Justices Will Know Insider Trading When They See It
A loose but useful way to think about U.S. insider-trading law is that it is supposed to encourage research, but discourage cheating. 1 So if you read a company's financial statements, examine its stock chart, inspect its products, survey its customers, compare its competitors and otherwise do the work of obtaining information that could affect its stock price, you can go ahead and trade on that information, and we all hope that you are rewarded for your efforts with an above-market return. But if you just play golf with the chief executive officer, and he tells you that the company is being acquired next week, we don't want you trading on that information, and if you do we want you to be rewarded with prison.
That is the intuition. It is not quite the law. It is not quite the law because, in the real world, it is not always easy to distinguish research from cheating. In practice, a lot of the stuff that investors do to research a company involves talking to the company. 2 Sometimes this occurs out in the open, like on a public earnings call. Sometimes it occurs out in the semi-open, like at an industry conference. Sometimes it occurs in private conversations with the company's investor-relations employees, whose job is, as the title implies, to have conversations with investors. Sometimes it occurs in private conversations with the company's executive management. Sometimes, I suspect, it even occurs in private conversations with the chief executive officer on the golf course.
You could imagine a world in which we drew the line by just banning all non-public conversations between companies and their investors: Public sources are research, but private conversations are cheating. It would in some ways be a simpler world. But for the most part, in the U.S., that's not what we do. 3 We've concluded -- and the "we" here is pretty abstract -- that those private conversations can be good. We want shareholders to be able to have an open exchange of views with the managers they've hired to run the companies they own. We want them to develop good hard-hitting questions and demand honest answers. We want companies to be able to meet with investors to try to persuade them to buy stock. We want Bill Ackman to be able to call up Valeant's CEO and ask, "Mike, is there any fraud going on at the company?" These things feel like research; they make prices more accurate and markets more efficient, so we want to encourage them. 4
Still, just getting tips from the CEO on the golf course feels icky.
And so U.S. insider-trading law presents an interesting line-drawing problem. Very loosely, we're okay with you trading on material nonpublic information that you got from the company, but not so much with you trading on material nonpublic information that you got from your shady buddy at the company. Since companies can only act through humans, the way we say that is that if an insider gives you information as part of his job, you can trade on it, but if he gives you the information in breach of his duty to the company, then you can't trade on it.
Still, though, how can you tell? Part of the job of an investor-relations person, or of a CEO for that matter, is to develop good relationships with investors. Part of the job of an investment analyst is to develop good relationships with corporate management. A CEO and an investor might chat regularly, exchange small talk, be personally fond of each other, even play golf together. And the CEO might give that investor nonpublic information. And that might still be okay: Warm as their relationship might be, it is still essentially a business relationship, and their exchange of information is still done on the company's behalf rather than in breach of a duty to the company.
The way you can tell that it's a breach of duty is this:
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.
That's from a 1983 Supreme Court decision called Dirks v. SEC, and it makes a kind of rough sense. If the insider is getting a kickback for giving you the information, he's probably not doing it on behalf of the company: He's probably doing it for himself, and in breach of his duty to the company.
But the Dirks test doesn't entirely correspond to our intuitions. Sometimes it is too harsh: Every insider gets some benefit out of every disclosure, even if it is just the warm feeling of knowing that he helped out a business acquaintance. For a long while after Dirks, prosecutors were making arguments exactly like that: They had to prove a personal benefit to prove insider trading, but that was not a high bar; just the joy of helping out another human was enough of a personal benefit. But in December 2014, a federal appeals court in New York put a stop to that in its Newman decision, ruling that the personal-benefit requirement, "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," and that "in order to form the basis for a fraudulent breach, the personal benefit received in exchange for confidential information must be of some consequence." Giving someone inside information in exchange for a sack full of money: illegal. Giving someone inside information and getting a vague warm feeling in return: fine.
Prosecutors were very upset about Newman and tried to get the Supreme Court to reverse it, but the Supreme Court ignored them. And rightly so, I think. The Newman case involved hedge-fund analysts who got allegedly material nonpublic information from an investor-relations employee at Dell and passed it on to other investors. In exchange, the investor-relations employee got some vague "career advice." No one got sacks of money. There were some awkward facts, 5 but for the most part the case seemed to be on the research side of the research/cheating divide. Sending Newman to prison would make it harder for other investors to do their jobs of finding stuff out about companies. 6
But if you read the Dirks test to require a real benefit, then it might be too lenient for our intuitions. Sometimes an insider tip is obviously cheating, even though there's no quid pro quo. If a CEO and an activist hedge fund manager discuss ideas for improving the company together over a round of golf, and the hedge fund manager buys or sells stock based on the conversation, that could well be the sort of interaction that makes our capital markets more efficient. But if a CEO and his brother-in-law just enjoy playing golf together, and the CEO tips off the brother-in-law to an upcoming merger not as part of any business-related conversation but just to help a family member make money, there's no efficiency gain in that. That's just cheating. It would clearly be illegal for the CEO himself to trade on the information; giving it to a family member seems equally illegal and for the same reasons.
