Things are looking up for Michael Steinberg.

Photographer: Jonathan Fickies/Bloomberg

What's Next for Insider Trading Law?

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Yesterday the U.S. Court of Appeals for the Second Circuit handed down a big decision in an insider trading case. A really big decision. Here is a TV segment titled "Did Appeals Court Ruling Legalize Insider Trading?" That kind of big. We talked about the decision yesterday, but today let's look into some more of the potential implications. 

Starting with: What will happen to this case? Everything can be appealed, but most of the time the buck stops with an appellate panel like the one that just reversed the convictions of Todd Newman and Anthony Chiasson. The government could still seek review of yesterday's decision, either by asking for en banc review in the Second Circuit or by petitioning to the Supreme Court. But this is a forceful unanimous decision by three respected judges, and it would be downright uncollegial for the circuit to review it en banc.  The Supreme Court, meanwhile, doesn't take that many cases and has, if anything, shown some inclination to limit rather than expand insider trading law.

But there's a bigger point. The decision in this case strikes me as not only right but almost uncontroversial. After the oral argument, everyone thought that the appellate panel would reverse Newman and Chiasson's convictions. There really was essentially no evidence that they knew they were trading on inside information. This case was at the very outer limit of the recent series of insider trading prosecutions, and that limit turned out to be too far.

On the other hand, while this case was decided correctly, the opinion is strikingly broad. I said yesterday that even the most classic golf-buddy insider trading -- corporate chief executive officer tells golf buddy that his company is being taken over, buddy trades -- might be legal under the Second Circuit's reasoning,   because the opinion requires prosecutors to prove that the inside information was divulged for "at least a potential gain of a pecuniary or similarly valuable nature," and not just out of friendship. That conclusion might not have been necessary to reach the result in Newman's and Chiasson's case -- perhaps it could have been decided on narrower grounds. But courts tend not to take appeals just to clean up the language in opinions. Prosecutors would have a better chance of getting this very broad opinion overturned if the actual decision seemed like a great injustice. But it doesn't. The narrow decision is pretty sympathetic; the actual human beings who were on trial here seem innocent.

Lawyers like to say that "hard cases make bad law," and there's some of that going on here: Some sympathetic defendants and unusual facts have led to a quite striking narrowing of insider trading law. But that shouldn't be too much of a surprise, because insider trading law is entirely made by judges on a case-by-case basis.

That's worth emphasizing: There's no law against insider trading. You can't find a statute banning it. You can't even find a regulation banning it. From yesterday's opinion (citations omitted):

Section 10(b) of the 1934 Act prohibits the use “in connection with the purchase or sale of any security . . . [of] any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe . . . .” Although Section 10(b) was designed as a catch‐all clause to prevent fraudulent practices, neither the statute nor the regulations issued pursuant to it, including Rule 10b‐5, expressly prohibit insider trading. Rather, the unlawfulness of insider trading is predicated on the notion that insider trading is a type of securities fraud proscribed by Section 10(b) and Rule 10b‐5. 

Given that the law of insider trading is made up by judges on a case-by-case basis, you can see why some judges want to be careful about only convicting people who really knew they were doing something illegal. If judges aren't sure whether something is a crime, it's a bit hard to send people to prison for doing it.

So one potential result of this case would be, just, someone might write some insider trading rules. I'm not sure I'd count on Congress for that, but one intriguing possibility would be if the Securities and Exchange Commission decided to actually write some insider trading rules. It's done that, a bit, in the past. There's a rule against insider trading on tender offers, and that rule, unlike general insider trading lawdoesn't require that the person providing the information get anything of value for it. And there are definitional rules about regular insider trading, one saying that trading when you are "aware of" material nonpublic information constitutes trading "on the basis of" that information, and another defining who has a "duty of trust of confidence" to keep information confidential. There's just no rule actually banning it. But if the SEC doesn't like how judges define insider trading -- and it doesn't -- perhaps it could make some rules actually, you know, defining insider trading.

The SEC is authorized right there in the statute to write the rules -- it's the Commission in "such rules and regulations as the Commission may prescribe" -- but that doesn't mean it has complete power to make criminal law. Justice Antonin Scalia, in another insider trading case, recently suggested that the SEC's rules should not be binding on judges in criminal cases. But most insider trading cases aren't criminal. Most are SEC civil -- or administrative -- cases, where the penalties are fines or industry bans, not prison.

You could imagine insider trading law splitting on roughly the lines set out by the court yesterday. Classic, old-school, bags-of-cash-in-parking-lots insider trading, the sort that just looks criminal, would remain criminal. (Much insider trading is still illegal, even under the Second Circuit's ruling.) But the sort of diffuse networks of hedge funds that, in prosecutors' and the SEC's telling, run on inside information, would now be limited to civil, SEC enforcement. You know: money. If your hedge fund trades on inside information, you might pay a huge fine, and your hedge fund might be shut down. But jail may be off the table, unless you really knew you were getting inside information and paying bribes for it.

