Insider Trading: There Oughta Be a Law

Feel free to exchange stock tips, fellas.

Photographer: Richard Heathcote/Getty Images

When is insider trading against the law? It's a trick question: There is no actual law against insider trading.

This became painfully clear last month when a federal appeals court tossed out the criminal convictions of two Wall Street hedge-fund managers who had been found guilty of the offense about two years ago. The court not only exonerated the traders, but also called into question the entire body of law that has resulted in scores of such convictions over the last several years.

It may sound simplistic to respond to this state of affairs with the pat observation that there oughta be a law. But the best way to clear away the confusion and mistrust this decision has created is through legislation. Ideally, Congress would pass a law that defines and bans insider trading. More realistically, the Securities and Exchange Commission could clarify its rules on the subject.

The SEC issued rules long ago to prohibit trading on the basis of material nonpublic information revealed in violation of a fiduciary duty. Its authority is based on one provision in the Securities Exchange Act of 1934, which broadly bans frauds on the market.

This leaves plenty of wiggle room, and for decades, prosecutors have had to make do with common law. In 1983, the Supreme Court added a level of complexity by ruling that people receiving stock tips (tippees) must know that their sources (tippers) disclosed information in exchange for something of value -- money, a job, a promotion.

Over time, prosecutors expanded the definition of value to include career advice and even friendship, making it all but meaningless. And the more expansive the definition, the easier it was for aggressive prosecutors to feed the public's desire for Wall Street scalps and advance their careers.

Enter the U.S. Court of Appeals for the Second Circuit, which on Dec. 10 issued its sharply worded opinion: Because the two convicted tippees didn't even know the two tippers, never mind what benefits they may have received, they couldn't have committed insider trading. Nevertheless, it should be indisputable that the tippers in this case divulged material nonpublic information in breach of their fiduciary duty.

This is no way to apply criminal justice. For one thing, it will be a lot harder to prosecute friends who exchange valuable inside tips on the golf course on Sundays, then trade on the information on Mondays, so long as nothing of "consequential" value changes hands. For another, the U.S.'s ability to stanch Wall Street corruption is crimped. Tippees can avoid prosecution if information is passed along a chain designed to keep tippers anonymous.

What the U.S. needs is a proper statute -- one that doesn't shift shape depending on who is heading the SEC or who is the U.S. attorney for Manhattan. It must reach conduct that strikes the average investor as wrong and feeds the impression that the markets are rigged.

The SEC can and should refine its rules, but it would be far better for Congress to act. "Only the legislature may define crimes and fix punishments," as Supreme Court Justice Antonin Scalia wrote last year. "Congress cannot, through ambiguity, effectively leave that function to the courts, much less to the administrative bureaucracy."

This needn't be partisan. Both parties should want to avoid letting U.S. markets take on the appearance of a fool's game in which retail investors always lose and insiders always win. Trading stock on purloined information shouldn't be harder to prosecute than trading in stolen goods out of the back of a truck.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.