgiving a gambling debt. The bookie could then tell his friends to trade, who could then tell their friends to trade. As long as none of those further down the chain knew the tipper’s gambling debt was forgiven, they would be in the clear.
Is it fair for rich, well-connected individuals with access to valuable corporate information to freely make money from it? Or is that deeply unfair? “I don’t know that it gives traders carte blanche to break the law,” Richard Holwell, a federal judge who’s presided over major Wall Street trials, told Bloomberg News. “But it certainly makes it easier to get away with.”
The events that led to this new legal reality began in November 2010, when a group of dark, unmarked cars pulled up to an office building in Stamford, Conn. The SEC, FBI, and prosecutors from the Manhattan U.S. Attorney’s Office were in the midst of a major investigation into insider trading at multiple hedge funds. Raj Rajaratnam, the co-founder of the $7 billion-plus Galleon Group, had been arrested the previous October; government investigators were chasing down Rajaratnam’s connections, and their connections’ connections. One trader on the list was Todd Newman, a portfolio manager at the hedge fund Diamondback Capital. The FBI had come to Diamondback’s Stamford office to try to persuade Newman to cooperate, or else storm in and search the premises. While that was happening, a separate FBI squad was preparing to raid Level Global, a Manhattan hedge fund co-founded by Anthony Chiasson. A third fund, Boston’s Loch Capital, was also targeted. Soon, FBI agents were carting hard drives and cell phones out of major investment firms in broad daylight.
Chiasson and Newman were charged with insider trading in January 2012. But it wasn’t a typical case. Rather, the two were at the outer extremity of a ring of six traders and analysts the government accused of playing a sort of demented game of “broken telephone”—sharing and trading on material nonpublic information. Bharara called it a “criminal club.” In one example, an investor relations employee at Dell shared the computer maker’s internal financial information with a friend at an asset management firm. The friend passed it along to an analyst at Diamondback, who passed it along to his boss—Newman—as well as to a friend at Level Global, who passed it to his boss, Chiasson. Newman and Chiasson traded on the information. In all, they made over $70 million trading tech stocks this way, according to the government. It was unclear what, exactly, they knew about the source of the information, but it certainly looked suspicious.
The courts began to consider: Was this illegal—or simply what traders in the modern market do every day?
Much of the insider trading that occurred during the Boesky era was straightforward and transactional, sometimes involving suitcases of cash delivered by men in suits in hotel lobbies. By the early 2000s, the government saw insider trading as more amorphous, an exchange of favors, rumors, and sometimes hard numbers passed along for goodwill or expectations of career help. Traders cared less about one-off mergers and more about companies’ quarterly earnings. But while this new mechanism for making money was highly profitable and unavailable to average investors, prosecuting it was hard.
The market’s driven by rumors at all times, with stock prices yo-yoing in response to “whisper numbers” about earnings or word that a big investor is preparing to buy or sell. There are so many factors and information sources affecting a share price that getting “edge”—a term for valuable market information that others don’t have—doesn’t guarantee that a trader will even make money. “You people in the media, you think we’re all like monkeys, like we’re just sitting around waiting for the bananas, and when we get the bananas, we jump up and down and eat them,” a former Galleon trader told me. “But it takes a tremendous amount of talent to know what to do with the edge, even if you get it.”
Soon after charges were filed against Newman and Chiasson, their defense lawyers got to work. They saw a major hole in the government’s case, and they intended to drive an 18-wheeler right through it.
Insider trading has never been clearly defined by law. Rather, its contours have been shaped through a series of court decisions, as if a major form of securities crime were a piece of beach glass at the mercy of the waves. A major ruling came from the Supreme Court in 1983, in Dirks v. SEC, which held that for a crime to have been committed, an insider leaking company information must have disclosed the information in return for a benefit. Providing help or favors to a friend could count. It followed that anyone receiving the information secondhand could be found liable for trading on it only if they knew it was the bad kind of information, i.e., that the person who first gave it out got something in return.