And so, even after Newman, courts don't take the personal benefit requirement too literally in friends-and-family cases. 7 The most important case is U.S. v. Salman, in which Bassam Salman was convicted of insider trading based on information about upcoming mergers that he got from his brother-in-law, Michael Kara, who in turn got it from his brother Maher Kara, who was an investment banker at Citigroup. 8 There was no evidence that Maher Kara got any quid pro quo in exchange for giving his brother the information. He just wanted to help:
Maher, for his part, 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.” For example, Maher testified that on one occasion, he received a call from Michael asking for a “favor,” requesting “information,” and explaining that he “owe[d] somebody.” After Michael turned down Maher’s offer of money, Maher gave him a tip about an upcoming acquisition instead.
Maher provided this information, he testified, to get Michael off his back. Maher explained: "The way that I thought I was helping myself was just by getting him off my back, and fulfilling whatever needs he had."
The personal benefit was not having to talk to his brother any more. After Newman, that doesn't seem like much of a personal benefit.
And yet this seems like cheating, not research. Maher Kara had no legitimate business purpose for giving this inside information to Michael Kara or Salman 10 ; Salman and Michael Kara did not come across it in the course of wide-ranging professional research into the companies they traded. Maher Kara just took information that didn't belong to him and gave it to a family member so he could make money off of it.
A federal appeals court in California affirmed Salman's conviction, ruling that "Proof that the insider disclosed material nonpublic information with the intent to benefit a trading relative or friend is sufficient to establish the breach of fiduciary duty element of insider trading." Like Newman, that decision seems to me to track standard insider-trading intuitions pretty well.
But today the Supreme Court announced that it will review Salman's conviction. Here are Salman's petition for review, the government's opposition and Salman's reply; here is a Bloomberg article. The Supreme Court will address this question from Salman's petition:
Does the personal benefit to the insider that is necessary to establish insider trading under Dirks v. SEC require proof of "an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature," as the Second Circuit held in United States v. Newman, or is it enough that the insider and the tippee shared a close family relationship, as the Ninth Circuit held in this case?
This strikes me as potentially a much bigger deal than Newman. To my eye, the appeals court decisions in both Newman and Salman correspond to longstanding intuitions about how insider-trading law is supposed to work: Businesslike use of nonpublic information for corporate purposes is legal, while personal use of nonpublic information for corrupt private purposes is not. The exact line-drawing can be tricky, but both appeals courts seem to have drawn the lines in sensible, intuitive, unsurprising ways.
Perhaps the Supreme Court agrees, and has taken the Salman case as a way to pat everyone on the back and affirm those decisions nationwide. 11 But it's also quite possible -- and, I think, more likely -- that the Supreme Court is taking this case to adjust the law. And if so, given that the Supreme Court is reviewing Salman and not Newman, the most likely outcome is that insider-trading law will get narrower rather than broader. 12
I've talked a lot about intuitions here, rather than laws; I've tried to explain insider trading in terms of concepts like "research" and "cheating" that appear nowhere in the law. Because there is barely any law: just a general prohibition against the use of "any manipulative or deceptive device or contrivance" in securities trading, and a long series of court decisions interpreting some kinds of insider trading as a violation of that prohibition. 13 Insider trading is illegal if and when it is "manipulative or deceptive," and it is "manipulative or deceptive" to the extent that our -- or rather, some judges' -- intuition says that it is cheating. You could imagine that judges who believe in the rule of law, and in the requirement that people should know in advance what the law is before they are sent to prison for breaking it, would find this an unsatisfactory state of affairs, and would want to give people like Salman, who is in a bit of an insider-trading gray area, the benefit of the doubt.
But Salman is only very barely in a gray area! Or rather, he is in a gray area of the law -- the borders of the Dirks/Newman personal-benefit test -- but not of the intuition. The facts of the case are about cheating, not about research, and if the Supreme Court lets him off, it will be on a legal technicality, not because he is in some moral sense blameless. Of course the Supreme Court is a court of law, not of intuition, and the legal technicality of "we forgot to make your conduct illegal" is a very good reason indeed to let someone off.
The Newman decision upset a lot of people. Bills were introduced in Congress. Prosecutors called it "dramatically wrong." Patrick Radden Keefe called it "unmistakably, a license to cheat." But it wasn't. It was an effort to draw the line between cheating and research. I think it got that line about right, and made it safer and more predictable for professional investors to go about their work without the risk of going to prison. Those bills in Congress went nowhere, because the Newman decision just wasn't really a problem.
But overturning Salman's conviction would be a license to cheat -- at least for a while. If the Supreme Court overturns Salman's conviction, it will be sending a clear message that our current insider-trading law does not at all match our intuitions about what it's supposed to do, that even clear and obvious cheating with corporate inside information is sometimes legal, just because no one ever thought to make a law against it. That would not necessarily be wrong: Really, no one did make a law against it, at least not a clear one. But I suspect that one result of such a decision would be that Congress would finally get around to making that law.