That doesn't seem like a terrible result to me, but I'm less enthused about imprisoning insider traders than a lot of people are. Intuitively, the divide until yesterday seemed to be that big insider trading cases tend to be criminal, because the sentencing guidelines, which are based on dollar amounts, give prosecutors a lot of leverage to get guilty pleas from people who made millions of dollars on possible insider trading. After the Second Circuit's ruling, the divide might be less about money and more about guilt: If you provably knew that you were corruptly obtaining information, then you go to jail, but if you just made a lot of money trading and got some tainted tips, you just have to give the money back.

One other question that comes up is what the effect of this decision will be on other pending cases. The most notable, perhaps, is that of Michael Steinberg, the SAC Capital portfolio manager convicted at a separate trial for basically the same set of facts as Newman and Chiasson. Steinberg traded based on tips from same set of tippers through same chain of "Fight Club" hedge fund analysts, so the result should be the same. That is, his appeal -- which is pending -- should succeed, and his conviction should be reversed. 

Now that's not necessarily true. Yesterday's decision was not about what happened, but about what was proved at trial. The record in Steinberg's trial is different from the record in Newman's and Chiasson's, and therefore the outcome might be different. Maybe in Steinberg's trial, prosecutors successfully proved that Chris Choi and Rob Ray -- the tippers responsible for Newman's and Chiasson's and Steinberg's information -- received a personal benefit for their tips, and that Steinberg knew about that benefit. I mean, no, that didn't happen, but prosecutors will get to argue it. I would not bet on their chances.  

Who else? Mathew Martoma's appeal is still pending. His odds do not look good. He was denied bail pending appeal because his case "lacks a 'substantial question' likely to result in a reversal." The big questions in yesterday's case were whether the tippers there were compensated, and whether Newman and Chiasson, who were far down in the tipping chain, knew about it. Martoma was convicted of getting inside information from a doctor who was working directly for him as a paid consultant. So, y'know. 

On the other hand, yesterday's appellate panel clearly thought that not only Newman and Chiasson, but everyone in their whole network of supposed insider traders, is probably not guilty. That covers Steinberg, but also six people who have pled guilty so far. Those people are probably mostly out of luck, but if their convictions aren't final they've got a shot.  I mean, this is fair enough:

Among those threatening to withdraw plea deals is Danny Kuo, a former Whittier Trust Co analyst who pleaded guilty in 2012 and turned cooperator. Roland Riopelle, Kuo's lawyer, said in an interview he had calls into the U.S. Attorney's Office. While he had not made a definite decision, the issue was "certainly worth studying."

"If there's no crime there, that's a good reason to withdraw your plea," he said.

The bigger effect, though, will be on cases that have nothing to do with this one, and that haven't yet been resolved. In cases where the alleged insider traders knew their sources, and knew that their sources were bribed, then prosecutors might have a bit more work to do to prove that beyond a reasonable doubt, but I'm not too worried about them rising to the challenge. In cases like Newman's and Chiasson's, though, where people are accused of insider trading based on nebulous third-hand tips rather than outright bribery, well, that might just not be a crime anymore.

  1. One of whom taught me securities law, which is maybe a strike against him.

  2. And there's no indication that anyone on the Second Circuit disagrees with it. Newman and Chiasson were previously granted bail pending appeal by a different Second Circuit panel, consisting of Guido Calabresi, José Cabranes and Barrington Parker. Parker was also on the merits panel and wrote yesterday's opinion, but Calabresi and Cabranes were not.

  3. I also told you not to take that as legal advice, dummy.

  4. And so it might only be what lawyers call "dicta," and not actual binding law.

  5. A tactical point. Footnote 5 of yesterday's opinion is about how prosecutors, somewhat nefariously, added Steinberg to Newman's and Chiarella's case, after their trial was over, because they wanted to ensure that his trial would take place before Judge Sullivan, the most pro-prosecutor judge in the Southern District for insider trading cases. But that strategy may have backfired. The appellate panel added Steinberg to the caption of the Newman/Chiasson case, because it was the same case as far as prosecutors, the district court, etc. were concerned. I don't know enough about Second Circuit procedure to answer this question, but it sure sounds like if it's the same case then it should be the same panel -- that is, prosecutors maneuvered Steinberg's case to get themselves a favorable district court judge, but perhaps at the cost of getting an unfavorable appellate panel. But I really am not sure about this.

  6. Kuo is in the Newman/Chiasson/etc. chain, pled guilty, but hasn't been sentenced yet.

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