By the time Newman and Chiasson’s cases went to trial, their lawyers, Stephen Fishbein, of Shearman & Sterling, and Gregory Morvillo, of Morvillo Law, respectively, were focused on the idea of “remote tippees”—people who are several steps removed from the original source of inside information. The information had flowed from Dell through two other people before reaching Newman; three for Chiasson. The lawyers argued that their clients had to have known that the original leaker had done something wrong—defined by having received a benefit—in order to have committed a crime themselves. The Dell source worked in the company’s investor relations department, which made the point harder to prove, since it was part of his job to share information with analysts. (In fact, the government hadn’t charged the Dell employee, implying he didn’t do anything illegal.) District Judge Richard Sullivan disagreed, the jury found Newman and Chiasson guilty, and they were sentenced to lengthy prison terms.
The men appealed, and two years later, in December 2014, the Second Circuit Court of Appeals issued a harsh rebuke to Bharara’s office, ruling that the U.S. Attorney had been too aggressive. Newman and Chiasson had their convictions overturned. The decision went far beyond simply clarifying that insider trading requires a person to know that the original source of a piece of information parted with it for a benefit; the court also ruled that the benefit had to be significant, an “exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” The hope of future career advice or casual friendship wasn’t enough. This sweeping change to the benefit requirement was a devastating blow to the government.
Bharara was enraged by the decision, publicly complaining that the precedent created an “obvious road map for unscrupulous investors.” Phones at the SEC started ringing off the hook, as defense lawyers called, trying to unravel or retract civil settlements that now looked weak.
The Supreme Court may clarify the situation when it rules on another insider trading case it agreed to take up in January, USA v. Salman. The court will rule on whether disclosing valuable information to help a relative—a brother in this case—qualifies as having received a personal benefit.
In the months after the Dean Foods trade, “Lefty,” as Mickelson is known, gave a clue as to the extent of his preoccupation with matters of money when, in January 2013, he complained about his high California tax rates and threatened to move to millionaire-friendly Florida: “If you add up all the federal and you look at the disability and the unemployment and the Social Security and the state, my tax rate is 62, 63 percent,” Mickelson said, according to the Associated Press. “So I’ve got to make some decisions.” He later apologized.
After Walters was charged, Mickelson tried to back away from the Walters-Davis train wreck. The SEC named Mickelson only as a “relief defendant,” meaning that he was seen to have received ill-gotten proceeds that he would be compelled to return but not as having engaged in unlawful behavior. “The complaint does not assert that Phil Mickelson violated the securities laws in any way. On that point, Phil feels vindicated,” Mickelson’s lawyer said in a statement. “At the same time, however, Phil has no desire to benefit from any transaction that the SEC sees as questionable.”
Experts and pundits quickly offered their own explanations for Mickelson’s seemingly miraculous escape. “The government can go after the original tippee, which is what they have done here,” says John Coffee, a Columbia law professor. But requiring proof that anyone else who traded on the information knew the original tipper was paid for it is too high a bar and will incentivize traders to simply not ask questions. “That is irrelevant information, it’s legally dangerous, and people don’t want to communicate it—and people don’t want to hear it,” Coffee says. “Wall Street runs as a favor bank, where people know if they get information today, they’ll get a favor tomorrow, and they keep it safe by never disclosing the source.”
At the May 19 press conference announcing the case, reporters in the room refused to cooperate with Bharara’s attempt to present the Walters indictment as a victory for justice and homed in on Mickelson’s glaring absence from the criminal charges. Martha Stewart, after all, did hard time.
“Why is it that Phil Mickelson is not charged in this?” a reporter asked as soon as the Q&A period began. Another chimed in: “Are you saying he didn’t realize he was going to be making money, that he’s an innocent person here?”
Bharara and Andrew Ceresney, the SEC’s head of enforcement, deflected the questions as best they could, but the subtext was clear: Mickelson wasn’t charged because of the Newman decision, the new precedent they all hated.
“I’m not going to comment,” Bharara said, more than once.
Finally, another, especially persistent reporter weighed in: “Doesn’t it undermine confidence in the markets to not charge the celebrity defendant and not explain why you are not charging the celebrity?” She added: “What message do you think that sends to the American public?”