A loose but useful way to think about life is that anything that starts "a loose but useful way to think about" a law thing is not legal advice. Also nothing in this column is ever legal advice.
I have of course written endlessly about insider trading. In particular, I sometimes say that "people think it is illegal because it is unfair, but it is actually illegal because it is theft." I think that that is more or less how the law puts into practice our very fuzzy intuitions about cheating and research, but I also think that there are multiple ways of thinking about the problem. Today, let's not talk about "fairness" or "theft" anymore.
Or other potentially gray-area conversations, like:
- Talking to people who talked to the company -- like sell-side research analysts, or analysts at other buy-side firms.
- Talking to people who don't work for the company but who otherwise know secret stuff, like suppliers or customers.
Broadly speaking, European insider-trading law is much more about information parity than U.S. law is, and my suspicion is that this works in Europe mostly because it is not enforced.
The U.S. has an information-parity law too, though. It is called Regulation FD, and it purports to punish companies for disclosing material nonpublic information to favored investors, and my suspicion is that it too works mostly because it is not enforced. Companies meet with investors all the time, and investors benefit from those meetings, but Regulation FD enforcement is far rarer than insider-trading enforcement.
In any case, Regulation FD violations are the company's problem: If you go to a meeting with a company's investor-relations team, and they tell you stuff that they weren't supposed to, they will get in trouble, but you won't. This is of course extremely not legal advice.
Again, Regulation FD seems to cut the other way. We encourage investors to ask the questions, but we encourage companies not to answer, or at least, not to answer privately.
Most notably, the case also involved information from an employee at Nvidia who did not work in investor relations.
On the other hand, reversing Newman's conviction probably does make it easier for managers of large decentralized hedge funds to commit insider trading with impunity. I think that this effect is generally overstated, but it's certainly stated a lot.
This too comes from Dirks, which says: "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."
We talked about Salman here. It's an important case in part because it's a post-Newman federal appellate opinion on the "personal benefit" test (the only one I know of), and in part because the opinion was written by Jed Rakoff, a well-known New York federal judge who happened to be in California that week.
Incidentally, Salman argued that he didn't know the information came from an insider: He thought it came from Michael Kara, the non-insider brother-in-law who gave it to him, and didn't know it came from Maher Kara, the banker. In his petition for Supreme Court review, Salman asked the Court to review whether the government had done enough to prove that he displayed "willful blindness" and so should have been convicted of insider trading even though he didn't strictly know that the information came from an insider. This argument did not persuade the appeals court (which noted that "Michael Kara (who pled guilty and testified for the Government) testified that, early in the scheme, Salman asked where the information was coming from, and Michael told him, directly, that it came from Maher"), and the Supreme Court declined to consider it, granting review only on Salman's Question 1, about the personal benefit test.
Citations omitted, here and everywhere.
Actually, early in Maher Kara's career at Citi, he does seem to have had a business purpose in talking with Michael, though by the time of the trading here it seems to have vanished. From the court of appeals decision:
At first, Maher sought help from Michael, who held an undergraduate degree in chemistry, in understanding scientific concepts relevant to his work in the healthcare and biotechnology sectors. In 2004, when their father was dying of cancer, the focus of the brothers’ discussions shifted to companies that were active in the areas of oncology and pain management. Maher began to suspect that Michael was trading on the information they discussed, although Michael initially denied it. As time wore on, Michael became more brazen and more persistent in his requests for inside information, and Maher knowingly obliged.
It's entirely possible. In particular, if that were the case, it would make sense for the Supreme Court to take Salman and not Newman, because Salman is "a clean case" in which the personal-benefit test is directly implicated, while in Newman, even if the Supreme Court disagreed with the appeals court about the details of the personal benefit test, the defendants would still win: The appeals court found, and the government more or less conceded, that they didn't know about whatever personal benefit the tippers got, and that that knowledge was essential for illegal insider trading.
Or perhaps it will stay more or less the same, but be recast in some clearer and more intuitive way. Anything's possible! Obviously in my own writing -- like in this post! (or this one!) -- I am often trying to find clearer and more intuitive ways to recast insider trading law. And obviously the Supreme Court is welcome to use any of them that it likes. All I ask is a footnote.
The “manipulative and deceptive devices” prohibited by Section 10(b) of the Act (15 U.S.C. 78j) and § 240.10b-5 thereunder include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.
But even that is just a (biased) summary of the court decisions. The "Preliminary Note" to Rule 10b5-1 says that the rule is intended only to define "when a purchase or sale constitutes trading 'on the basis of' material nonpublic information," and that
The law of insider trading is otherwise defined by judicial opinions construing Rule 10b-5, and Rule 10b5-1 does not modify the scope of insider trading law in any other respect.
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